CEGSDISCUSSIONPAPER SERIES

No.2018-CEGS-04

Measuring Mongolia’s Gains from Trade and Increased
Integration in the World Economy
Enkhmaa Battogtvor

横浜国立大学

成長戦略研究センター

リサーチャー2019 年 3 月

横浜国立大学

成長戦略研究センター

Center for Economic Growth Strategy(ＣＥＧＳ)
Yokohama National University
79-4 Tokiwadai hodogaya-ku
Yokohama 240-8501 JAPANCEGSMeasuring Mongolia’s Gains from Trade and Increased Integration in theWorld Economy
Enkhmaa Battogtvor
Department of Economics
Yokohama National University
battogtvor-enkhmaa-wg@ynu.jp

Craig Parsons
Department of Economics
Yokohama National University
parsons-craig-gj@ynu.ac.jp

Abstract
Following the gains from variety literature (Broda and Weinstein, 2006), we estimated thewelfare impact of the dramatic increase in imported varieties growth in Mongolia and found it
to be considerably larger than that found in previous studies of other countries. Our results
show that from 1988 to 2015, the gains from variety were equal to 22 percent of Mongolia’sGDP, or 0.8 percent annually. Also, by calculating Novy measures of trade costs, we find thatthe tariff-equivalent trade costs between any two partners fell dramatically since the dissolutionof and Mongolia`s exit from the Soviet-led CMEA (Council of Mutual Economic Association).
Our calculations suggest that the costs between Mongolia and China, now its biggest trading
partner, fell from 114% to 63%. This is twice the decline of the post-NAFTA US-Mexico trade
costs. Other bilateral trade cost declines (e.g. with Germany) were even greater. As such, thispaper documents one of the largest trade liberalizations in modern history.

1

JEL Classification Codes: F14, F15, L13, L
Keywords: Gains from trade, Novy Measure, Elasticity of substitution, Welfare effect of tradeliberalization, Economic Integration, Mongolia

21. Introduction

Mongolia undertook serious economic reforms in 1990 after the collapse of the Soviet
Union and suffered a long and dramatic process of transformation into the free-market
economy, easing price controls, liberalizing domestic and foreign trade. The centrally planned
economy, state-owned industries and banking systems were transferred into the private sectors.
The economy is still in transition. However, imports and exports have soared and the nature ofimports, exports and trading partners have changed dramatically over the past 20-plus years.
The paper first estimates the comprehensive gains from variety for Mongolian economy
during 1988-2015, following the seminal works by Feenstra (1994) and Broda and Weinstein(2006). We also look at the changes in major trade partners and then calculate bilateral trade
costs using the method developed by Novy (2013). 1 We find that Mongolia’s gains from newvariety far surpass other transitional economies. We also find that while bilateral trade costs
fell dramatically for most partners. For example, ss Mongolia’s number one trading partnerchanged from Russia to China, the trade costs with China fell from roughly from a 100% tariff
equivalent to 60% or so. At the same time, trade costs between Russia and Mongolia were
unchanged, however. For some partners who are far more remote, relative to Mongolia, suchas Australia and Thailand, the fall in trade costs was dramatic, falling from over 500% toaround 200% in the last twenty years. There were also large differences across similar
economies. Trade costs between Mongolia and Japan fell by half (200% to 100%) while for
Korea and Mongolia there was a much smaller decline. For Europe, there were also significant
declines across the board.

1

This discussion paper is an extension of Battogtvor’s PhD dissertation and a working paper by Parsons andBattogtvor (2019).

3

The gains from variety for Mongolian economy were estimated, using six-digit
harmonized system (HS) products data which is the most disaggregated data available for
Mongolia. We estimated 1390 elasticities and with the elasticities, we constructed an exact
price index to measure the welfare gains from variety growth. This method is consistent withthe theory of monopolistic competition and is robust in empirical applications (Feenstra, 1994).
The results show that the welfare gain owing to newly imported varieties from 1988 to2015 amounts to 22 percent of GDP, or 0.8 percent annually. This is a significant result
considering the moderate annual gains from 0.1 percent (Broda and Weinstein, 2006) to 0.4
percent (Chen and Ma, 2012) the most studies show.
We contribute to the growing literature by providing a measure of Mongolia’s welfare
gain due to import variety from 1988 to 2015. This is the first such study to apply themethodology of Broda and Weinstein (2006) to calculate Mongolian gains from variety, thus
we had two motivations in mind. First, by measuring Mongolia’s gains from import varieties
after the liberalization in 1990s, we provided supporting evidence favoring trade liberalization
for developing countries. Second, we estimated elasticities exclusive to Mongolia using ahighly disaggregated import data and these elasticities may be useful for other studies. Also,using the Novy method, we find that trade costs between Mongolia’s partner fell dramatically,
often over 100%, far larger than even the largest free trade agreements.
The rest of the paper is organized as follows. Section 2 gives and overview ofMongolia’s transition from a barter trade socialist Soviet satellite state to an open economy in
the in the earlier 1990s to present. Section 3 first summarizes the prima facie gains from tradeas evidenced by rising per capita income and rising real wages. Next, and one of our uniquecontributions, we calculate the additional welfare gains from increased varieties of goods as
Mongolia (a la Feenstra, 1994, 2010 and Broda and Weinstein 2006) opened up and normalized
4

trade relations. Section 4 measures the increase in the degree of bilateral integration with its
major trading partners. This is done using original measures of trade costs using themethodology of Novy (2013). Section 5 concludes.

2. Mongolia’s Transition to an Open Economy
Mongolia is now one of the freer countries in the world. With average tariffs rates below 5%(UN Trains) and essentially no import quotas or tariff-rate quotas (Sharma and Davaakhuu,
2015) it is clearly open to trade now. Despite some non-tariff barriers to trade, not unique toMongolia, the country has seen its imports and exports skyrocket over the last 20 years.
Mongolia joined the WTO in 1997. To appease the existing members and gain accession, it
engaged in a number of trade and domestic liberalizations. However, its true first break fromnear autarky to a more freely trading country occurred earlier, after the Soviet Union
collapsed and Mongolia was no longer confined to various, restricted, barter-type trading
within the Soviet-led Council of Mutual Economic Assistance (CMEA or COMECON) of
which it was a member from 1962 to 1991.
Looking at Figure 1, we can see that trade was almost non-existent since then late1980s where uniform and reliable data becomes available. Though in absolute levels, it isquite small, we can see a significant increase in trade after leaving CMEA, and then again
after accession to the WTO, where trade double from 1996 (pre-accession) to 2004. But thereal trade take-off occurs when the mining sector gets moving (helped by enormous inflowsof FDI by foreign mining firms) soar. The new export-led rise in incomes in turn spurredconsumption in general of and consumption of imports, in particular, in this resource-rich,
but land-landlocked and relatively undiversified economy.

5

Figure 1 Exports and Imports (Billion Dollars)
8
7
6
5
4
3
2
1
0
1988

1992

1996

2000

2004

Exports

2008

2012

2016

Imports

Source: Authors’ figure based on wits.worldbank.org data.

