Explaining Home Bias in Trade: The Role of Time Costs

Abstract

We study how time costs, combined with elasticity of substitution across home and foreign goods, can explain the home bias puzzle in a framework of flexible prices. Using a simple two-country model, we show that introducing time costs to an otherwise standard competitive model improves its ability to rationalize home bias in trade. Our analysis suggests that home bias and corresponding incomplete risk-sharing naturally arise in the presence of time costs, even under the assumption of complete financial markets and low elasticity of substitution between home and foreign goods.