Product heterogeneity, cross-country taste differences, and the growth of world trade

This paper extends the analysis of the “home market” effect in Krugman (1980) to a flexible demand structure and examines the dynamic effects of trade liberalization. I first develop a model in which consumers are heterogeneous in their valuations of product attributes and firms offer goods of heterogeneous attribute levels. With international trade in the presence of cross-country taste differences, consumption is home-biased in the immediate aftermath of liberalization. Once industries specialize, the volume of trade grows and so do the gains from liberalization. In the long-run equilibrium with open markets, the volume of trade is diminished by the existence of cross-country taste differences only if countries specialize completely. I then show that the adaptation of industrial composition to the demand structure of the European common market was associated with growing within-European trade in the automotive industry.