NBER WORKING PAPER SERIES
GLOBALIZATION AND THE GAINS FROM VARIETY
Christian Broda
David E. Weinstein
Working Paper 10314
http://www.nber.org/papers/w10314
NATIONAL BUREAU OF ECONOMIC RESEARCH
1050 Massachusetts Avenue
Cambridge, MA 02138
February 2004
We would to thank Alan Deardorff, Robert Feenstra, Jonathan Eaton, Amartya Lahiri, Mary Amiti, and Kei-
Mu Yi for excellent comments and suggestions. Rachel Polimeni provided us with outstanding research
assistance. David Weinstein was at the Federal Reserve Bank of New York when most of this research was
done. In addition, he would like to thank the Center for Japanese Economy and Business for research support.
The views expressed herein are those of the authors and not necessarily those of the National Bureau of
Economic Research.
©2004 by Christian Broda and David E. Weinstein. All rights reserved. Short sections of text, not to exceed
two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is
given to the source.
Globalization and the Gains from Variety
Christian Broda and David E. Weinstein
NBER Working Paper No. 10314
February 2004
JEL No. F1, E3
ABSTRACT
Since the seminal work of Krugman (1979), product variety has played a central role in models of
trade and growth. In spite of the general use of love-of-variety models, there has been no systematic
study of how the import of new varieties has contributed to national welfare gains in the United
States. In this paper we show that the unmeasured growth in product variety from US imports has
been an important source of gains from trade over the last three decades (1972-2001). Using
extremely disaggregated data, we show that the number of imported product varieties has increased
by a factor of four. We also estimate the elasticities of substitution for each available category at the
same level of aggregation, and describe their behavior across time and SITC-5 industries. Using
these estimates we develop an exact price index and find that the upward bias in the conventional
import price index is approximately 1.2 percent per year. The magnitude of this bias suggests that
the welfare gains from variety growth in imports alone are 2.8 percent of GDP.
Christian Broda
Federal Reserve Bank of New York
christian.broda@ny.frb.org
David E. Weinstein
Columbia University, Department of Economics
420 W. 118th Street
MC 3308
New York, NY 10027
and NBER
dew35@columbia.edu
Globalization and the Gains from Variety
I) Introduction
It is striking that in the quarter-century since Krugman (1979) revolutionized
international trade theory by modeling how countries could gain from trade through the import of
new varieties, no one has structurally estimated the impact of increased variety on aggregate
welfare. As a result, our understanding of the importance of new trade theory for national
welfare rests on conjecture, calibration, and case studies. This paper represents the first attempt
to provide an answer to the question of how much increases in traded varieties matter for the US.
Analyzing the most disaggregated US import data available for the period between 1972 and
2001, we find that consumers have low elasticities of substitution across similar goods produced
in different countries. This establishes the reasonableness of a key assumption underlying the
Dixit-Stiglitz (1977) framework – namely, that consumers value variety. Moreover, we find that
the four-fold increase in available global varieties arising in the last 30 years has produced a
large welfare gain for the United States. Increases in imported varieties have raised US real
income by about 3 percent. In short, our results provide stunning confirmation of the importance
of thinking about international trade within the Dixit-Stiglitz framework.
In order to generate these point estimates, our work makes contributions to a number of
literatures. The first is toward the measurement of prices. One of the major problems confronting
economists is how to build an aggregate price index that allows for the creation of new goods
and varieties. While there is general agreement that this is important, efforts to accomplish it
2
have proved elusive.
1
As a result, economists have taken two approaches to the problem, neither
of which is ultimately satisfying. Following the pioneering work of Hausman (1981), one
strategy has been to estimate the price drop implied by the existence of an individual new good,
e.g. Apple-Cinnamon Cheerios. A second approach is to make extreme assumptions about how
new goods are valued, e.g. all varieties enter into utility virtually identically (Romer (1994)).
Unfortunately, the extreme data requirements of the Hausman methodology has limited its
application to only a handful of goods while the extreme assumptions of the second approach
raise questions about the validity of the calculations.
The starting point for our analysis is the seminal work of Feenstra (1994). In this paper,
Feenstra develops a robust and easily implementable methodology for measuring the impact of
new varieties on an exact price index of a single good using only the data available in a typical
trade database. Unfortunately, his approach has two drawbacks that have prevented researchers
from adopting it more widely. First, it is computationally extremely intensive. As a result,
Feenstra only applied the methodology to 8 goods – far fewer than the 30,000 necessary to
reconstruct the US import price index over the last 30 years. Second, Feenstra’s methodology
tends to generate a large number of elasticities that take on imaginary values, which are hard to
interpret. This paper solves both problems – the first through higher processor speed and the
second by modifying Feenstra’s estimation strategy – and demonstrates the relative ease with
which the Feenstra sub-indexes can be used to compute an aggregate price index.
To calculate an aggregate import price index, we first have to estimate a number of
parameters that are of wide interest. This constitutes our second contribution. In particular, we
1
For example, Charles Shultze (2003, p. 19) writes, “The [National Academy of Sciences panel on the CPI]
recognized that research into the welfare effects associated with new goods is important and should be pursued. But
it emphasized the immense practical difficulties in the way of providing estimates of demand curves and virtual
prices, especially if done across the large number and wide variety of products that would be required.”
3
estimate elasticities of substitution among goods at various levels of aggregation. At the lowest
level of aggregation available for trade data (8-digit for 1972-1988 and 10-digit for 1990-2001)
we estimate almost 30,000 elasticities. This enables us to directly test a number of important
stylized facts. For example, we directly demonstrate the validity of Rauch’s (1999) conjecture
that goods traded on organized exchanges are indeed more substitutable than those which are
not. We are able to document that varieties appear to be closer substitutes the more disaggregate
the product category. We also find that the median elasticity of substitution has fallen over time
indicating that traded goods have become more differentiated. In sum, we develop the most
comprehensive examination of elasticities of substitution that has ever been attempted.
We then use these estimated parameters to reconstruct the US import price index while
hewing very closely to theory. Starting with the constant elasticity of substitution utility function
which underlies the Spence-Dixit-Stiglitz (henceforth SDS) framework, we compute an exact
aggregate price index for the CES utility function that allows for changes in varieties. Since this
is the same assumption that is used in much of the new trade theory, economic geography, and
growth literatures (Helpman and Krugman (1985), Grossman and Helpman (1991), Fujita,
Krugman, and Venables (1999)), our estimates can be directly applied to these literatures. Our
results suggest that the impact of increased choice on an exact price index has been enormous.
Whereas previous authors have found small changes in import prices and the terms of trade as a
result of variety changes, our study finds that price indices that do not take new and disappearing
varieties into account seriously overestimate import price increases. Over the last thirty years, if
one adjusts for new varieties, import prices have been falling 1.2 percent per year faster than one
would surmise from official statistics. In aggregate terms this means that the aggregate price
