Working Paper: CEPR ID: DP17409
Authors: Wei Li; Bin Qiu; Zi Wang; Yanbo Zeng; Yuan Zi
Abstract: We revisit the Armington model developed by Feenstra, Luck, Obstfeld, and Russ (2018) that allows the elasticity of substitution between the domestic and foreign varieties to be different from that between alternative foreign varieties. We develop a novel two-stage gravity-based framework to estimate these two elasticities using data on bilateral trade flows, tariffs, and domestic production, exactly the same set of data used for counterfactual analysis. Our estimates suggest that the elasticity of substitution between the domestic and foreign varieties is 43% lower than that between alternative foreign varieties. We apply the model to quantify the global consequences of the US-China trade war starting from 2018. Counterfactual analysis suggests that imposing a uniform elasticity of substitution across all varieties would lead to (i) considerable underestimation of the third-country welfare gains from the US-China trade war, and (ii) overestimation of the noncooperative tariffs between the U.S. and China.
Keywords: trade elasticities; gravity equation; trade war
JEL Codes: F10; F13; F14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Protectionist tariffs (F13) | Shift in demand to third countries (F29) |
| Imposing a uniform elasticity of substitution across all varieties (D11) | Underestimation of third-country welfare gains from the US-China trade war (F69) |
| Imposing a uniform elasticity of substitution across all varieties (D11) | Overestimation of non-cooperative tariffs between the US and China (F14) |
| US-China trade war (F19) | Welfare effects (D69) |
| Average protectionist tariffs on Chinese imports (F13) | Comparison with pre-trade war tariffs (F14) |
| Elasticity of substitution between domestic and foreign varieties (F14) | Effectiveness of protectionist tariffs (F13) |
| Elasticity of substitution between alternative foreign varieties (F31) | Effectiveness of protectionist tariffs (F13) |