The Gains from Trade with Monopolistic Competition: Specification, Estimation, and Mis-Specification

Abstract

The difficulty of incorporating general equilibrium price effects into econometric estimating equations has deterred most researchers from econometrically estimating the welfare gains from trade liberalization. Using a paired-down CES monopolistic competition example, we show that this difficulty has been greatly exaggerated. Along the way, we estimate -indeed precisely estimatelarge welfare gains from trade liberalization as measured by compensating variation.Unlike calibration methods, econometric methods allow researchers to isolate the violence done by the model to the data. We find that the CES monopolistic competition model horribly misspecifies behavioural price elasticities and general equilibrium price feedbacks. The model as conceived is therefore of limited value for analysing the effects of trade liberalization. We report a number of specification issues that should point the way to better theoretical modeling. e.g., one-time compensating variation gains of 0.4 percent with a standard error of less than 0.1 percent.In terms of our first goal, this paper is closely related to Eaton and Kortum (2002) who estimate complex behavioural and general equilibrium price responses in the context of a Ricardian model. They also compute the welfare gains from trade liberalization. We go a little further by treating welfare gains as an uncertain quantity whose mean and standard error must be estimated. Our aim of estimating welfare gains is shared by Feenstra (1988) and Berry, Levinsohn and Pakes (1999) who provide in-depth studies of the welfare gains from automotive sector voluntary export restraints. See Feenstra (1995) for a review of the literature. The second goal of this paper is to econometrically assess the model for evidence of misspecification. Estimated welfare gains are model-dependent: if the model is inadequate, so too are the welfare estimates. Our focus is on whether the CES monopolistic competition model adequately captures price effects. Here we extend the work of Harrigan (1996), Jensen (2000), and Evenett and Keller (2002) who carefully examined the behavioural income elasticities implied by the model. Our work is also related to the volume-of-trade equations considered by Helpman (1987), Hummels andLevinsohn (1993, 1995), andDebaere (2002), though it is not obvious how these volume-of-trade equations can be extended to include price effects.The analysis is built upon a new and labouriously constructed database on bilateral tariff rates for 14 importers trading with 36 exporters over the 1972-1992 period for 28 manufacturing industries. (Our sample size is dictated by the availability of scarce bilateral tariff data.) In our search for potential mis-specifications of the behavioural and general equilibrium import responses to tariff changes, we examine both within and between country-pair sample variation. Estimates based on the between country-pair sample variation exploit the fact that, for example, the United States both imports more from Canada than from Iran and has lower tariffs against C...

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