The Home Bias in Trade International Finance Puzzle - dummies

The Home Bias in Trade International Finance Puzzle

By Ayse Evrensel

The home bias in trade puzzle refers to the concept that people have a strong preference for consumption of their home goods. Empirical evidence indicates that, within a country trade is much larger than international trade, which suggests a bias for home goods. This observation implies that international goods markets may be much more segmented than one usually assumes.

The existence of national borders may contribute to market segmentation, which, among other things, involves trade barriers. To explain this bias, one needs to assume empirically plausible trade costs, as well as a lower elasticity of substitution across traded goods. The term elasticity of substitution refers to the ease with which domestic goods (nontraded) can be substituted with traded goods.

In terms of international trade, border costs imply trade barriers such as tariffs and nontariff barriers (quantitative trade restrictions such as quotas, health and environmental regulations, and customs-related paperwork), transportation costs, and exchange rate risk. Some models suggest that these border costs don’t have to be too large to generate the observed bias for home goods.

As long as interaction takes place between border costs and the elasticity of substitution between home and foreign goods, a bias for home goods is in play. Additionally, if a bias for home goods does exist, such as having a preference for the “Made in America” label, it works like any other trade cost.