Figure 2 shows Mongolian imports share of GDP from 1988 and 2016. The share wasnearly zero in 1988. It quickly rose after the liberalization in 1990, and reached 45 percent
when Mongolia accessed to the World Trade Organization (WTO) in 1997. By 2012, theshare was 61 percent of GDP. 2

2
However, as a result of the downturn in the economy (in part due to falling resources prices), the ratio ofimports to GDP has dropped since 2012.

6

Figure 2. Imports Share of GDP (%)
70.0%
61%

60.0%

54%

50.0%

51%

45%

43%

40.0%
38%

30.0%

33%

19%

20.0%

15%

10.0%
3%

1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015

0.0%

48%

Import/GDP

Source: Authors’ calculation based on import data from wits.worldbank.org and GDP datafrom the World Bank Development Indicators (online).

Naturally, the manufacturing and agriculture sectors shrank, and rural poverty is stilla serious problem, but GDP per capita has risen dramatically. Being only $506 in 1997, in
2017, Mongolia’s GDP per capita is $3,717 (World Bank data in current US$, non-PPP). The
commodity price spikes in and around 2008 have done much to make the value of its exports
soar, and dramatically raise the standard of living in this country of just over 3 million
people.
Not only did the volume of trade increase dramatically, but also the ranking of its
major trading partners underwent radically change. In the past, imports were sourced
primarily from its old CMEA leader, Russia, with Chinese imports a distant second place.
Now in 2016, imports from China are the greatest, though Russian imports follow in a close
second these days.

7

Figure 3. Source of Mongolia’s Imports (1996)

Source: Figures 3-6 by Yoshie Kawabe based on data from UN Comtrade
China, Hong
Kong SAR
0.8%

others
12.8%
RussianFederation
36.4%

Norway
1.1%
USA
2.3%
Singapore
3.1%
Rep. of Korea
3.9%
Italy
5.1%

Germany
7.4%

Japan
11.7%

China
15.4%

Figure 4. Source of Mongolia’s Imports (2016) Source: UN Comtrade
Ukraine others
1.0%
14.7%
Viet Nam
1.2%

China
31.1%

Poland
1.2%
Malaysia
1.2%
Germany
3.6%
USA
4.2%
Rep. of Korea
5.9%

RussianFederation
25.8%

Japan
9.9%

8

Figure 5. Source of Mongolia’s Exports (1996) Source: UN Comtrade
Netherlands
0.8%
China, Hong
Kong SAR
1.4%

Japan
0.5%

USA
0.2%

Germany
0.1%

Canada0.1%
others1.0%

Rep. of Korea
2.2%

United Kingdom
12.7%

China
17.9%

RussianFederation
63.1%

Figure 6. Source of Mongolia’s Exports (2016) Source: UN Comtrade
Germany
0.9%

Italy
0.7%

Singapore
0.3%

Japan
0.3%

RussianFederation
1.1%

China, Hong
Kong SAR
0.2%
USA
0.2%
Rep. of Korea
0.2%

United Kingdom
16.0%

others
1.1%

China
79.0%

9

On the export side, the change is even more dramatic. While 63% of Mongolian
exports went to Russia in 1996, now, virtually no exports go there. China now accounts fornearly 80% of all Mongolia exports. Trucks laden with copper and coal go in droves to feed
the energy and mineral-hungry China. The second largest export destination is, by far, theUK. Over 95% of those exports are gold.
While the gains from trade in moving from a highly restrictive, highly controlled andnearly balanced barter trade to a more ‘normal’ trading country must have been enormous, asdata from the CMEA era is scant, and incomparable, we do not attempt to assess those gains
here. Instead, we focus on the huge, continued gains Mongolia has made as it pursues its
own, free trade liberalization path since 1996. We assess these gains in two ways: 1)
examining the additional gains from trade due in an increase in variety of imports coming
into Mongolia over the years; and 2) by measuring how much ‘trade costs’ have implicitly
fallen for Mongolia major trade partners on a bilateral basis in recent years. In other words,
with which countries has Mongolia become “closer” in a trade sense, as it continues to grow.
These questions would be interesting for any country, but may more of even more interest forthis transitional, land-locked, resource-rich country.
3. Traditional Gains from Trade and Gains from Increased Variety
It is clear that Mongolia has gained economically since the break up of the Soviet Union andaccession into the WTO. As shown in the previous section, imports and exports soared and
GDP per capita in nominal terms rose from just over $500 in 1997 to $3,717 in 2017. In PPPadjusted terms GDP per capita was $12,900 in 2017. This is on par with, say, Peru andlagging a bit behind another former COMECON member, Bulgaria which stood at $20,900 in
the same year.

10It would be tempting to conduct a Huber (1971)-style gains from trade calculation.
Seemingly, Mongolia moved from a near autarkic state to a very open on in a matter of a few
years. However, unlike the classic Huber study of Japan which quickly changed from a selfimposed, near autarky country to a situation of nearly complete free trade (tariffs wereallowed to be no more than 5%), Mongolia`s experience is not as amenable to such analysis.
For one, Mongolia was trading with the Soviet Union, but under the opaque barter system of
COMECON and which data is scarce and prices and values impossible to map onto somemarket-based equivalent. Likewise, construction of internal, autarky relative price indiceswould be difficult, if not impossible to construct because of the Soviet-style planned
economy that operated in Mongolia.
Unlike Huber (1971), however, we do have GDP and GDP per capita and wage data,
at least shortly after Mongolia transformation, and thus we clearly see that overall welfare
rose (though the transition was long and painful). As mentioned in the previous section, GDPper capita rose seven-fold from 1997 to 2017 in twenty years. Growth in real wages tells aneven more dramatic story. A real wage index (wages in domestic currency deflated bydomestic inflation) rose from 7.175 in 1995 to 124.22 in 2011, a seventeen-fold increase in
16 years. 3
In this section, we augment the prima facie evidence of Mongolia`s great gains from
opening up, with additional gains to a massive increase in variety of imports available to theliberalized economy. Here, we implement the methodologies developed by Feenstra (1994)
and Broda and Weinstein (2006) to estimate variety adjusted price indices andeconometrically estimate the necessary elasticities of substitutions necessary to calculate
additional gains from variety. Though these methods have been employed in many othercountries (US, Hong Kong, other transitional countries), to our knowledge, ours if the first3

Real wage index data from www.ceicdata.com accessed March 11, 2019.

