Development accounting and international trade

Development accounting shows that a significant part of cross-country income differences is attributed to differences in total factor productivity (TFP), but the sources of TFP differences are not well understood. This paper considers the role of international trade to explain cross-country income differences in TFP. By using a multi-country Ricardian trade model, I distinguish trade costs and trade policy factors from a pure technology factor in TFP. Under the baseline parameterization, my model shows that conventional TFP measures overestimate fundamental productivity differences by 30%. I then show that trade costs significantly influence welfare: small European countries enjoy 10 - 15% higher welfare through their proximity to larger and more productive neigh- boring countries, while Oceanian and countries in southern Africa suffer from 10 - 20% lower welfare due to their remoteness. Trade policy also has impacts: tariffs decrease welfare by 1 - 10%, while free-trade agreements increase welfare by 1 - 5%. These gains from trade are considerably smaller if general equilibrium effects are not considered.