Abstract

We study aggregate implications of endogenous production network formation in a multi-location general equilibrium trade model. Firms search for suppliers and buyers across locations subject to matching frictions, generating gravity structure of production networks. We show that equilibrium is inefficient due to search and matching externalities and characterize the optimal policy to correct for them. We derive sufficient statistics formula for global and each region’s welfare and characterize the precise deviation from the fixed network environment. Our model calibrated to Chilean firm-to-firm trade data predicts an increase in domestic supplier and buyer linkages in response to import tariff reduction, consistent with our reduced-form evidence from the recent trade liberalization episode. We show that endogenous networks are quantitatively relevant for domestic and international trade cost shocks.