Cultural Proximity and Production Networks

We examine how cultural proximity shapes production networks, and affects aggregate welfare and productivity. We combine a new dataset of firm-to-firm trade for a large Indian state with information on cultural proximity between firms derived from India’s caste and religious classifications. We find that cultural proximity reduces prices and fosters trade at both intensive and extensive margins. We argue that these results are driven by increasing trust between firms, which in turn solves contracting frictions. We then propose a quantitative firm-level production network model, where cultural proximity influences trade and matching costs. We derive estimable equations from the model and estimate parameters leveraging variation in the cultural group composition of firm owners. Our counterfactual exercises indicate that social inclusion policies raise welfare by as much as 1.76%, while social isolation lowers welfare by 1.45%. Reducing contracting frictions increases welfare by 0.87% as trade becomes less reliant on cultural proximity