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It Is Much Bigger Than What We Thought: New Estimate of Trade Diversion

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Abstract

Conventional estimate of the trade diversion (TD) effect of preferential trade agreements (PTAs) tends to be much smaller than that of the trade creation (TC) effect. This paper ex- amines two sources of estimation bias of the TD effect. The first bias of TD arises from the difficulty in controlling for multilateral resistance and other unobserved time-varying country heterogeneity when estimating both TC and TD effects simultaneously due to perfect mul- ticollinearity. The second one is the underestimation of TD and arises from the failure to recognize that the concept of TD is inapplicable for a substantial proportion of PTAs and, thus, that the conventional method wrongly counts cases where trade cannot be diverted as cases where trade is not diverted. This paper corrects these two biases by using fixed effects and introducing a new measure of TD which provides a better mapping between the theoretical concept and data characteristics. Removing the two sources of bias leads to a twelve-fold in- crease in the estimate of the TD effect. It is found that the total TD effect is comparable to the TC effect in dollar terms.

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Paper provided by School of Economics, University of Queensland, Australia in its series Discussion Papers Series with number 489.

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Date of creation: 16 Oct 2013
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Handle: RePEc:qld:uq2004:489

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  1. Shang-Jin Wei & Arvind Subramanian, 2003. "The WTO Promotes Trade, Strongly But Unevenly," IMF Working Papers, International Monetary Fund 03/185, International Monetary Fund.
  2. Roy, Jayjit, 2011. "Is the WTO mystery really solved?," Economics Letters, Elsevier, Elsevier, vol. 113(2), pages 127-130.
  3. Kowalczyk, Carsten, 2000. "Welfare and Integration," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 41(2), pages 483-94, May.
  4. Krishna,Pravin, 2005. "Trade Blocs," Cambridge Books, Cambridge University Press, Cambridge University Press, number 9780521770668.
  5. Egger, Peter & Larch, Mario, 2008. "Interdependent preferential trade agreement memberships: An empirical analysis," Journal of International Economics, Elsevier, Elsevier, vol. 76(2), pages 384-399, December.
  6. James E. Anderson & Eric van Wincoop, 2003. "Gravity with Gravitas: A Solution to the Border Puzzle," American Economic Review, American Economic Association, American Economic Association, vol. 93(1), pages 170-192, March.
  7. Daniel Trefler, 2001. "The Long and Short of the Canada-U.S. Free Trade Agreement," NBER Working Papers 8293, National Bureau of Economic Research, Inc.
  8. I-Hui Cheng & Howard J. Wall, 2005. "Controlling for heterogeneity in gravity models of trade and integration," Review, Federal Reserve Bank of St. Louis, Federal Reserve Bank of St. Louis, issue Jan, pages 49-63.
  9. Ghosh, Sucharita & Yamarik, Steven, 2004. "Are regional trading arrangements trade creating?: An application of extreme bounds analysis," Journal of International Economics, Elsevier, Elsevier, vol. 63(2), pages 369-395, July.
  10. Andrew K. Rose & Eric van Wincoop, 2001. "National Money as a Barrier to International Trade: The Real Case for Currency Union," American Economic Review, American Economic Association, American Economic Association, vol. 91(2), pages 386-390, May.
  11. Baier, Scott L. & Bergstrand, Jeffrey H., 2004. "Economic determinants of free trade agreements," Journal of International Economics, Elsevier, Elsevier, vol. 64(1), pages 29-63, October.
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