Abstract: Information frictions prevent importers from observing the price of a good in every market. In this paper, we seek to explain how the presence of such frictions shape the flow of goods between countries. To this end, we introduce rationally inattentive importers in a multi-country Ricardian trade model. The amount of information importers process about each country is endogenous and reacts to changes in observable trade costs. Unlike traditional trade costs, changes in information processing costs have non-monotonic and asymmetric effects on bilateral trade flows. We go on to show quantitatively how small differences in distance generate large differences in trade flows, thereby shedding light on the distance elasticity puzzle. The model also generates a novel prediction regarding the relationship between information processing costs and the concentration of import distributions that finds support in the data.
Keywords: Rational inattention, incomplete information, distance elasticity.
JEL Classification: D83; F10; F19; L15