Review of International Economics, Forthcoming
46 Pages Posted: 2 May 2013 Last revised: 20 Nov 2016
Date Written: November 19, 2016
One channel of welfare-improving globalization is through the increasing integration of trade. Although this is attributed to decreasing effects of distance across countries, the workhorse models of gravity fail to capture it, the so-called the missing globalization or the distance puzzle. This paper shows that this puzzle may be due to the restricting assumption of constant elasticity of substitution (CES) preferences working behind the gravity models. We test the validity of this assumption for different trade intervals and show that it is violated due to the distance elasticity of trade decreasing with the amount of trade. Accordingly, we consider a type of non-CES utility function, namely constant absolute risk version (CARA), and analytically show that the negative relation between trade and distance elasticity of trade is captured by CARA preferences. We estimate the gravity equation implied by CARA preferences, empirically confirm the endogenous relation between trade and distance elasticity of trade, and show that the distance puzzle is solved under CARA preferences. According to the data set used, CARA preferences are also econometrically selected over CES preferences based on their goodness of fit.
Keywords: Distance Puzzle, Non-CES Preferences, U.S. Imports
JEL Classification: F12, F13, F14
Suggested Citation: Suggested Citation
Yilmazkuday, Hakan, A Solution to the Missing Globalization Puzzle by Non-CES Preferences (November 19, 2016). Review of International Economics, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2258804 or http://dx.doi.org/10.2139/ssrn.2258804