DP15374 Gravity with Granularity

Author(s): Holger Breinlich, Harald Fadinger, Volker Nocke, Nicolas Schutz
Publication Date: October 2020
Keyword(s): Aggregative Game, CES Demand, Gravity Equation, oligopoly
JEL(s): F12, F14, L13
Programme Areas: International Trade and Regional Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=15374

We evaluate the consequences of oligopolistic behavior for the estimation of gravity equations for trade flows. With oligopolistic competition, firm-level gravity equations based on a standard CES demand framework need to be augmented by markup terms that are functions of firms' market shares. At the aggregate level, the additional term takes the form of the exporting country's market share in the destination country multiplied by an exporter-destination-specific Herfindahl-Hirschman index. For both cases, we show how to construct appropriate correction terms that can be used to avoid problems of omitted variable bias. We illustrate the quantitative importance of our results for combined French and Chinese firm-level export data as well as for a sample of product-level imports by European countries. Our results show that correcting for oligopoly bias can lead to substantial changes in the coefficients on standard gravity regressors such as distance or the impact of currency unions