Discussion paper

DP16762 Poor Substitutes? Counterfactual methods in IO and Trade compared

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.


Head, K and T Mayer (2021), ‘DP16762 Poor Substitutes? Counterfactual methods in IO and Trade compared‘, CEPR Discussion Paper No. 16762. CEPR Press, Paris & London. https://cepr.org/publications/dp16762