11

such welfare calculations for Mongolia. 4 Later, in section 4, we employ another recent
method, developed by Novy (2013) to measure the reductions in bilateral trade costs between
Mongolia and its major trading partners.
The quantitative analysis of gains from variety starts with the seminal work of Feenstra(1994). Feenstra (1994) showed how to estimate the elasticity of substitution of individual
products. Using these elasticities he offered the formula for an exact price index that canaccount for entry and exit of varieties. By doing so, Feenstra (1994) demonstrated that new
product varieties lead to an increase in consumer utility. However, a comprehensive measureof the gains from import variety puts tremendous demands on data availability, and was notrealized until Broda and Weinstein (2006) who applied it systematically to US data. They foundthat the total gain from the introduction of new varieties in the U.S. was 2.6 percent of GDP
between 1972 and 2001.
Following Broda and Weinstein (2006), a body of country studies emerged, using thesame methodology. 5 Chen and Ma (2012) found that the welfare gain in the Chinese economy
as a result of new import variety amounts to 4.9 percent of GDP, or 0.4 percent annually
between 1997 and 2008. Minondo and Requena (2010) investigated the welfare gains due toSpanish imports of new varieties over the period 1988-2006. They found that the total welfare
gain is equal to 1.2 percent of GDP in 2006. In a comparative study of Switzerland and the
U.S., Mohler (2009) estimated a lower and an upper bound of the gains from variety. He foundthat during the period from 1990 to 2006, the gains from variety in Switzerland were between
0.3 and 4.98 percent of GDP and that in the U.S. the gains from variety were between 0.5 and

4The work here is an extension of Battogtvor’s doctoral dissertation. More details can be found in a related
earlier working paper Battogtvor and Parsons (2019).

As a reference, only few papers are mentioned here. In addition to its welfare gain estimation, Broda andWeinstein (2006) paper is often cited for the import demand elasticity estimation. Already estimated data of
73 countries excluding Mongolia is available at the following Columbia university webpage:
http://www.columbia.edu/~dew35/TradeElasticities/TradeElasticities.html

512

4.7 percent of GDP. Mohler and Seitz (2010) applied the methodology to the 27 countries of
the European Union for the period of 1999 to 2008. Their results show that within the European
Union, especially “newer” and smaller member states exhibit high gains from newly imported
varieties. For instance, Estonia gained 2.80 percent of GDP (GDP of Estonia), Slovakia 2.37
percent, Latvia 1.65 percent, Bulgaria 1.59 percent, and etc. They also found that interestingly,
two of the largest economies in the group, France and Germany, both had negative gains fromvariety. They argue that the reason for this is that these larger economies were already heavily
integrated in the European economy and did therefore not experience the increase in productvarieties as did the “new”, smaller economies.
We contribute to the growing literature by providing a measure of Mongolia’s welfare
gain due to import variety from 1988 to 2015. This is the first study that pursues this measure
for Mongolia, thus we have two motivations in mind as briefly stated in the introduction. First,
as a small open economy, Mongolia underwent a drastic liberalization after the dissolution of
the Soviet Union. The economy is still now in transition. Thus, measuring Mongolia’s gains
from import varieties provides supporting evidence favoring trade liberalization for developing
countries. It may also provide informative implications to Mongolia’s policymakers. Second,
we obtain estimates for hundreds of elasticities of substitution using a highly disaggregatedimport data of Mongolia, which may be useful for other studies. For example, different
elasticities may imply different responsiveness of imported products to demand shocks or
exchange rate movements suggested by Chen and Ma (2012).
The definition of variety used in this paper is same as the variety defined in Broda andWeinstein (2006), which is an Armington (1969) definition of a product variety. By thisdefinition, a variety is a particular good produced in a particular country. To be more specific,
a product in this paper is defined as a six-digit HS good. To give an example, sparkling wine

13

(with HS-6 product code 220410) was imported from only one country, Germany, in 1989, in
contrast to this, in 2015 the same wine was imported from 13 different countries such as France,
Spain, Italy, Chile etc. This represents an increase of single variety to 13 different varieties.
Therefore, by the Armington (1969) assumption, an HS-6 product supplied by one country is
regarded as different from the same product supplied by any other country.
Gains from increased import varieties are not limited to consumers. Access to more
imported varieties may enhance productivity growth, leading domestic firms to gain
substantially. In fact, with the widely used constant elasticity of substitution (CES) structure,
new varieties could be modeled either as consumption goods or as intermediate inputs (Romer,1994). We follow Broda and Weinstein (2006) and treat all imported goods as intended forfinal consumption.
Data and Descriptive Analysis
To construct the variables needed to estimate the variety gains from trade, we used the United
Nations Comtrade - International Trade Statistics database. The import data of Mongolia wasfor the years 2002, 2008-2012, 2015- 2016 was not available. Therefore, we used the export
data of rest of the world to Mongolia from 1988 to 2015, thus covering 28 continuous years.
Furthermore, due to the insufficient numbers of varieties, HS-6 products with less than 37
observations are dropped (37 is somewhat arbitrary, but a natural cut-off point in the data).
This is due to the problem that many products were not imported to Mongolia constantly
throughout the period. Specifically, when Comtrade had import data, but reported the countryof origin as ‘Unspecified’, that data point was dropped. Likewise, if there was ‘Value’ but no‘Quantity’ of imports, that data point was also dropped. In the end, we have 158 thousand
observations of 1628 products. Gross domestic product (GDP) data were taken from the WorldBank Database.
14

To study the welfare implication of the drastic increase in imports of Mongolia, weshould consider the increase in value of each product (i.e. the intensive margin) and the increasein the number of products and varieties for each product (i.e. the extensive margin).
Table 1 summarizes the count measure of imported varieties of Mongolia between 1988
and 2015 and reveals that behind the rapid growth in import value, the growth in importvarieties is similarly dramatic. Column (2) reports the number of HS-6 products for the related
years. We can see that the number of these products increased by a factor of seven-fold during
the period, from only 226 in 1988 to 1610 in 2015. Moreover, column (5) shows the total
number of imported product varieties, which can be calculated as the number of HS-6 products
multiplied by the average variety in column (4).

Table 1 Variety in Mongolian Imports (1988-2015)

All 1988 goods

Year
(1)
1988

Number of
HS-6
products(2)
226

Mediannumber ofexportingcountries(3)
1

Averagenumber ofexportingcountries
(4)
1.1

Total
number ofvarieties(5)
255

All 2001 goods

2001

1512

3

3.5

5304

All 2015 goods

2015

1610

5

6.2

10052

Common, 1988-2015

1988

219

1

1.1

247

Common, 1988-2015

2015

219

3

8.0

1746

1988 not in 2015

1988

7

1

1.1

8

2015 not in 1988

2015

1391

3

6.0

8306

Source: Authors’ calculations based on the UN Comtrade data.

It can be seen from column (5) that the total number of varieties increased 40 times,
from 255 to 10052. This is a remarkable increase that no other country study has ever shown.
Columns (3) and (4) show the median and average number of source countries exporting to15

Mongolia, i.e. the number of varieties. We can observe that the number of exporting countries
increased over time. In 1988 only one variety or source country was available per good, but in2015 on average six varieties were available. The middle part of the Table 1 reports statisticsof the common goods which were available in both the beginning and the end of the period. It
is notable that, on average, these common products were imported from only one source
country in 1988, however in 2015 the number of source countries rose to eight. The last two
rows of the table show that there are 1391 new goods which were not available in 1988,
imported from six different countries on average. These dramatic changes in goods andvarieties suggest that conventional measures using a fixed basket of goods or varieties could
be largely biased. Consequently, these facts demonstrate that the gains from variety are notnegligible.
Methodology: the Broda and Weinstein Method
Following Feenstra (1994, 2010) and Broda and Weinstein (2006), we start by deriving
an exact price index for a constant elasticity of substitution (CES) utility function of a single
good with a constant number of varieties. 6 This index is then extended by allowing for new
and disappearing varieties. Finally, we show how to construct an aggregate import price index
and gains from variety formula. Let us start with a simple CES utility function with thefollowing functional form for a single imported good. Assume that varieties of a good 𝑔𝑔 aretreated as differentiated across countries of supply, c:1−𝜎𝜎𝑀𝑀𝑔𝑔𝑔𝑔 = �� 𝒹𝒹𝑔𝑔𝑔𝑔𝑔𝑔 𝑚𝑚𝑔𝑔𝑔𝑔𝑔𝑔 𝑔𝑔 �𝑐𝑐∈𝐶𝐶1
�1−𝜎𝜎𝑔𝑔 �;𝜎𝜎𝑔𝑔 > 1

(1)

For more details, refer to Feenstra (1994, 2010), Broda and Weinstein (2016) and an earlier working
paper in Battogtvor and Parsons (2019).

