Revisiting the sectoral Linder hypothesis: Aggregation bias or fixed costs?

Abstract

AbstractThis paper reassesses and revisits the Sectoral Linder Hypothesis due to Hallak, which posits that similar tastes for quality lead to more intensive trade between similar countries at the sectoral level. First, the measure of demand similarity used in this paper is based on the distribution of income estimated from household surveys. The paper finds that a similarity measure based on the income distribution produces stronger results than the traditionally used measure based on GDP per capita. Moreover, the country/product level extensive margin is taken into account. This is important because similarity is likely to affect the fixed costs of trade and the fixed costs of alternative means of servicing a market (i.e., licensing and FDI). Fixed costs, in turn, affect the number and average productivity of firms that engage in bilateral trade and hence the overall volume of trade. This paper employs the method by Helpman et al. to control for the extensive margin. Heteroskedasticity is addressed using a feasible generalized least squares (FGLS) approach. The findings show that once controlling for the effect of similarity on the extensive margin, the Linder hypothesis holds at more aggregate levels. Other robustness checks suggest that results are not confined to products that are vertically differentiated.