Modeling Heterogeneous Direct and Third‐Country Effects of the Trade Policy Network

ABSTRACT This paper derives a structural Melitz‐type gravity model featuring heterogeneous trade cost elasticities to estimate indirect and modular effects of trade agreements in a large panel dataset. Indirect or third‐country effects are heterogeneous and nest trade diversion and reverse trade diversion. Our results show considerable heterogeneity of trade effects of agreements depending on pair‐specific variable and fixed costs. For a single agreement, indirect partial effects are small relative to direct partial effects. However, a counterfactual simulation of the effects of the global network of agreements over 1972–2017 highlights that aggregate trade diversion can be substantial, because of the large and increasing number of existing agreements. Other factors like agreement depth, comparative advantage and specialization patterns of members also condition the potential for trade diversion of trade agreements.