Volatility and the Gains from Trade
Trade liberalization changes the volatility of returns by reducing the negative correlation between local prices and productivity shocks. In this paper, we explore these second moment effects of trade. Using forty years of agricultural micro-data from India, we show that falling trade costs due to expansions of the Indian highway network reduced the responsiveness of local prices to local rainfall but increased the responsiveness of local prices to prices elsewhere. In response, farmers shifted their production toward crops with less volatile yields, especially so for those with poor access to risk mitigating technologies such as banks. 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' risk-return preferences from the gradient of the mean-variance frontier at their observed crop choices—to quantify the second moment effects of trade. We find that first moment gains from specialization dominate second moment effects on average and that improvements in risk-mitigating technologies would encourage farmers to take advantage of higher-risk higher-return allocations, with the strength of these effects hinging on whether the riskiest crops are also the comparative advantage ones.
We thank Costas Arkolakis, Kyle Bagwell, Dave Donaldson, Jonathan Eaton, Marcel Fafchamps, Pablo Fajgelbaum, Chang-Tai Hsieh, Sam Kortum, Yu-Jhih Luo, Rocco Machiavello, Kiminori Matsuyama, John McLaren, Nina Pavcnik, Steve Redding, Andres Rodriguez-Clare, Esteban Rossi-Hansberg, Andy Skrzypacz, Bob Staiger, Jon Vogel and seminar participants at Columbia University, Dartmouth College, George Washington University, Harvard University, University of Maryland, 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, Daniel O'Connor, Saptarshi Majumdar, 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. This material is based upon work supported by the National Science Foundation under grant SES-1658838. 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...