Trade creation and diversion revisited: Accounting for model uncertainty and natural trading partner effects

The effect of preferential trade agreements (PTAs) on trade flows is subject to model uncertainty stemming from the diverse and even contradictory effects suggested by the theoretical PTA literature. The existing empirical literature has produced remarkably disparate results and the wide variety of empirical approaches reflects the uncertainty about the correct set of explanatory variables that ought to be included in the analysis. To account for the model uncertainty that surrounds the validity of the competing PTA theories, we introduce Bayesian model averaging (BMA) to the PTA literature. Statistical theory shows that BMA successfully incorporates model uncertainty in linear regression analysis by minimizing the mean squared error, and by generating predictive distributions with optimal predictive performance. Once model uncertainty is addressed as part of the empirical strategy, we find strong evidence of trade creation, trade diversion, and open bloc effects. Our results are robust to a range of alternative empirical specifications proposed by the recent PTA literature. Copyright (c) 2010 John Wiley & Sons, Ltd.