Market potential and economic development with non-homotheticity

Abstract

We investigate the relationship between GDP per capita, trade costs, demand, and income inequality between 1996 and 2011. Specifically we apply the aggregate AIDS-based gravity model as developed in Fajgelbaum and Khandelwal (2016) to a panel of 40 countries to generate a new measure of market potential. We then relate this measure of market potential to country level GDP per capita finding a significant positive relationship which performs better than CES-based measures of market potential. The AIDS model allows for non-homotheticities in demand and the possibility that nations produce goods with higher or lower income elasticities. Income inequality and GDP per capita of trade partners matter for domestic incomes but interact with these elasticities. Our paper shows that LDCs that export products with low income elasticities like India and China rank much lower in market potential than in a CES or a translog specification.