616

where C denotes the set of all countries and hence of all potentially available varieties. In theequation, 𝑚𝑚𝑔𝑔𝑔𝑔𝑔𝑔 is the subutility derived from the consumption of imported variety c of good 𝑔𝑔

in period t; 𝒹𝒹𝑔𝑔𝑔𝑔𝑔𝑔 is the corresponding taste or quality parameter. The elasticity of substitution
among varieties of good 𝑔𝑔 is given by 𝜎𝜎𝑔𝑔 and is assumed to be larger than one.

Let 𝐼𝐼𝑔𝑔𝑔𝑔 ⊂ 𝐶𝐶 be the subset of all varieties of good 𝑔𝑔 imported in period t. Using standard

cost minimization for the subutility function (1) gives us the minimum unit-cost function:1−𝜎𝜎𝑔𝑔𝜙𝜙𝑔𝑔𝑔𝑔 �𝐼𝐼𝑔𝑔𝑔𝑔 , 𝑑𝑑⃗𝑔𝑔𝑔𝑔 � = � � 𝑑𝑑𝑔𝑔𝑔𝑔𝑔𝑔 �𝑝𝑝𝑔𝑔𝑔𝑔𝑔𝑔 ��

11−𝜎𝜎𝑔𝑔(2)

𝑐𝑐∈𝐼𝐼𝑔𝑔𝑔𝑔

where 𝑝𝑝𝑔𝑔𝑔𝑔𝑔𝑔 is the price of variety c of good 𝑔𝑔 in period t and 𝑑𝑑⃗𝑔𝑔𝑔𝑔 is the vector of taste or quality
parameters for each country.

Suppose the set of varieties 𝐼𝐼𝑔𝑔 in period 𝑡𝑡 and 𝑡𝑡 − 1 are identical, the taste parameters𝑑𝑑⃗𝑔𝑔 are also constant over time and 𝑥𝑥⃗𝑔𝑔𝑔𝑔 and 𝑥𝑥⃗𝑔𝑔𝑔𝑔−1 are the cost-minimizing consumption bundle
vectors for the varieties of good 𝑔𝑔 for given the price vectors. In this case Diewert (1976)
defines an exact price index as a ratio of the minimum cost functions:

𝑃𝑃𝑔𝑔 �𝑝𝑝⃗𝑔𝑔𝑔𝑔 , 𝑝𝑝⃗𝑔𝑔𝑔𝑔−1 , 𝑥𝑥⃗𝑔𝑔𝑔𝑔 , 𝑥𝑥⃗𝑔𝑔𝑔𝑔−1 , 𝐼𝐼𝑔𝑔 � =𝜙𝜙𝑔𝑔𝑔𝑔 �𝐼𝐼𝑔𝑔 , 𝑑𝑑⃗𝑔𝑔 �
𝜙𝜙𝑔𝑔𝑔𝑔−1 �𝐼𝐼𝑔𝑔 , 𝑑𝑑⃗𝑔𝑔 �(3)

where the price index does not depend on the unknown taste or quality parameters 𝑑𝑑𝑔𝑔𝑔𝑔 . Sato

(1976) and Vartia (1976) have derived the exact price index for the case of the CES unit-costfunction. It can be written as the geometric mean of the individual variety price changes:
𝑤𝑤

𝑔𝑔𝑔𝑔𝑔𝑔𝑝𝑝𝑔𝑔𝑔𝑔𝑔𝑔
𝑃𝑃𝑔𝑔 �𝑝𝑝⃗𝑔𝑔𝑔𝑔 , 𝑝𝑝⃗𝑔𝑔𝑔𝑔−1 , 𝑥𝑥⃗𝑔𝑔𝑔𝑔 , 𝑥𝑥⃗𝑔𝑔𝑔𝑔−1 , 𝐼𝐼𝑔𝑔 � = � ��𝑝𝑝𝑔𝑔𝑔𝑔𝑔𝑔−1

𝑐𝑐∈𝐼𝐼𝑔𝑔

17(4)

where the weights are calculated using the expenditure shares 𝑠𝑠𝑔𝑔𝑔𝑔𝑔𝑔 :𝑠𝑠𝑔𝑔𝑔𝑔𝑔𝑔 − 𝑠𝑠𝑔𝑔𝑐𝑐𝑐𝑐−1
�ln 𝑠𝑠𝑔𝑔𝑔𝑔𝑔𝑔 − ln 𝑠𝑠𝑔𝑔𝑔𝑔𝑔𝑔−1
𝑤𝑤𝑔𝑔𝑔𝑔𝑔𝑔 =𝑠𝑠𝑔𝑔𝑔𝑔𝑔𝑔 − 𝑠𝑠𝑔𝑔𝑔𝑔𝑔𝑔−1∑𝑐𝑐∈𝐼𝐼𝑔𝑔 ��ln 𝑠𝑠𝑔𝑔𝑔𝑔𝑔𝑔 − ln 𝑠𝑠𝑔𝑔𝑔𝑔𝑔𝑔−1
�

𝑠𝑠𝑔𝑔𝑔𝑔𝑔𝑔 =(4.1)

𝑝𝑝𝑔𝑔𝑔𝑔𝑔𝑔 𝑥𝑥𝑔𝑔𝑔𝑔𝑔𝑔∑𝑐𝑐∈𝐼𝐼𝑔𝑔 𝑝𝑝𝑔𝑔𝑔𝑔𝑔𝑔 𝑥𝑥𝑔𝑔𝑔𝑔𝑔𝑔(4.2)

