DP16762 Poor Substitutes? Counterfactual methods in IO and Trade compared

Author(s): Keith Head, Thierry Mayer
Publication Date: November 2021
Date Revised: December 2021
Keyword(s): Constant Elasticity of Substitution, Counterfactual analysis, industrial organization, oligopoly, tariffs, Trade
JEL(s): F1, L1
Programme Areas: Industrial Organization, International Trade and Regional Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=16762

Constant elasticity of substitution (CES) demand for monopolistically competitive firm-varieties is a standard tool for models in international trade and macroeconomics. Inter-variety substitution in this model follows a simple share proportionality rule. In contrast, the standard toolkit in industrial organization (IO) estimates a demand system in which cross-elasticities depend on similarity in observable attributes. The gain in realism from the IO approach comes at the expense of requiring richer data and greater computational challenges. This paper uses the dataset of Berry et al. (1995), who established the modern IO method, to simulate counterfactual trade policy experiments. We use the CES model as an approximation of the more complex underlying demand system and market structure. Although the CES model omits key elements of the data generating process, the errors are offsetting, leading to reasonably accurate counterfactual predictions. For aggregate outcomes, it turns out that incorporating non-unitary pass-through matters more than fixing over-simplified substitution patterns. We do so by extending the commonly used methods of Exact Hat Algebra and tariff elasticity estimation to take into account oligopoly.