Traders, Courts and the Home Bias Puzzle

Recent evidence shows that the "home bias puzzle" in international trade maybe associated with the mere presence of national borders (McCallum (1996)). In this paper we provide a theoretical framework to explain why borders may matter so much for trade. Our argument is that even between perfectly integrated and similar countries the legal system differs, so that legal costs are higher when business is done abroad. Using a matchig model of trade, we show that the home bias is associated with both less searching foreign sellers in the home market and a lower probability of cross-border matches being accepted. In industries characterized by high turnover legal costs may reduce trade because reducing the mass of searching foreign sellers and increasing at the same time that of searching domestic sellers