Welfare Implications of Solving the Distance Puzzle: Global Evidence from the Last Two Centuries
One sentence summary: The distance puzzle corresponds to about 81% of a cumulative welfare loss in the world, whereas solving it corresponds to about 58% of a welfare gain.
The corresponding paper by Hakan Yilmazkuday has been accepted for publication at Journal of International Trade and Economic Development.
The working paper version is available here.
Abstract
Non-technical Summary
The negative effects of distance on trade are shown to increase over time in standard gravity regressions, which is against the expectations due to decreasing costs of transportation and communication. The so-called "distance puzzle" has been investigated extensively in the literature, where several explanations have been offered, including information barriers, augmented trade barriers, the role of nontradables, marginal costs of transportation, the composition of trade, zero-trade observations, trading propensities of entrants, domestic versus international integration of markets or nonhomothetic preferences. Nevertheless, none of the studies in the literature have investigated the welfare implications of the distance puzzle before and after it is solved.
This paper focuses on the welfare implications of the distance puzzle by considering the implications of a standard trade model. Theoretically, it is shown that changes in the distance elasticity of trade can be connected to the changes in the welfare gains from trade by using bilateral distance measures and bilateral expenditure shares across countries. When trade implications of this model are estimated in a log-linear Ordinary Least Squares (OLS) regression (where zero-trade observations are ignored by construction), the distance puzzle is confirmed, and it is shown that the world economy has a cumulative welfare loss (about 81%) due to this puzzle in the last two centuries. When zero-trade observations are included in a Pseudo-Poisson Maximum Likelihood (PPML) regression, the distance puzzle is solved, and it shown that the world economy has a cumulative welfare gains from trade (about 58%) due to reductions in the negative effects of distance on trade over time. Whereas 47% of these welfare gains are through international trade, 11% of them are through domestic trade.
The implications of the model have also been used to measure the potential future gains from trade. This has been achieved by considering a hypothetical case in which the effects of distance have been set to zero, both within and across countries. The corresponding results have shown that the potential future gains from domestic trade are about 79%, whereas those from international trade are about 197%, suggesting that there is much more to be done to reduce the negative effects of distance on trade.
Abstract
This paper theoretically shows that changes in the distance elasticity of trade can be connected to welfare changes that depend on bilateral distance measures and expenditure shares of countries. Empirical results based on international and domestic trade data from the last two centuries show that the negative effects of distance on trade have increased over time when zero trade observations are ignored in inconsistent OLS estimations, confirming the distance puzzle in the literature. The corresponding welfare implications suggest that the world economy has experienced a cumulative welfare loss (about 81%) due to this puzzle in the last two centuries. When the puzzle is solved by considering zero trade observations in PPML estimations, the tables turn such that there are significant welfare gains from trade (about 58%) during the same period due to the decreasing negative effects of distance on trade over time. Welfare gains from further reductions in the negative effects of distance are investigated as well, suggesting significant potential gains from trade in the future.
Non-technical Summary
The negative effects of distance on trade are shown to increase over time in standard gravity regressions, which is against the expectations due to decreasing costs of transportation and communication. The so-called "distance puzzle" has been investigated extensively in the literature, where several explanations have been offered, including information barriers, augmented trade barriers, the role of nontradables, marginal costs of transportation, the composition of trade, zero-trade observations, trading propensities of entrants, domestic versus international integration of markets or nonhomothetic preferences. Nevertheless, none of the studies in the literature have investigated the welfare implications of the distance puzzle before and after it is solved.
This paper focuses on the welfare implications of the distance puzzle by considering the implications of a standard trade model. Theoretically, it is shown that changes in the distance elasticity of trade can be connected to the changes in the welfare gains from trade by using bilateral distance measures and bilateral expenditure shares across countries. When trade implications of this model are estimated in a log-linear Ordinary Least Squares (OLS) regression (where zero-trade observations are ignored by construction), the distance puzzle is confirmed, and it is shown that the world economy has a cumulative welfare loss (about 81%) due to this puzzle in the last two centuries. When zero-trade observations are included in a Pseudo-Poisson Maximum Likelihood (PPML) regression, the distance puzzle is solved, and it shown that the world economy has a cumulative welfare gains from trade (about 58%) due to reductions in the negative effects of distance on trade over time. Whereas 47% of these welfare gains are through international trade, 11% of them are through domestic trade.
The implications of the model have also been used to measure the potential future gains from trade. This has been achieved by considering a hypothetical case in which the effects of distance have been set to zero, both within and across countries. The corresponding results have shown that the potential future gains from domestic trade are about 79%, whereas those from international trade are about 197%, suggesting that there is much more to be done to reduce the negative effects of distance on trade.
The corresponding paper by Hakan Yilmazkuday has been accepted for publication at Journal of International Trade and Economic Development.