Entrepreneurial Risk and Diversification through Trade

Abstract

In this paper I develop a theory of risk diversification through geography. In a general equilibrium trade model with monopolistic competition, characterized by stochastic demand, risk-averse entrepreneurs exploit the imperfect correlation of demand across countries to lower the variance of their total sales. I provide an analytical characterization of the firm’s problem, and show that both entry and trade flows to a market are affected by its risk-return profile, which in turn depends on the multilateral covariance of the country's demand with all other markets. In addition, I show that such firm-level risk diversification behavior has important general equilibrium implications for the welfare gains from trade, which can be higher than the gains predicted by standard trade models. In the second part of the paper, I use data on Portuguese firm-level domestic and international sales to provide evidence that the risk-return trade-off is an important driver of observed trade patterns, both on the extensive and intensive margins. Finally, once I structurally estimate the model, I show that the risk diversification channel has a non-trivial effect on the welfare gains from trade, which are, on average, 9% higher than in traditional models with risk neutrality.

Keywords: Risk diversification, demand shocks, international trade patterns, welfare gains from trade

JEL Classification: F10, F14, F15