2.4 Gravity model of international trade

The gravity model of international trade explains how countries trade based on their economic size and distance from each other. Like planets attracting each other, bigger economies trade more, while greater distances reduce trade flows.

Other factors like shared languages, borders, and trade agreements also influence trade patterns. This model helps economists understand and predict trade relationships between countries, though it has some limitations in capturing all real-world complexities.

Gravity Model of International Trade

Principles of gravity trade model

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• Economic model explains bilateral trade flows between countries
  • Inspired by Newton's law of universal gravitation
  • Assumes trade flows proportional to economic sizes and inversely proportional to distance between them (U.S. and China)
• Key assumptions of the gravity model:
  • Countries with larger economies tend to trade more with each other (U.S. and Canada)
  • Trade flows decrease as distance between countries increases (U.S. and Australia)
  • Other factors influence trade flows
    • Common language (U.S. and U.K.)
    • Shared borders (U.S. and Mexico)
    • Trade agreements (NAFTA)

Determinants of bilateral trade flows

• Economic size of trading partners
  • Measured by GDP or GNP
  • Larger economies have greater capacity to produce and consume goods and services (U.S. and Japan)
• Geographical distance between trading partners
  • Proxy for transportation costs, time, and other trade barriers
  • Greater distances tend to reduce trade flows (U.S. and Brazil)
• Other determinants of bilateral trade flows:
  • Common language and cultural similarities (U.S. and Australia)
  • Shared borders and contiguity (U.S. and Canada)
  • Membership in trade agreements or economic unions (EU members)
  • Historical ties and colonial relationships (U.K. and India)

Interpretation of gravity model results

• Gravity model estimated using log-linear regression equation:
  • $ln(Trade_{ij}) = \beta_0 + \beta_1 ln(GDP_i) + \beta_2 ln(GDP_j) + \beta_3 ln(Distance_{ij}) + \epsilon_{ij}$
    • $Trade_{ij}$: trade flows between countries i and j
    • $GDP_i$ and $GDP_j$: economic sizes of countries i and j
    • $Distance_{ij}$: geographical distance between countries i and j
    • $\epsilon_{ij}$: error term
• Interpreting coefficients:
  • $\beta_1$ and $\beta_2$: expected to be positive, indicating larger economies trade more
  • $\beta_3$: expected to be negative, indicating greater distances reduce trade flows
  • Coefficients represent elasticity of trade with respect to explanatory variables (1% increase in distance reduces trade by X%)

Applications and limitations in trade analysis

• Empirical applications of gravity model:
  • Estimating impact of trade agreements and economic integration on trade flows (NAFTA)
  • Analyzing determinants of bilateral trade patterns (U.S. and China)
  • Assessing effects of trade policies and barriers on international trade (tariffs)
• Limitations of gravity model:
  • Simplifying assumptions may not always hold in reality
  • Omitted variable bias: model may not capture all relevant factors affecting trade flows
  • Endogeneity issues: some explanatory variables may be endogenous to trade flows (GDP and trade)
  • Limited ability to account for heterogeneity of goods and services traded
• Despite limitations, gravity model remains widely used and empirically successful tool in international trade analysis (over 10,000 published papers)