Heterogeneous Internal Trade Cost and Its Implications in Trade

Contrary to the convenient assumption, this paper shows that internal trade cost is heterogeneous across countries. This heterogeneous internal trade cost contaminates the importer fixed effect in a ratio type gravity estimation making exporter fixed effect a better measure of country’s competitiveness. Further quantification analysis shows that R&D data can approximate country level technology parameter quite well after netting out the effect from internal trade cost and the model with internal trade cost can match real income data very well. The model with internal trade cost is not only consistent with price data but also outperforms other alternatives in fitting R&D data. This paper offers a novel answer to the question why small countries export less than large ones. That is small countries trade more with themselves because of lower internal trade costs they have.