So far, it was assumed that all varieties of good 𝑔𝑔 were available in both periods tocalculate the exact price index. To include new and disappearing varieties into account,
Feenstra (1994) showed how to modify this exact price index for the case of different, but
overlapping, sets of varieties in the two periods. This contribution of Feenstra is given by thefollowing proposition.
Proposition: For every good 𝑔𝑔, if 𝑑𝑑𝑔𝑔𝑔𝑔𝑔𝑔 = 𝑑𝑑𝑔𝑔𝑔𝑔𝑔𝑔−1 for 𝑐𝑐 ∈ 𝐼𝐼𝑔𝑔 = �𝐼𝐼𝑔𝑔𝑔𝑔 ∩ 𝐼𝐼𝑔𝑔−1 �, 𝐼𝐼𝑔𝑔 ≠ ∅, then theexact price index for good 𝑔𝑔 with change in varieties is given by
𝜋𝜋𝑔𝑔 �𝑝𝑝⃗𝑔𝑔𝑔𝑔 , 𝑝𝑝⃗𝑔𝑔𝑔𝑔−1 , 𝑥𝑥⃗𝑔𝑔𝑔𝑔 , 𝑥𝑥⃗𝑔𝑔𝑔𝑔−1 , 𝐼𝐼𝑔𝑔 � =𝜙𝜙𝑔𝑔𝑔𝑔 �𝐼𝐼𝑔𝑔𝑔𝑔 , 𝑑𝑑⃗𝑔𝑔 �
𝜙𝜙𝑔𝑔𝑔𝑔−1 �𝐼𝐼𝑔𝑔𝑔𝑔−1 , 𝑑𝑑⃗𝑔𝑔 �(5)

1

𝜆𝜆𝑔𝑔𝑔𝑔 𝜎𝜎𝑔𝑔−1= 𝑃𝑃𝑔𝑔 �𝑝𝑝⃗𝑔𝑔𝑔𝑔 , 𝑝𝑝⃗𝑔𝑔𝑔𝑔−1 , 𝑥𝑥⃗𝑔𝑔𝑔𝑔 , 𝑥𝑥⃗𝑔𝑔𝑔𝑔−1 , 𝐼𝐼𝑔𝑔 � ��𝜆𝜆𝑔𝑔𝑔𝑔−1

where

𝜆𝜆𝑔𝑔𝑔𝑔 =∑𝑐𝑐∈𝐼𝐼𝑔𝑔 𝑝𝑝𝑔𝑔𝑔𝑔𝑔𝑔 𝑥𝑥𝑔𝑔𝑔𝑔𝑔𝑔∑𝑐𝑐∈𝐼𝐼𝑔𝑔𝑔𝑔 𝑝𝑝𝑔𝑔𝑔𝑔𝑔𝑔 𝑥𝑥𝑔𝑔𝑔𝑔𝑔𝑔

and

𝜆𝜆𝑔𝑔𝑔𝑔−1 =∑𝑐𝑐∈𝐼𝐼𝑔𝑔 𝑝𝑝𝑔𝑔𝑔𝑔𝑔𝑔−1 𝑥𝑥𝑔𝑔𝑔𝑔𝑔𝑔−1∑𝑐𝑐∈𝐼𝐼𝑔𝑔𝑔𝑔−1 𝑝𝑝𝑔𝑔𝑔𝑔𝑔𝑔−1 𝑥𝑥𝑔𝑔𝑔𝑔𝑔𝑔−1

(6)

(7)

Feenstra’s theoretical contribution is correcting the conventional price index 𝑃𝑃𝑔𝑔 (𝐼𝐼𝑔𝑔 ) bymultiplying it with an additional term which captures the influence of new and disappearing18

varieties. This additional term is called the lambda ratio. The numerator of this term, 𝜆𝜆𝑔𝑔𝑔𝑔 ,captures the impact of newly available varieties. 𝜆𝜆𝑔𝑔𝑔𝑔 is the ratio of expenditures on varieties

available in both periods (i.e., 𝑐𝑐 ∈ 𝐼𝐼𝑔𝑔 = �𝐼𝐼𝑔𝑔𝑔𝑔 ∩ 𝐼𝐼𝑔𝑔−1 �) relative to the entire set of varieties
available in period t (i.e., 𝑐𝑐 ∈ 𝐼𝐼𝑔𝑔𝑔𝑔 ). Hence, 𝜆𝜆𝑔𝑔𝑔𝑔 decreases when expenditure share of newvarieties increases and therefore, the exact price index decreases relative to the conventional
price index. On the other hand, the denominator of the lambda ratio, 𝜆𝜆𝑔𝑔𝑔𝑔−1, captures the impact

of disappearing varieties. 𝜆𝜆𝑔𝑔𝑔𝑔−1 increases when there are only few disappearing varieties, andtherefore the exact price index is relatively low when compared to the conventional price index.
The exact price index also depends on the elasticity of substitution between varieties,
𝜎𝜎𝑔𝑔 . If 𝜎𝜎𝑔𝑔 is high,1

𝜎𝜎𝑔𝑔 −1

𝜆𝜆𝑔𝑔𝑔𝑔is close to zero and the additional term �𝜆𝜆𝑔𝑔𝑔𝑔−11
𝜎𝜎𝑔𝑔−1�is close to unity.

Hence the variety change has small influence on the price index. This is intuitive, when 𝜎𝜎𝑔𝑔 ishigh since new and disappearing products are close substitutes to existing varieties, they only
have a minor influence on the price index.
The exact price index with variety change for good 𝑔𝑔 was derived in equation (6).

Aggregating it for all imported goods G gives us the aggregate exact import price index:

Π(𝑝𝑝⃗𝑡𝑡 , 𝑝𝑝⃗𝑡𝑡−1 , 𝑥𝑥⃗𝑡𝑡 , 𝑥𝑥⃗𝑡𝑡−1 , 𝐼𝐼 ) =𝜙𝜙𝑡𝑡 �𝐼𝐼𝑡𝑡 , 𝑑𝑑⃗ �

𝜙𝜙𝑡𝑡−1 �𝐼𝐼𝑡𝑡−1 , 𝑑𝑑⃗ �(8)

𝑤𝑤𝑔𝑔𝑔𝑔𝜆𝜆𝑔𝑔𝑔𝑔 𝜎𝜎𝑔𝑔−1= 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶(𝐼𝐼) � ��
𝜆𝜆𝑔𝑔𝑔𝑔−1

(9)

𝑔𝑔∈𝐺𝐺

where 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶(𝐼𝐼 ) = ∏𝑔𝑔∈𝐺𝐺 𝑃𝑃𝑔𝑔 (𝐼𝐼𝑔𝑔 )𝑤𝑤𝑔𝑔𝑔𝑔 and the weights 𝑤𝑤𝑔𝑔𝑔𝑔 are defined in equation (4.1). Equation(9) shows that the aggregate exact import price index is the product of the aggregate

conventional import price index, CIPI(I), and the aggregated lambda ratios which is referred19

as an “aggregate bias” of the import price in Broda and Weinstein (2006).
The aggregate import bias, or simply the bias measure, is thus an indicator of an upwardbias of the aggregate conventional import price index compared to the aggregate exact importprice index. The ratio between aggregate exact price index including variety and the aggregate
conventional price is as follows.

𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 =𝑤𝑤𝑔𝑔𝑔𝑔𝜎𝜎𝑔𝑔 −1∏(𝐼𝐼)
𝜆𝜆𝑔𝑔𝑔𝑔= ���𝜆𝜆𝑔𝑔𝑔𝑔−1
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶(𝐼𝐼)
𝑔𝑔∈𝐺𝐺

(10)

Using a simple Krugman-style (1980) economy, the inverse of the bias can be weighted
by the import expenditure share to obtain the gains from variety:

𝐺𝐺𝐺𝐺𝐺𝐺 = �

1�𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵

𝑤𝑤𝑡𝑡 𝑀𝑀

𝑤𝑤𝑔𝑔𝑔𝑔 𝑤𝑤𝑡𝑡−
𝜎𝜎𝑔𝑔 −1

𝜆𝜆𝑔𝑔𝑔𝑔− 1 = �� ��
𝜆𝜆𝑔𝑔𝑔𝑔−1
𝑔𝑔∈𝐺𝐺

�

𝑀𝑀

−1

(11)

where 𝑤𝑤𝑡𝑡 𝑀𝑀 is the import expenditure share in t. 7
Estimation Strategy

In order to compute the exact import price index in equation (9), we have to estimate
the elasticity of substitution between varieties of each good. (See Battogtvor and Parsons(2019) for detailed of the estimation method developed by Feenstra (1994) and improved by
Broda and Weinstein (2006).)
Why Elasticities are Important?
An elasticity of substitution is measured as the ratio of proportionate change in the20relative demand for two goods to the proportionate change in their relative prices. In order toobtain estimates, we make several simplifying assumptions. Similarly, in order to value
varieties, let us assume that we have only one or at most two elasticities of substitution, an
assumption often made when using a utility function. This will implicitly assume the following(Broda and Weinstein, 2006). First, elasticities of substitution among varieties of different
goods are the same. However, the same amount of increase in price of a variety of two different
goods may be valued differently by consumers. For example, presumably consumers care more
about varieties of computers than crude oil. So, all increases in imports do not give the samegains in reality. Second, elasticities of substitution across goods equals that across varieties ofa given good. However, presumably we care more about the different varieties of vegetables
than about varieties of potatoes. The third, and probably the most problematic issue arises fromthe assumption that all varieties enter into the utility function with a common elasticity. For
example, let’s say Saudi Arabian oil prices went up. Then what will happen to our imports of
Mexican oil? What will happen to our imports of automobiles? One should rise and the othershould fall. The reason is that Mexican oil is almost the perfect substitute of the Saudi Arabian
oil and cars are the complements. However, if we assume that the elasticities are equal, then it
is very hard to interpret the meaning of the elasticity and there will be no intuition to its
magnitude.
In this section, we discuss the results of our estimation of Mongolian welfare gains
from an increased import product variety from 1988 to 2015. The estimation has four steps.
First, elasticities of substitution 𝜎𝜎𝑔𝑔 for each product are estimated. Second, we use equation (7)to calculate the lambda ratios 𝜆𝜆𝑔𝑔 for each imported product category. Third, with 𝜎𝜎𝑔𝑔 and 𝜆𝜆𝑔𝑔 ,we obtain an estimate of the exact price index for each product after import variety change.
Finally, using equation (9), we apply the log-change ideal weights to the price movements ofeach good in order to estimate the impact of variety growth on the aggregate import price index.
21

Then with the knowledge of each year’s aggregate import price index, using equation (11), wequantify the variety gains from trade with respect to GDP.
Our Estimates of Elasticities of Substitution
We estimated for each HS-6 product and obtained 1390 elasticities of substitution(“sigmas” henceforth). The sigmas are too numerous to report so in Table 2, we present thedescriptive statistics of sigmas and Table 3 reports sigmas for the 20 products with the largest
import share. Looking at these tables, we get a sense of the degree of substitutability among
varieties. If sigma is high, say above 10 or 20, then this suggests that the gains from variety aresmall. Intuitively, when 𝜎𝜎𝑔𝑔 is high, since new and disappearing products are close substitutes

to existing varieties, they will only have a minor influence on the price index and hence thegains from variety. 8 Conversely, if sigma is low, then this suggests that goods are highly
differentiated by country, meaning the potential for gains from variety is high.
Table 2 Estimated Elasticities of Substitution
StatisticHS-6 level

Percentile 90

12.1

Percentile 50 (Median)

3.6

Percentile 10

1.8

Mean

8.4

No of HS products

1390

Median variety per product14

Note: Authors’ calculation. See text for explanation.

8

If we look at equation (6) and (9), it is clear that if 𝜎𝜎𝑔𝑔 is high,𝜆𝜆𝑔𝑔𝑔𝑔�𝜆𝜆

𝑔𝑔𝑔𝑔−1high.

1
𝜎𝜎𝑔𝑔 −1�1

𝜎𝜎𝑔𝑔 −1is close to zero and the additional termis closer to unity. Hence the variety change has small influence on the price index, when 𝜎𝜎𝑔𝑔 is22

Table 2 shows that the average elasticity of substitution is 8.4. and median is 3.6.9 Table
3 shows that the most products with the largest import share, with only one exception, havelower elasticities of substitution, implying a larger gain from variety.
Table 3 Sigmas for the 20 Products with the Largest Import ShareHS-6
products
271000

2.39

Importshare (%)
22.95

870323

1.44

2.33

8429521.20

1.33870410

24.63

1.33

8703227.33

1.118704232.43

1.06

1101002.21

1.05

Motor vehicles for the transport of goods Dumpers designed for offhighway use
Other Vehicles, Spark-ignition Engine Of a cylinder capacity
exceeding 1,000 cc but not exceeding 1,500 cc
Motor vehicles for the transport of goods GVW exceeding 20 metric
tons
Wheat Flour, Meslin Flour

7308908.69

1.02

Other Structures and Parts of Structures, of Iron or Steel

2523295.04

1.01

Other Portland Cement2402202.90

0.94

Cigarettes (Containing Tobacco)

8431493.39

0.81

Parts of Derricks, Cranes, Graders, Levelers, Scrapers or Pile-drivers

1806905.06

0.788474902.26

0.753004902.07

0.73

Cocoa Preparations (In Containers, Packings, in Liquid, Powder,
Granular Form)
Parts of Machinery for Sorting, Crushing, Mixing, Molding or
Shaping
Other Medicaments (Put up in Packings for Retail Sale)

721420

17.22

0.72

6104625.78

0.70

630221

3.71

0.66

Concrete reinforcing bars and rods, Hot-rolled, Hot-drawn, Hotextruded
Women's or Girls' Trousers, Breeches, of Cotton, Knitted or
Crocheted
Bed Linen, Printed, of Cotton

732611

4.11

0.59

Grinding Balls and Similar Forged or Stamped Articles for Mills

2713203.26

0.58

Petroleum Bitumen

1704903.12

0.55

Other Sugar Confectionery, Not Containing Cocoa

Sigma

Descriptions
Petroleum Oils, Oils Obtained from Bituminous Minerals,
Preparations Thereof
Other Vehicles, Spark-ignition Engine Of a cylinder capacity
exceeding 1,500 cc but not exceeding 3,000 cc
Machinery With a 360 degrees Revolving Superstructure

Source: Authors’ calculation.
For comparison, results of Broda and Weinstein (2006) are as follows: the mean is 17.3 in HS9, 7.5 in
SITC-5 and median is 3.7 in HS9, 2.8 in SITC-5 in period 1972-1988 in US.

