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

  • Huiwen Lai
  • Daniel Trefler

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 estimate large 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 mis-specifies 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.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 9169.

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Date of creation: Sep 2002
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Handle: RePEc:nbr:nberwo:9169
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