Openness Is a Matter of Degree: How Trade Costs Reduce Demand Elasticities

The relative costs of trading different goods vary independently of the relative costs of producing them. The costs of trade are also often high. As a result, producer price elasticities of demand in economies that trade are usually much lower than purchaser price elasticities. Trade costs could thus explain why cross-country variation in the composition of output is much less sensitive to variation in relative production costs (or comparative advantage) than is predicted by standard open-economy models, in which demand elasticities are infinite. However, this sensitivity is greater in countries with lower trade costs – which are consequently ‘more open’.