Competitiveness and Elasticity of Trade

Abstract

The elasticity of substitution between goods from different countries is the most important parameter in the standard models of international macroeconomics of business cycles and international trade as it determines the trade effects of changes in competitiveness and trade policy. I identify industry level elasticity of substitution parameters in a structural gravity framework with measures of competitiveness and tariffs by applying state-of-the-art methods for structural gravity model estimation. When elasticity of substitution is identified through relative output prices or unit costs, I find median industry level elasticity of substitution between 0.7 and 0.9, which suggest that volume of trade is inelastic to changes in competitiveness. When elasticity of substitution is identified through tariffs, the median industry level elasticity of substitution is around 3, which is about half of the median estimate of trade elasticity in the trade literature. Higher tariff-based estimates are in line with the view that trade costs lead to higher trade effects as they disproportionately reduce trade of intermediate inputs in global value chains.