Can Multi-Stage Production Explain the Home Bias in Trade?

Kei-Mu Yi

Federal Reserve Bank of Philadelphia

November 2008

WP 08-12/R – A large empirical literature finds that there is too little international trade, and too much intra-national trade to be rationalized by observed international trade costs such as tariffs and transport costs.

The literature uses frameworks in which the nature of production is assumed to be unaffected by trade costs. This paper investigates whether a model in which the nature of production can change in response to trade costs — a framework with multi-stage production — can better explain the home bias in trade. The author finds that the model can explain about 2/5 of the Canada border effect; this is about two-and-one-half times what a model with one stage of production can explain. The model also explains a significant fraction of a key dimension of Canada-U.S. trade, the high degree of "back-and-forth" trade or vertical specialization.

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