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

The relative costs of trading different goods vary much less than the relative costs of producing them. The costs of trade are also often high. In consequence, as this paper shows theoretically and with simulations, demand elasticities in open economies are much lower than substitution elasticities between different national varieties of goods. Output structures in open economies thus respond to variation of relative production costs in qualitatively the same way as in closed economies, in sharp contrast to what standard trade theory predicts, but the degree of responsiveness tends to be higher in countries with lower trade costs.