Measuring the Effects of Endogenous Policies on Economic Integration

Despite widespread anecdotal evidence that lower trade barriers increase international trade, there is little firm quantitative evidence of the ‘trade-cost elasticity’ of trade flows, one of the two key aggregate statistics that have recently been identified as sufficient to quantify the economic welfare effects of trade-policy liberalizations and/or trade-cost reductions (the other statistic being the import-penetration ratio). In other words, most estimates of the trade-cost elasticity are imprecise and lack consistency. In this article, we discuss two issues that are critical in better assessing empirically the trade-flow and welfare effects of trade liberalizations (or trade-cost changes). The first issue is how to quantify the trade-cost elasticity when trade costs themselves are approximated imperfectly. The second issue is that typical empirical evaluations to estimate the impact of trade-policy liberalizations on trade flows use the ‘gravity equation’. However, the self-selection of country pairs into such agreements introduces endogeneity bias in the estimation of the trade-cost elasticity in gravity equations, requiring better identification techniques. (JEL codes: F10; F12 and F13)