A Solution to the Missing Globalization Puzzle by Non-CES Preferences
Florida International University
November 12, 2013
One channel of globalization is through the increasing integration of trade. Although this is attributed to decreasing effects of distance across countries (due to advances in transportation technology and/or the expansion of trade agreements to distant countries), the working-horse models of gravity fail to capture it because of resulting in non-decreasing distance elasticity of trade estimates over time, the so-called the missing globalization or the distance puzzle. This paper shows that this puzzle arises 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 the implied distance elasticity of distance (under CES preferences) decrease with trade; therefore the assumption of CES is violated. 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 also estimate the gravity equation implied by CARA preferences and empirically confirm the endogenous relation between trade and distance elasticity of trade. According to the data set used, CARA preferences are also econometrically selected over CES preferences based on their goodness of fit.
Number of Pages in PDF File: 31
Keywords: Distance Puzzle, Non-CES Preferences, U.S. Imports
JEL Classification: F12, F13, F14
Date posted: May 2, 2013 ; Last revised: November 13, 2013