Volatility and the Gains from Trade
By reducing the negative correlation between local prices and productivity shocks, trade liberalization changes the volatility of returns. In this paper, we explore the second moment effects of trade. Using forty years of agricultural micro-data from India, we show that falling trade costs increased farmer's revenue volatility, causing farmers to shift production toward crops with less risky yields. We then characterize how volatility affects farmer's crop allocation using a portfolio choice framework where returns are determined in general equilibrium by a many-location, many-good Ricardian trade model with flexible trade costs. Finally, we structurally estimate the model—recovering farmers' unobserved risk-return preferences from the gradient of the mean-variance frontier at their observed crop choice—to quantify the second moment effects of trade. While the expansion of the Indian highway network would have increased the volatility of farmer's real income had their crop choice remained constant, by changing what they produced farmers were able to avoid this increased volatility and amplify the gains from trade.
We thank Costas Arkolakis, Kyle Bagwell, Dave Donaldson, Jonathan Eaton, Marcel Fafchamps, Pablo Fajgelbaum, Sam Kortum, Rocco Machiavello, Kiminori Matsuyama, John McLaren, Steve Redding, Andres Rodriguez-Clare, Esteban Rossi-Hansberg, Chang-Tai Hsieh, Andy Skrzypacz, Jon Vogel and seminar participants at Columbia University, George Washington University, Harvard University, the NBER ITI Winter Meetings, Pennsylvania State University, Princeton University, Princeton IES Summer Workshop, Purdue University, Stanford University, University of British Columbia, University of California - Berkeley, University of California - Davis, University of North Carolina, University of Toronto, and University of Virginia. We thank Scott Fulford for kindly providing the rural bank data we use. Rodrigo Adao, Fatima Aqeel, Masao Fukui, Annekatrin Lüdecke, and Yuta Takahashi provided exceptional research assistance. Part of this paper was completed while Allen was a visitor at the Stanford Institute for Economic Policy Research (SIEPR), whose hospitality he gratefully acknowledges. All errors are our own. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
- By strategically reallocating crops, Indian farmers were able to hedge against increased volatility and increase the total gains from...