Gravity with History: On Incumbency Effects in International Trade

Countries trade more if they liberalized their trade relationship earlier. We derive a gravity equation featuring this path dependence due to sunk market-access costs that generate incumbency effects. We provide supporting evidence for the underlying mechanism and derive an augmented ACR (Arkolakis, Costinot, and Rodríguez-Clare 2012) formula for the gains from trade that accounts for incumbency effects. A quantification suggests our mechanism explains up to 25% of countries’ home shares, and the gains from trade are, on average, 10% larger when allowing for incumbency effects. The analysis further reveals novel distributional effects of trade, boosting real wages but reducing profits.