### A Solution to the Missing Globalization Puzzle by Non-CESPreferences

**One sentence summary**: The distance puzzle in international trade is solved when non-CES preferences are considered on the demand side.

The corresponding paper by Hakan Yilmazkuday has been published at Review of International Economics.

**Abstract**

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.

**Non-technical Summary**

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, due to decreasing freight costs over time as shown in the following figure.

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
transportation 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, 2016), 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 puzzle is even more surprising.

Using a standard data set in the gravity literature in the
context of a demand-side model, this paper first confirms that there is a
distance puzzle by showing that the distance elasticity of trade (in absolute
terms) is increasing over time when constant elasticity of substitution (CES) preferences
are considered.

This result is robust to the consideration of different
measures of distance (e.g., distance between capital cities, most agglomerated
cities, or population weighted measures) as well as the consideration of
distance intervals as in Eaton and Kortum (2002). We claim that this result may
be due to the structure of CES preferences literally implying a constant
elasticity of substitution and a log-linear gravity relation between trade and
distance. In particular, if distance elasticity of trade is endogenously
determined, this would violate the assumption of CES and thus lead to biased
empirical results. We test this hypothesis by differentiating the distance
elasticity of trade across different trade intervals (e.g., distance elasticity
of trade regarding trade smaller and larger than the median trade) for each
year individually. Independent of the number of intervals considered, our
results show that the (absolute value of) distance elasticity of trade
systematically decreases with the amount of trade for each individual year.
Therefore, the assumption of CES is violated for each year in our sample, and
this may result in biased estimates of the distance elasticity of trade leading
to the distance puzzle. Hence, an alternative modeling approach is required
that will lead to endogenously determined distance elasticity of trade that
decreases (in absolute value) with respect to the amount of trade.

Accordingly, we introduce a type of non-CES preferences,
namely constant absolute risk aversion (CARA), to investigate an alternative
structural relation between trade and distance, namely a lin-log gravity-type
relationship, which is obtained by endogenously determined elasticity of
substitution as the name non-CES literally implies. The key innovation is that
under CARA preferences, the distance elasticity of trade is shown to be
endogenously determined and decreasing with the quantity traded, which is
exactly what we are looking for. We test the lin-log gravity relation implied
by CARA preferences using exactly the same data set that we use for CES
preferences and show that the distance puzzle is solved under CARA preferences
because of the negative effects of distance decreasing over the sample period.

On top of solving the distance puzzle, we also show that
CARA preferences are econometrically selected over CES preferences based on
their goodness of fit.

The results are further shown to be robust to the
consideration of (i) alternative distance measures, (ii) a balanced panel of
countries, (iii) zero-trade observations, and (iv) alternative combinations of
gravity variables.

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