Specialization, market access and real income

This paper estimates the impact of external demand shocks on real income. We utilize a first order approximation to a wide class of small open economy models that feature sector-level gravity in trade flows, which allows us to measure foreign shocks and characterize their welfare impact in terms of reduced-form elasticities. We use machine learning techniques to group 4-digit manufacturing sectors into a smaller number of clusters, and show that the cluster-level elasticities of income with respect to foreign shocks can be estimated using high-dimensional statistical techniques. Foreign demand shocks in complex intermediate and capital goods have large positive impacts on real income, whereas impacts in other sectors are negligible. We show that the estimates imply that countries that specialize in these sectors enjoy greater gains from increased openness, and that (small) export subsidies to these sectors are welfare-improving. Finally, a calibrated multi-sector production and trade model with input–output linkages and external economies of scale can match the empirical estimates.