The role of product differentiation
Generally, in the gravity equations of the trade–migration nexus based on (18.58), the estimate of some trade cost-related variable—such as the log stock of immigrants in a country—reflects two elements: the elasticity of substitution across varieties and the effect of the immigrant network on iceberg trade costs. Moreover, the stronger the degree of product differentiation within a sector or product class, i.e., the lower the elasticity of substitution, the larger one would conjecture the trade cost effect of the network to be since informational needs are higher and potential informational asymmetries are stronger. Also, specific preferences for goods from their source countries can be assumed to be stronger when goods are more differentiable. Combining these considerations with our discussion of the gravity model (18.66) above, and writing square brackets to denote a functional dependence, the empirical estimate of the network ν¯i:=σ−1νa+νTim. In light of the above discussion, it is very reasonable to assume that νTim depends negatively on σ. Hence, the estimate of ν¯i can be expected to be non-monotonic in σ with intermediate levels of differentiation leading to the largest estimated coefficient.
Nonetheless, the literature frequently disaggregates the trade data according to the degree of differentiation. This practice has started with the seminal work of Gould (1994), though he distinguished between consumer and producer goods. Also, Rauch and Trindade (2002) have prominently made the distinction operative by classifying products into three categories of goods ranked with declining degree of differentiation: goods traded on public exchanges (such as the London metal exchange or the Chicago board of trade) are homogeneous goods and the associated σ is high, goods for which reference prices exist are more easily differentiable and σ is of intermediate level, and the remaining goods also known as differentiated goods with low levels of σ. Peri and Requena-Silvente (2010) classified goods in a way directly related to estimates