923Change in Varieties
The second step is to calculate the changes in variety over time (i.e. the lambda ratio).
The calculation of lambdas requires the existence of common varieties in the beginning and at
the end of the period.10 This is one of the major obstacles we face when implementing thetechnique. As a result, there are fewer lambda ratios than product groups or sigmas. Somelambda ratios cannot be defined at the HS-6 level since there is no common variety. We thenfollow Broda and Weinstein (2006) and define the lambda ratio at the HS-4 level.
Table 4 shows the summary statistics for the lambda ratios. The median lambda ratio
is 0.96, which implies that the typical imported product category in Mongolia experienced apositive variety growth of about 4 percent. 11 Using the lambda ratios as a measure of variety
growth is more sophisticated than just counting new and disappearing varieties. Due to thelarge number of new varieties with small market shares, just counting the new varieties can bemisleading. Thus, this underscores the importance of carefully measuring variety growth when
making price and welfare calculations. The measure also accounts for the importance ofdifferent varieties to the consumer budget decision by using expenditure shares as weights. The
lower the lambdas, the greater the number of varieties, and thus the more we spend on newvarieties.
Table 4 Descriptive Statistics of Lambda Ratios
StatisticHS-6 level

Percentile 5

0.14

Percentile 50 (Median)

0.96

Percentile 95

4.78

The reason why we need common varieties is that we cannot value the creation and destruction of a variety
without knowing something about how this affects the consumption of other varieties (Broda and Weinstein,2006).
11
Calculated as 1/0.96=1.042 or 4.2%.
1024

Note: Due to the existence of outliers reaching highabsolute values, the median is preferable tothe mean.

Welfare Gains from Variety
Using the estimated elasticities of substitution and the lambda ratios, we next calculate
the variety change effects on price. Following equation (9) and aggregating the lambda ratios
yields estimates of the impact of variety growth on the aggregate exact import price index.
Table 5 reports the results.
In column (4) of Table 5, the ratio of the aggregate exact price index including variety
and the aggregate conventional price index is reported as the bias measure as in equation (10).
It is worth explaining the intuition behind this bias. If this fraction is lower than one, it meansthat the changing set of imported varieties has lowered the import price index. In that case, theconsumers benefit from lower unit costs of imports. Thus, these lower costs are the source of
the welfare gains. On the other hand, if the bias is larger than one, this means that the importprice index is increased by the changing variety set. Thus, the disappearing varieties are morevaluable to the consumers than the new varieties and it results in welfare loss. Column (4)shows that in most years, the bias is lower than one, meaning the variety change resulted inlower import price index. On average, the bias measure is 0.978 which means that ignoring
new and disappearing product varieties in the conventional price index had led to an upwardbias of 2.25 percent. 12 This is the same thing as saying that import price inflation is overstatedby 2.25 percent per year.
Finally, we are now able to calculate the welfare effect of the fall in the Mongolian
exact import price.

1

Calculated as (− 1) × 100. For more details, refer to an earlier working paper (Battogtvor and𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏
Parsons, 2019).

1225

Column (5) of Table 5 presents the gains from variety for every year from 1988 until
2015. The results show that on a yearly basis, the welfare gains due to the increase in imported
product varieties in Mongolia, accounted for an average of 0.8 percent of GDP. This meansthat a representative Mongolian consumer would be willing to give up 0.8 percent of her
income to access the new import varieties every year. The welfare gains for the whole sample
period from 1988 to 2015 is approximately 22 percent of the GDP and it is a remarkable result
considering the moderate gains the most studies show.
Considering the relatively high results of the welfare gain, we consider the following
two reasons among many, to be important. First, as presented in section 3, the Mongolian
import share of GDP is extremely high. In Table 5, Column (3) shows the import shares from1988 to 2015. The import share rose significantly after 1996 and the average was 36 percent
during the period. This is rather high compared to other studies. For instance, Broda andWeinstein (2006) found the ideal import share of the U.S.to be 6.7 percent for 1972-1988 and10.3 percent for 1990-2001, respectively and Chen and Ma (2012) found the log-change ideal
weight of China’s import in GDP to be 11.5 percent during 1997-2008. Since we used the shareof imports in GDP as a weight 𝑤𝑤𝑡𝑡 𝑀𝑀 in equation (11), and the Mongolian import share of GDP

is relatively high, the variety gain is consequently high. Second and the main reason is that not
only the growth in number of varieties was drastic, but also the growth in number of products
was significant. Column (1) and (2) of Table 5 present the average number of varieties andnumber of HS-6 products, respectively. We can see that during the period, the number ofvarieties rose 6 times, from one to six, and on the other hand, the number of products rose 7
times, from 226 to 1610. This means that the numerator of the lambda ratios, 𝜆𝜆𝑔𝑔𝑔𝑔 , which

captures the impact of newly available varieties is low. Since 𝜆𝜆𝑔𝑔𝑔𝑔 is the ratio of expenditures

on varieties available in both periods (i.e., 𝑐𝑐 ∈ 𝐼𝐼𝑔𝑔 = �𝐼𝐼𝑔𝑔𝑔𝑔 ∩ 𝐼𝐼𝑔𝑔−1 �) relative to the entire set of26

varieties available in period t (i.e., 𝑐𝑐 ∈ 𝐼𝐼𝑔𝑔𝑔𝑔 ), evolving of the new variety decreases 𝜆𝜆𝑔𝑔𝑔𝑔 . Hence,the exact price index is relatively low and the welfare gain is relatively high.
Table 5 Import Price Bias and the Gains from Variety
Year

1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Total (1988-2015)
Average per-annum

Averagenumber ofvarieties
(1)
1.1
1.2
1.3
1.2
1.4
1.6
2.1
2.5
2.9
2.9
3.0
2.8
3.3
3.5
3.5
4.1
4.3
4.4
4.6
4.9
5.1
4.9
5.7
6.6
7.1
7.7
7.4
6.2

Number of
HS-6
products
(2)
226
275
342
485
783
791
1114
1216
1408
1382
1398
1410
1521
1512
1542
1579
1592
1573
1601
1587
1599
1601
1608
1611
1613
1614
1616
1610

3.8

1293

Import
Share

Bias

(3)
0.01
0.01
0.01
0.03
0.17
0.19
0.15
0.18
0.37
0.45
0.43
0.38
0.44
0.46
0.49
0.50
0.51
0.47
0.43
0.49
0.54
0.53
0.48
0.61
0.57
0.50
0.43
0.33

(4)
1.000
0.992
0.993
1.017
0.911
0.888
1.041
0.903
0.811
0.998
1.011
0.973
0.978
0.942
0.959
0.966
0.991
1.009
1.036
0.957
0.983
0.993
0.993
0.981
1.049
0.937
1.027
1.058

0.36

0.978

Gains from
Variety
(%)
(5)
0.00%
0.01%
0.01%
-0.06%
1.56%
2.32%-0.60%
1.84%
8.14%
0.07%
-0.46%
1.06%
1.01%
2.79%
2.10%
1.75%
0.45%
-0.40%-1.53%
2.17%
0.95%
0.36%
0.32%
1.18%
-2.68%
3.27%-1.15%-1.84%
22.63%
0.81%

Note: Authors’ calculation based on six-digit disaggregated data from UN Comtrade. See text for
detailed explanation.

