Distribution capital and the short- and long-run import demand elasticity

Abstract

The elasticity of substitution between home and foreign goods is one of the most important parameters in international economics. The international macro literature, which is primarily concerned with short-run business cycle fluctuations, assigns a low value to this parameter. The international trade literature, which is more concerned with long-run changes in trade flows following a change in relative prices, assigns a high value to this parameter. This paper constructs a model where this discrepancy between the short- and long-run elasticities is due to frictions in distribution. Goods need to be combined with a local non-traded input, distribution capital, which is good specific. Home and foreign goods may be close substitutes, but if distribution capital is slow to adjust then agents cannot shift their consumption in the short run following a change in relative prices, and home and foreign goods appear as poor substitutes in the short run. In the long run this distribution capital can be reallocated, and agents can shift their purchases following a change in relative prices. Thus the observed substitutability gets larger as time passes.