Working Paper: CEPR ID: DP16762
Authors: Keith Head; Thierry Mayer
Abstract: Constant elasticity of substitution (CES) demand for monopolistically competitive firm-varieties isa standard tool for models in international trade and macroeconomics. Inter-variety substitution in thismodel follows a simple share proportionality rule. In contrast, thestandard toolkit in industrial organization (IO) estimates a demand system in which cross-elasticitiesdepend on similarity in observable attributes. The gain in realism from the IO approach comes at theexpense of requiring richer data and greater computational challenges. This paper uses the dataset ofBerry et al. (1995), who established the modern IO method, to simulate counterfactual trade policyexperiments. We use the CES model as an approximation of the morecomplex underlying demand system and market structure. Although the CES model omits key elementsof the data generating process, the errors are offsetting, leading to reasonably accurate counterfactual predictions.For aggregate outcomes, it turns out that incorporating non-unitary pass-through matters more than fixingover-simplified substitution patterns. We do so by extending the commonly used methods of Exact Hat Algebraand tariff elasticity estimation to take into account oligopoly.
Keywords: constant elasticity of substitution; industrial organization; oligopoly; trade; tariffs; counterfactual analysis
JEL Codes: F1; L1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| CES model (D58) | reasonably accurate counterfactual predictions (C53) |
| elasticity of substitution (D11) | CES model's predictions (E17) |
| market shares (L17) | CES model's predictions (E17) |
| passthrough rates (G19) | relationship between tariffs and prices (F14) |
| nonunitary passthrough (H29) | outcomes (P47) |
| CES model approximates passthrough accurately (C51) | matches aggregate targets (C52) |
| consumer heterogeneity (D19) | passthrough elasticity (H30) |
| random coefficients (C39) | selection effect (C24) |
| selection effect (C24) | influences demand elasticity (D12) |