The effect of free trade agreements revisited: Does residual trade cost bias matter?

This paper revisits a prominent gravity model-based empirical literature on the effects of free trade agreements by accounting for a potential bias caused by unobservable trade costs that operate through general equilibrium constraints. It embeds state-of-the-art panel estimation techniques in a recently proposed two-step remedy that features a constrained ANOVA-type estimation. Using a dataset on manufacturing trade flows in eight sectors in 40 countries and a rest-of-the-world aggregate for the period 1990-2002, it finds evidence of significant residual trade cost bias. The direction and magnitude of bias vary across sectors, with the standard one-step approach used in the literature overestimating or underestimating the partial effect of free trade agreements by up to 110 percent. Overall, coefficients on trade costs variables are jointly significantly different between the standard method and the two-step method. The biases in partial effect estimates translate into biases in general equilibrium effects.