Inequality, Nonhomothetic Preferences, And Trade: A Gravity Approach

Abstract

We construct the first direct classification of goods as luxuries or necessities that is compatible with international trade data. We then use it to test an idea that has not been tested directly in the literature: countries' income distributions are important determinants of their import demand, and in particular of the difference in their import demands of luxuries versus necessities. We interpret this result with the aid of a model in which preferences are nonhomothetic, thus relaxing a long-held and standard - but empirically dubious - assumption in the theory of international trade. Our model is strongly borne out by the results: imports of luxuries increase with importing country's inequality, and imports of necessities decrease with it. Our calculations imply that if income distribution in the United States became as equal as in Canada, the US would import about 9 - 13% less in luxury goods and 13 - 19% more in necessity goods.