Love of variety and gains from trade

Abstract

We show analytically and quantitatively how gains from trade depend on love of variety, defined as the extent to which an additional product variety generates benefits in either final or intermediate consumption. To do this, we use a multi-country, multi-sector heterogeneous-firm gravity trade model where love of variety is parameterized separately from product substitutability using a generalized CES demand function. Counterfactual simulations based on a calibrated version of this model show that the gains from trade commonly vary by a proportion of one to three depending on the value of the love-of-variety elasticity. Trade war simulations also point to the strong sensitivity of the assessed impacts. We conclude that love of variety may be an important determinant of the gains from trade, an aspect that has so far been overlooked for the sake of convenience in the modeling framework and due to lack of empirical estimates.