Trade in Intermediate Goods and the Welfare Gain From International Trade

In this paper, we introduce a general equilibrium model of international trade that takes into account the industry linkages between intermediate goods and consumption goods producers to quantitatively measure the countries welfare gains and losses from different trade policies on intermediate and consumption goods. Our model extends the inter-industry trade model of Ricardo (1817), intra-industry model of Krugman (1980), and firm heterogeneous model of Melitz (2003). Reduction of tariffs affect welfare of countries through direct effects on income, cost of export, and cost of input bundles of production (labor and intermediate goods), and indirectly through changes in term of trades, and endogenous entries and exits in many industries due to the general equilibrium adjustment of the input-output linkages. The model have three main implication on estimating the welfare gain from trade. First, since the share of domestic production in expenditure of an industry can correspond to different shares of domestic production in consumption and intermediate goods expenditure on that industry, taking not into account some differences between intermediate and consumption goods (as it common in the literature) can significantly distort the estimated welfare gains from trade. Second, only the elasticities of substitution of intermediate goods sectors affect the welfare gain from trade. Third, the trade elasticities of consumption goods have much lower effect on welfare gain from trade than trade elasticities of intermediate goods. By taking the model into data, we show that the median of welfare loss of countries from moving from free trade in intermediate goods is more severe than the same policy on consumption goods.