Juyoung Cheong, Do Won Kwak and Kam Ki Tang, School of Economics Discussion Paper No. 491 September 2013, School of Economics, The University of Queensland. Australia.


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Since Rose’s (2004) striking finding of negligible WTO trade effects, numerous studies have at- tempted to solve the so-called WTO puzzle. These studies adopt novel model specifications to control for potential sources of bias, but often lead to conflicting results. Multilateral resistance terms (MRTs), unobserved country-pair heterogeneity (UCPH) and heteroskedastic errors in log- linear model are considered the most crucial controls. What has gone unnoticed, however, is that the first two controls lead to identification problems in the estimation of WTO trade effects. We show that controlling for MRTs leads to near-prefect multicollinearity because of a structural rela- tionship between the variables that measure the GATT/WTO membership statuses of any country- pairs. Also because of this structural relationship, accounting for UCPH using country-pair fixed effects (CPFEs) could reduce the number of observations that contribute to the identification of WTO trade effects by more than 98%. These identification problems make the estimates of WTO trade effects very imprecise and sensitive to model specifications, partly explaining the diverse re- sults in the literature. We propose a two-stage method that avoids these identification problems.