A Solution to the Missing Globalization Puzzle by Non‐CES Preferences

• Author: Hakan Yilmazkuday
• DOI: http://doi.org/10.1111/roie.12278
• Published date: 01 August 2017
• Date: 01 August 2017

A Solution to the Missing Globalization Puzzle

by Non-CES Preferences

Hakan Yilmazkuday*

Abstract

One channel of welfare-improving globalization is throughthe increasing integration of trade.Although this

is attributed to decreasing effects of distance across countries, the workhorse models of gravity fail to cap-

ture it, the so-called “missing globalization” or “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 as a result of the distance elasticity of trade decreasing with the amount of trade. Accordingly, we

consider a type of non-CESutility function, namely constant absolute risk version (CARA),and analytically

show that the negative relation between trade and distance elasticity of trade is capturedby CARA prefer-

ences. We estimate thegravity equation implied by CARA preferences, empirically confirmthe 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 preferencesbased on their goodness of fit.

1. Introduction

The international trade literature characterizes welfare-improving globalization as the

increasing integration of trade. This integration is mostly attributed to the decreasing

effects of distance over time owing to decreasing freight costs over time as shown in

Figure 1.

1

Puzzlingly, however, evidence of long-distance trade integration is nowhere

to be found in the estimates of the distance elasticity derived from standard workhorse

models of international trade (a.k.a. “gravity” models). As is now well documented

(see, e.g. Disdier and Head, 2008), gravity estimates of the elasticity of trade with

respect to distance have continually and regularly been found to be non-decreasing (or

even increasing) over time. In other words, despite vast improvements in transporta-

tion and communication technologies over the latter half of the twentieth century,

standard gravity regressions still find that these innovations have done nothing to

make long-distance trade more feasible relative to trade over shorter distances. This

has been referred to in the literature as the “missing globalization” puzzle (Coe et al.,

2007) or “distance puzzle.” Since the estimates of the distance elasticity may also be

capturing other unobservable trends in trade costs such as falling costs of long-

distance commercial flights (as in Yilmazkuday and Yilmazkuday, forthcoming), long-

distance phone calls or internet (as in Clarke and Wallsten, 2006), and the spread of

the English language (as in Ku and Zussman, 2010), the presence of the distance puz-

zle is even more surprising.

* Yilmazkuday: Department of Economics, F lorida International University , Miami, FL 33199, USA.

E-mail: hyilmazk@fiu. edu. The author would like to thank the editor, Edwin Lai, two anonymous refer-

ees and the participants at the Midwest International Economics Meetings, University of Michigan for

valuable comments and suggestions. The usual disclaimer applies.

V

C2017 John Wiley & Sons Ltd

Review of International Economics, 25(3), 649–676, 2017

DOI:10.1111/roie.12278

Accordingly, many studies in the literature have attempted to find a solution to this

puzzle. In order to explain the severity of the puzzle, Buch et al. (2004) have argued

that the effects of globalization are captured by the constant in gravity regressions,

Portes and Rey (2005) have introduced information barriers, Brun et al. (2005) have

considered an augmented trade barrier function, Engel (2002) have focused on the

role of nontradables’ sectors, Estevadeordal et al. (2003) have considered possible

increases in marginal costs of transportation with respect to of production, Berthelon

and Freund (2008) have investigated the role of composition of trade among indus-

tries, Felbermayr and Kohler (2006) have taken into account zero-trade observations,

Head et al. (2009) have included fixed effects in their regressions to account for trad-

ing propensities of entrants, Yotov (2012) has considered the increase in international

economic integration relative to the integration of internal markets, and Yilmazkuday

(2014a) has considered the internal location of production of exporters.

2

Although

some of these studies have found decreasing coefficients of distance over time, they

have drawbacks of either requiring additional data sets (of which construction is

achieved by alternative proxies) or finding minor reductions in the distance elasticity

of trade compared with the expectations arising from Figure 1. Moreover, despite find-

ing a possible solution through an augmented trade barrier function, Brun et al. (2005)

Figure 1. Ad Valorem Freight Rates

Notes: This figure is a combination of Figure 5 and Figure 6 in Hummels (2007). We depict

the fitted ad valorem rates for air and ocean freight given in Hummels (2007) for the period

over 1974–2004.

Source: Hummels (2007)

650 Hakan Yilmazkuday

V

C2017 John Wiley & Sons Ltd