DP15374 Gravity with Granularity
We demonstrate that the estimation of gravity equations of trade flows suffers from
an omitted variable bias when firms are granular and behave oligopolistically. We
show how to correct for this bias in the estimation of both firm- and industry-level
gravity. Using French and Chinese export data, we find that the oligopoly bias leads to
a substantial underestimation of the effects of distance on trade flows. In a calibrated
version of the model, the welfare gains from a trade liberalization are found to be almost
twice as large under oligopoly as under monopolistic competition.