Reading Report # 3

“Estimating Trade Flows: Trading Partners and Trading Volumes”.

- Elhanan Helpman, Marc Melitz and Yona Rubinstein (2008)

ECO603: Advanced Econometrics

Submitted to:

Chen Zhihong
Professor, SITE, UIBE

Submitted by:

Syed Nazrul Islam

Student ID: DE201760011

Dated: 13 December 2017

 “Estimating Trade Flows: Trading Partners and Trading Volumes”.

1. The question to be investigated and why it is meaningful:

The gravity equation, pioneered by Tinbergen (1962), has dominated empirical research in
international trade and economics. Most of the earlier studies using Tinbergen specification are
based on samples that have only positive trade flows between them. The authors of the paper
argued that earlier studies produce biased estimates as they give up important information in data
and the symmetric nature of standard specification of gravity equation. To correct these biases, the
paper develops a theory to predict positive as well as zero trade flows between countries. Using the
developed theory, the paper also describes the estimation procedure exploiting the information
contained in data sets of both trading and non-trading countries. The developed gravity equation
accounts for firm heterogeneity including trade fixed costs and asymmetries between the volumes
of export across countries which are very important for data analysis. The study is, therefore, an
important direction for future research in international trade.
2. The assumptions of the paper and if they are legitimate:
The paper assumes that firms vary by productivity and profitability of exports varies by destination. It is
higher for exports to countries with higher demand levels, lower variable and fixed export costs.
Positive trade flows from one country to another is thus considered as aggregate exports over varying
distributions of firms. The assumptions help the model to predict zero exports from one country to
another for some country pairs as well as zero exports from country i to j, but with positive exports
from country j to i. The assumptions are therefore legitimate for the modeling of new gravity equation.
3. The data set used in the paper:
The researchers use 11 main variables in their study which include 8 binary variables (e.g. common
border, island, landlocked, colonial ties, currency union, legal systems, FTA, and entry costs),
distance (between importer’s i and exporter’s j capital), religion (defined uniquely) and WTO (vector
of 2 dummies). The bilateral trade data are taken from Feenstar’s “World Trade Flows, 1970-92 and
1980-97” from which they constructed a matrix of trade flows with 158X157=24,806 observations.
The sources of country level data are the Penn World Tables 6.1, World Bank Development
Indicators and CIA’s World Factbook. In addition, the paper uses data from Rose (2000), Gilack and
Rose (2002) and Roses (2004) mainly for identifying WTO membership and currency union.
Moreover, the researchers constructed the regulation (entry) costs of firm entry using relevant cost
data reported in Djankov et. al. (2002).
4. The theoretic model:
The theoretical model developed in the paper follows Melitz (2003) specification of a general
equilibrium model of a trading country in which firms are heterogeneous in productivity.
Explaining a representative country’s utility function, demand function for imported goods, price
indexes, the paper develops the following theoretical equations based on which the empirical
method is developed:
[ Profit condition] (1-α)(ηijcjaij/αPi)1-ε Yi = cjfij … … … (1)
[ Bilateral trade volume] Vij= ∫ a dG(a) for aij ≥ aL
1-ε
… … …(2)
0 otherwise
[ Import Value function] Mij=(cjηij/α)1-ε YiNjVij … … … (3)
Pi1-ε =∑ (cjηij/α)1-ε NjVij … … … (4)
The above for equations provide a mapping from the income level Yi, the number of firms Ni, the
unit cost ci, the fixed cost fij, and the transport cost ηij to the bilateral trade flows, Mij.
5. The empirical method:
The paper first formulates a fully parameterized estimation procedure for the model, which delivers
the benchmark results. Later the paper progressively loosens parametric restrictions and re-
estimates the model. Based on the theoretical framework, the paper finally constructs several
equations for estimation purpose. First, the paper constructs the gravity equation as the following
specification.
 mij = β0 + λj + χi − γ dij + wij + uij … … …(5)
where χi = (ε − 1)pi + yi is a fixed effect of the importing country and λj = −(ε − 1) ln cj + nj is a
fixed effect of the exporting country.
Then the paper specified a model for firm selection into export markets which is specified as
follows-
zij = γ0 + ξ j + δi − γ dij − κθij + εij ... … …(6)
where zij is a latent variable, εij ≡ uij + νij ∼ N(0, ζ2u+ σ2ν ) is i.i.d,, ξ j = −ε ln c j + θEX, j is an
exporter fixed effect, and δi = (ε − 1)pi + yi − θIM,i is an importer fixed effect.. The paper,
however, does not impose the restriction ζ2ε= ζ2u+ ζ2ν =1 and therefore specify the Probit equation
in the following form:
ρij = Pr(Tij = 1 | observed variables)
= Φ(γ0*+ ξj*+ δi*− γ∗dij − κ∗θij … … … (7)
Finally, the paper constructs a consistent estimation of (5) using the following transformation-
mij = β0 + λj + χi − γ dij + ln{exp[δ(ˆzij*+ ˆεij*)]− 1}+ βuε ˆεij* + eij .. … .. (8)

where βuε ≡ corr (uij, εij )(ζu/ζε) and eij is an i.i.d. error term satisfying E[eij | ., Tij = 1] = 0. The
paper runs traditional estimates of gravity equation and Probit equations using specification (7) and (8).
Later on the paper turns to second stage estimation of (8) using NLS) which also requires first stage
probit selection equation (7) estimation.
6. The summary of results:
Most of the regression coefficients are found to be significant at 5% and 1% level of significance.
The traditional trade flow estimation of gravity equation is consistent to other studies which drawn
from symmetric trade flow and country fixed effect. The marginal effect using Probit equation shows
that it very same variables that impact export volumes from j to i also impact the probability that j
exports to i. In almost all cases the impact goes in same direction except the common border. Among
others, the paper finds that WTO membership, common religion have a very strong and significant
effect on the formation of bilateral trading relationship.
In the second stage estimation with some excluded variables and adding an additional variable
reflecting regulation cost, the NLS estimation shows that the correction for selection and omitted
variable biases have measurable downward impact on the estimated coefficients. A variety of
robustness checks confirm that the resulting estimates are not sensitive to estimation methods.
7. The contribution and limitation of the paper and the possible extension:
The paper develops an estimation procedure that corrects certain biases embodied in the usual gravity
model of trade flows. The developed two equation system enables to decompose the impact on trade
volumes of all trade resistance measures into their intensive and extensive margin components. As
noted by the researchers, the estimation procedure is easy to implement and flexible to econometric
specifications. That is, the procedure provides the researcher with flexibility and convenience in
individual applications.
The time period covered in the paper data used in the paper is 1970-1997. Almost 20 years have
passed since then. Many regulatory constraints and trade barriers have been removed during that time
and many developing countries is converging due to high growth and improvement of factor
productivity. Further robustness of the gravity model proposed in the paper can be checked with
updated trade data.
8. The publication information such as the journal, issue and year:
Researchers: (1) Elhanan Helpman ( Department of Economics, Harvard University); (2) Marc
Melitz (Department of Economics, Harvard University); (3) Yona Rubinstein
(Department of Management, London School of Economics).
Journal Information: Quarterly Journal of Economics, Vol. 123, No.2, PP.441-487.
Year of Publication : 2008