Juyoung Cheong, Do Won Kwak and Kam Ki Tang, School of Economics Discussion Paper No. 489 September 2013, School of Economics, The University of Queensland. Australia.


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Conventional estimate of the trade diversion (TD) effect of preferential trade agreements (PTAs) tends to be much smaller than that of the trade creation (TC) effect. This paper ex- amines two sources of estimation bias of the TD effect. The first bias of TD arises from the difficulty in controlling for multilateral resistance and other unobserved time-varying country heterogeneity when estimating both TC and TD effects simultaneously due to perfect mul- ticollinearity. The second one is the underestimation of TD and arises from the failure to recognize that the concept of TD is inapplicable for a substantial proportion of PTAs and, thus, that the conventional method wrongly counts cases where trade cannot be diverted as cases where trade is not diverted. This paper corrects these two biases by using fixed effects and introducing a new measure of TD which provides a better mapping between the theoretical concept and data characteristics. Removing the two sources of bias leads to a twelve-fold in- crease in the estimate of the TD effect. It is found that the total TD effect is comparable to the TC effect in dollar terms.