Zeros and the Gains from Openness

Timothy Uy

No 1158, 2015 Meeting Papers from Society for Economic Dynamics

Abstract: Despite the enormous growth in global trade and investment, most countries still do not trade or invest with one other. I document that 80% of bilateral trade and FDI relationships are zeros. I construct a model that rationalizes these zeros and allows new bilateral relationships to form (aggregate zero-to-one transitions) following policy reform. Firms incur two types of costs when operating internationally: (1) fixed costs preventing them from operating - identified using the variation in zeros, and (2) iceberg costs reducing the amount they sell when they operate -- identified using variation in positive flows. The global bilateral fixed costs estimated from the zeros are novel to the literature, which has focused on country- or sector-specific fixed costs. I develop an algorithm that enables me to (1) compute an approximate equilibrium where exact equilibria do not exist, and (2) reduce the computational complexity to one that grows linearly, as opposed to exponentially, in the number of countries, mitigating the curse of dimensionality. Welfare gains in models with no aggregate entry and exit account for only 41% of the average gains obtained in the model where zeros matter, signifying that this aggregate extensive margin matters for understanding what countries gain from openness.

Date: 2015
New Economics Papers: this item is included in nep-int
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