In international trade models, the assumption of homothetic preferences ensures that income elasticities of demand are equal to one, allowing the analysis to focus on the supply side. Over the years, many important insights have been facilitated by this assumption. These include the idea that differing factor proportions can motivate trade, as well as more recent discoveries about firm behavior in an international trade setting. However the assumption of homothetic preferences has been questioned from an empirical standpoint. In particular, we do not observe an income elasticity of demand equal to one in the data. When preferences are assumed to be non-homothetic instead, so that aggregate demand varies with aggregate income as well as the income distribution, the focus of the analysis shifts to the demand side.
The Linder hypothesis is perhaps the best known argument featuring a central role for the demand side in the determination of trade patterns. Consumers earning similar incomes consume similar baskets of goods, which in turn drives specialization in production and hence exporting to countries where incomes are similar. Underpinning this specialization, the higher the average national income level, the higher the average quality of goods produced and consumed. This leads countries at a given income level to specialize and trade amongst themselves at a corresponding level of product quality.
Linder proposed this as a competing hypothesis to the idea that trade is driven by relative factor proportions as in the Heckscher-Ohlin (H-O) model, which was the dominant hypothesis explaining international trade at the time. His motivation was that the majority of world trade occurred between similar rich countries, which the H-O model had difficulty explaining. This was also the motivation behind the development of the increasing-returns-based trade literature. In certain respects, it was also the motivation behind the more recent ‘Ricardian revival’, which shows that variations in technology play a significant role in explaining world trade patterns. A new empirical literature is emerging to assess the role of non-homothetic preferences. The findings so far suggest that demand-side factors may be at least as important as those on the supply side in explaining world trade patterns.
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