# **1. Introduction**

The Internet has dramatically transformed the way countries trade by reducing the costs of exporting. Firms use the Internet to market their goods, find and communicate with customers, and complete transactions. As a result, the technology has allowed countries to export more and to export new products. There are also online marketplaces that reduce the matching costs between buyers and sellers. The level of Internet adoption has increased dramatically over the last ten years and it has been argued that the growth in digital connectivity has promoted more international trade and the emergence of international production networks (Baldwin, 2014).

In this paper, we quantify the impact of Internet adoption on international trade. Beyond just evaluating the impact of the Internet on bilateral exports, we disaggregate the effects of the Internet on trade and examine how the Internet affects bilateral exports in three ways. First, we investigate how the Internet affects the average value of trade flows (the intensive margins) and the number of goods exported (the extensive margins). Second, we examine whether the Internet has additional effects on exports when both the exporter and importer have similar levels of Internet adoption. Lastly, we explore whether the Internet has a differential impact on the type of goods being traded. We employ a gravity-like estimation specification with a panel data of aggregate trade flows from 2001 to 2013 from the UN COMTRADE database. We measure the level of Internet adoption in the exporter and importer by the percentage of individuals using the Internet per 100 persons from the ITU database.

We find that the Internet has a positive impact on the international trade but the effect is nuanced. Higher Internet adoption increases bilateral exports but it is the exporter’s Internet adoption level that is more important for bilateral exports. A 10 percent increase in the exporter’s Internet adoption leads to a 1.9 percent increase in bilateral exports, while a 10 percent increase in the importer’s Internet adoption leads to a 0.6 percent increase in bilateral exports. An increase in the Internet adoption affects the intensive and extensive margins differently depending on whether the increase occurs in the exporter or importer. When the Internet adoption increases in the exporter, it increases the number of goods being exported more than the average value of existing goods. The impact of the exporter’s Internet adoption on bilateral exports occurs largely through the extensive margin. In contrast, when the Internet adoption increase in the importer, the average value of existing exported goods increase. The impact of the importer’s Internet adoption on bilateral exports occurs through the intensive margin. We find that there is a pattern of positive assortative matching, where country pairs with high Internet adoption levels have higher trade outcomes. Compared to other country pairs, countries with both high levels of Internet adoption have 29.6 percent more bilateral exports, 21.7 percent higher intensive margins and 6.5 percent higher extensive margins.

We show that the estimation results are robust with an instrumental variable and an alternative measure of the Internet. The estimation may be affected by the endogeneity between the Internet adoption and trade, where more trade can increase a country’s income and encourage more Internet infrastructure and adoption. We use the price of broadband subscription in the country as an instrumental variable for the Internet adoption. The level of Internet adoption also may not capture the full extent of the quality and quantity of the Internet services in the country, so we use the download speeds as an alternative measure of Internet. The results in both robustness checks do not differ from our main results.

Our paper adds to the branch of literature that examines the effects of communication technology on international trade flows. The seminal paper in this literature is Freund and Weinhold (2004) that show how the growth of Internet (measured by the number of web hosts) can increase the growth of exports.

2