Endogenous Markup, Per Capita Income and Population Size in the Gravity Equation

Abstract

Abstract While recent studies use asymmetric trade costs and non-homothetic preference to explain why trade grows strongly with income per capita, this paper proposes a new explanation using a random search framework based on Burdett and Judd (1983). I show that the values of international trade flows as a share of income are generally larger in high-income countries because the markups in high-income countries are generally larger than those in low-income countries. In addition, firms’ price setting strategy creates an endogenous wedge between bilateral trade flow and gains from trade.