International Trade Puzzles: A Solution Linking Production and Preferences

International trade literature tends to focus heavily on the production side of general equilibrium, leaving us with a number of empirical puzzles. There is, for example, considerably less world trade than predicted by Heckscher-Ohlin-Vanek (HOV) models. Trade among rich countries is higher and trade between rich and poor countries lower than suggested by HOV and other supply-driven theories, and trade-to-GDP ratios are higher in rich countries. Our approach focuses on the relationship between characteristics of goods and services in production and characteristics of preferences. In particular, we find a strong and significant positive correlation of more than 45% between a good’s skilled-labor intensity and its income elasticity, even when accounting for trade costs and cross-country price differences. Exploring the implications of this correlation for empirical trade puzzles, we find that it can reduce HOV’s overprediction of the variance of the net factor content of trade relative to that in the data by about 60%. Since rich countries are relatively skilled-labor abundant, they are relatively specialized in consuming the same goods and services that they are specialized in producing, and so trade more with one another than with poor countries. We also find a positive sector-level correlation between income elasticity and a sector’s tradability, which helps explain the higher trade-to-GDP ratios in high-income relative to low-income countries. JEL Codes: F10, F16, O10.