DP7685 | The Tip of the Iceberg: Modeling Trade Costs and Implications for Intra-Industry Reallocation

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When trade costs are of the iceberg type (Samuelson 1952) and markups are independent of trade costs, relative prices across markets are distorted, but relative prices within markets are not. When trade costs depart from the analytically convenient iceberg type, distortion will also occur within markets. In this paper we build a heterogeneous firm model of trade that allows for both iceberg and per-unit costs. An important theoretical finding is that these within-market distortions create an additional channel of gains from trade through within-industry reallocation. We fit the model to firm-level export data, by product and destination, using a novel minimum distance estimator and find that average per-unit costs, expressed relative to the consumer price, are 35-45%, depending on the elasticity of substitution. The pure iceberg model is therefore rejected. Finally, we calibrate the model and quantify the costs of protectionism. Simulations indicate that the welfare costs are roughly 50% higher when tariffs are per-unit compared to when they are iceberg.