Demand Risk and Diversification through International Trade

Abstract

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 spatial correlation of demand across countries to lower the variance of their global sales. I show that the model-consistent measure of demand risk, the “Diversification Index”, depends on the multilateral covariance of a country's demand with all other markets. The model implies that both the probability of entry and the level of trade flows to a market are increasing in the Diversification Index. The firms' risk diversification behavior can generate, upon a trade liberalization, a strong competitive pressure on prices, which in general equilibrium can lead to higher welfare gains from trade than the ones predicted by trade models with risk neutrality. To assess the quantitative relevance of the risk diversification channel, I rely on a panel of domestic and international sales of Portuguese firms. I estimate “risk-augmented” gravity regressions at the firm and country level, and show that the Diversification Index significantly affects trade patterns at the extensive and intensive margins. Once I structurally estimate the model, I document that the risk diversification channel explains 15% of the observed trade patterns, and increases welfare gains from trade by 16% relative to models with risk neutrality. Finally, the quantitative application highlights the role of demand uncertainty in shaping the economic consequences of the recent integration of China in the global economy.