27

4. Trends in bilateral trade costs over time (Novy method)
In this section, we present calculations of relative trade costs between Mongolia and its
major trading partner over the period 1988-2017. As we have seen in Section 2, Mongolia’s
exports and imports have skyrocketed. Also, its traditional trading relationship with Russia
has declined dramatically (particularly in exports to Russia), while trade with China hassoared. Rather than thee crude measures of increased and changing integration in the world
economy, we present results of the so-called Novy (2013) measure. The basic idea behind themodel-based measure is that, if any two countries are truly more open to trade with eachother, we should see the trade between the two countries grow more than the trade withineach country. That is to say, there are various frictions to any trade, whether it between
within or across borders. Natural tariffs only apply to international trade, but othertransportations cost exist within and outside of natural border. What really matters, is thedegree in which consumers of a country are choosing to import rather than buy domestically.
In a truly borderless world, consumers say, in Canada, would be just as likely to buy shoes
made in the US or France as in Canada.
The method of constructive the measure of bilateral costs is quite
straightforward and given by the formula below.

1/(2𝜎𝜎−2)

�𝑥𝑥𝑖𝑖𝑖𝑖 𝑥𝑥𝑗𝑗𝑗𝑗 �𝜏𝜏𝑖𝑖𝑖𝑖 = ��(𝑥𝑥𝑖𝑖𝑖𝑖 𝑥𝑥𝑗𝑗𝑗𝑗 )−1

Tau is the “trade cost” measure we will calculate from 1988 to 2017, each year, for eachcountry pair (e.g. Mongolia-China, Mongolia-Japan, etc.). However, as this measure requires
trade in both directions of the country pair, but there is not always trade recorded in both28

directions for each year, there are missing values for many observations, especially in theearlier years. Sigma are taken from our estimated elasticities of substitution.
The various “x”s are trade values in nominal terms. As such, Xij represents, for example,
Japanese exports to China. In turn, Xji is China’s exports to Japan. All data are in dollars.
Ideally, for intra-national trade, we would use Gross Output minus Exports obtained from
Input-Output tables. This data is now readily available for OECD and many other countries.
Unfortunately, older Input-Output data is not readily available for Mongolia for older years
and plagued with problems. In lieu of I/O data we use the simpler method used in Wei (1996)
which is simply GDP less exports as a crude proxy for intra-national trade. While wecalculated the taus for 115 trade partners of Mongolia, Table 6 shows the results the Novy
measure for Mongolia’s for a select sample of trade partner over the three decades. Also, forreasons of space, not all years are reported in Table 6, but are available upon request.
As we can see, there is a clear, general decline in trade costs across the board, with a few
exceptions. Germany, for example, saw its bilateral trade costs fall from 271% (tariffequivalent) in 1988 to 164% in 2017. China, now Mongolia’s largest destination for exports
by far, and who shares a border with Mongolia, saw its costs fall from 114% in 1994 to 63%
in 2017. Compare this the findings of Novy (2013) in which he found that the trade costs
between US and Mexico fell from 50% to 30% in the years following (North American Free
Trade Agreement (NAFTA). This suggests the falls in trade costs between China andMongolia were larger, and at the same time tells us that the border is “thicker” than thatbetween the US and Mexico.

29

Table 6 Tau Values for a Sample of Mongolia’s Trading Partners
1988 1990 1994 1998 1999 2000 2005 2006 2008 2012 2017
Australia
n/a6.53 05.16 3.39 4.44 3.38 2.40
2.11
2.22 1.83
2.50
Austrian/an/a
3.15 3.03 2.99 2.79
2.25 2.02
1.57 1.34
1.91
China
n/a
n/a
1.14 0.95 0.95 0.68
0.65 0.52
0.44 0.34
0.63Francen/an/a
2.57 2.18 2.45 1.62
1.85 1.69
1.65 1.54
2.05
Germany
2.71 2.48 1.93 1.57 1.75 1.44
1.39 1.36
1.18 1.17
1.64
India
4.25 3.62
n/a 2.75 2.61 2.44
3.00 2.07
1.31 1.36
2.4
Japan
2.42 2.18 1.65 1.36 1.63 1.51
1.62 1.45
1.07 1.13
1.32
Korea
n/a
n/a
1.69 1.35 0.663 1.26
1.34 1.22
0.82 0.73
1.32
Netherlands
n/an/a
2.32 2.16 2.26 1.54
2.30 2.36
1.59 1.25
2.06
Russian Fed
n/an/an/a 0.83 0.80 0.60
0.86 0.78
0.63 0.65
0.95
Thailandn/a
4.91 2.79 2.10 3.65 1.821
2.13 2.13
1.63 1.75
n/a
UK
n/a
n/a
2.32 1.97 1.98 1.58
1.89 1.75
1.66 1.59
1.9
US
n/a
n/a
2.12 1.70 1.79 1.31
1.48 1.49
1.39 1.12
2.12
Source: Authors’ own calculations.
n.b. Other partners’ data and many years have been omitted to fit on the page. Data for other countries
and years is available upon request.

5. Conclusion
Mongolia underwent radical changes both through its market liberalization (internallyand externally) and by abandoning its 30-year old system of trade networks based on the old
Soviet-Bloc trading regime (CMEA) to embrace a relatively open trading stance with theentire world. The massive expansion of trade resulted in dramatic increases in both thevolume and variety of imports from the entire world. These new imports are being financed,
in most part, by Mongolia comparative advantage in resources, the bulk of which are being
exported to neighboring China.
While this important transformation has similarities in Eastern Europe (Bulgaria,
Poland, etc.), Mongolia`s trade patterns and experience has some distinct characteristics. Two30

most notable differences would be its heavy reliance on natural resource exports, but also its
geographical position in East Asia and great distance from the EU and the US. Also, while
the welfare gains from increased variety from former Socialist states have been measured,
such estimates for Mongolia have, thus far, been notably absent. Lastly, it has been 30 years
on since Mongolia first shifted its trade focus away from Russia and towards China yet theliterature on Mongolia trade transformation and experience seems to end in the 2000s.
As such this paper provided a much more detailed account of Mongolia’s experience.
First, the nature of Mongolia radical change in trade partners is documented. Next, welfare
gains provided by new econometric estimates over 30 years tells us that, indeed, the newaccess to goods outside the Soviet-bloc has contributed to gains much greater than othertransitional economies (much of which are neighbors with wealthy Western Europe) haveseen. According to our estimates, Mongolia experienced an addition 22% gain in welfare dueto the massive increase in imported varieties. Lastly, we use the Novy method to demonstrate
which countries Mongolia is becoming ‘closer’ to. Naturally, the “border” between Mongolia
and China became much more ‘narrow’, falling from a tariff equivalent of 114% in 1994 to
63% in 2017. But we also see that the tariff-equivalents for some of Mongolia’s other major
partners have fallen by more than 100%. Yet, despite this, with most partners, the trade costs
are still over 200%. It will be interesting to see how much more the trade costs of thisresource-rich, landlocked nation, decline in the next twenty years or so.
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