Markups, Production Relocation, and the Gains from Trade

Abstract This paper develops a multisector, multicountry model of international trade and profit shifting that embeds imperfect competition into Eaton and Kortum (2002)’s Ricardian trade model and allows markup distributions for both imports and exports to vary across sectors and countries. We first show theoretically how the gains from trade liberalization depend on the markup distribution for imported relative to exported goods. To bring the model to the data, we estimate both trade elasticities and a rich set of country- and industry-specific import demand elasticities for over 36,000 distinct sector-country pairs. We find that cross-country heterogeneities in export markups relative to import markups are a first-order determinant of the gains from trade and especially the welfare losses from tariffs. By flexibly taking heterogeneity in markups into account, these losses are up to three times larger for net exporters of high-markup products. We apply our model to the 2018–19 U.S.–China trade war and show that U.S. welfare losses from the tariff war are more than twice as high once markups and profit shifting are taken into account, whereas China benefited slightly overall.