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The gravity model in

international trade
CASE STUDY FOR CROATIA

AUTHORS:
Lander Bijnens
Louis Claes dErckenteel
Peter Filipic
Benjamin Kardum
Robine Van Campen

Table of contents
1. THEORETICAL POINT OF VIEW OF GRAVITY MODEL ......................................................................... 2
2. GRAVITY MODEL OF INTERNATIONAL TRADE ................................................................................... 4
2.1 Gold medal ........................................................................................................................................ 4
2.2. Silver medal ..................................................................................................................................... 4
2.3 Bronze medal .................................................................................................................................... 4
2.4 Fixed country effects ........................................................................................................................ 5
2.5 Fixed and variable trade cost ........................................................................................................... 5
3. TRADE OVERVIEW CROATIA ............................................................................................................... 6
4. ECONOMETRIC ANALYSIS ................................................................................................................... 8
4.1 Model for year 2002 ..................................................................................................................... 8
4.2 Model for year 2007 ..................................................................................................................... 9
4.3 Model for year 2014 ................................................................................................................... 11
5. CONCLUSION ..................................................................................................................................... 12

1. THEORETICAL POINT OF VIEW OF GRAVITY MODEL


The gravity model of trade is used to predict the bilateral trade flows based on the economic
sizes and distances between two countries. The basic model for trade between two countries
(i and j) is based on the law of gravity in physics, which states that the force of gravity between
two objects is proportional to the product of masses of the two objects divided by the square
of the distance between them. In symbols:
1

Fij =G

Mi Mj
3

Dij

In this equation F is the trade flow between countries i and j (or the force of the gravity), M i
and Mj are the masses of each country, Dij is the distance between the two countries and G is
a constant. So according to this model the exports from country i to country j are explained
by their economic sizes, population, direct geographical distances and some dummy variables
incorporating institutional characteristics common to specific flows.
This standard gravity model can be augmented with several variables to test whether they are
relevant in explaining trade, this is called the augmented gravity model. Infrastructure
endowments (subsidies), squared differences in capita per income and real exchange rates
are examples of these variables.
The model was first used in 1962 by the dutch economist Jan Tinbergen. Also Pyhnen (1963)
and Linnemann (1966) proposed and tested similar models to analyze international trade
flows. In 1970 Leamer and Stern provided some foundations with their book on quantitative
international economics. This is based on the potluck assumption, which means that all of
the goods produced in the nations are thrown in a pot and each country draws its
consumption out of the pot in proportion to its income. The expected value of the
consumption of country i produced by country j will be equal to the product of the share of
world GDP of country i times the share of world GDP of country j. This means that the bilateral
trade is in proportion to the GDP shares. In 1979 Anderson was the first to formulate a gravity
equation from a model that considered product differentiation. The next theoretical
foundations of the gravity equation came when Bergstrand explored the theoretical
determination of bilateral trade in which gravity equations are related to simple monopolistic
competition models. Krugman and Helpman worked with a differentiated product framework
with enlarging returns to scale to justify the gravity model in 1985. Deardorff verified in 1995
that the gravity equation characterizes a lot of models and can be explained from different
standard trade models. More recently Anderson and Van Wincoop published a theory close
to Andersons theory from 1979: the main value added is the derivation of a practical way of
using the full expenditure system to estimate key parameters on cross-section data.
Recent years a lot of papers are published by empirical trade economists, the methodological
advances in these papers have been generally ignored in wider literature as they are typically
viewed as contributions to narrow empirical topics.

The popularity of the model is based on three pillars:


1. There is a demand for knowing what normal trade flows should be (international key
flows are a key element in all economic relationships).
2. The date to estimate the normal trade flows are easily accessible to all researchers.
3. The several high profile papers have formed the respectability of the gravity model and
have created a set of practices that any empirical researcher needs to make empirical
choices.
The gravity model estimates the pattern of international trade and has been used to test
hypotheses implanted in pure economic theories of trade. In this case trade will be based on
relative factor abundances, the Heckscher-Ohlin model is an example of such a model. The
model essentially says that nations will import goods that are produced with scarce factor(s)
and export products that use abundant and cheap factor(s). This model builds on Ricardos
theory of comparative advantage, which says that a firm, individual or nation has an
comparative advantage over another if he can produce a good at a lower relative opportunity
cost. There are several reasons why the gravity model is more successful as the other ones:
- A number of results of studies do not match the expectations of the comparative
advantage theories. E.g. the US (most capital intensive country in the world) exports
more in labor intensive industries.
- Countries with similar levels of income trade more, which indicates that these
countries are trading in differentiated goods because of their similarities. This is the
opposite of what the Heckscher-Ohlin model states.

2. GRAVITY MODEL OF INTERNATIONAL TRADE


As mentioned in the previous section the gravity model is based on the law of gravity in
physics. Further in-depth analysis shows that the gravity equation in its core is an expenditure
equation due to the estimation of bilateral trade. With some mathematical manipulation we
can observe the following transformation of the physics concept towards the economics
concept:
=

1 2

12 1

(1)

With difference to physics gravity constant in economic models occurs un-constant regarding
to GDPs which varies over time. The concept of the above equation is based on two important
parameters: measures openness of a nation (nations export and import to world markets),
and P measures prices (price indices or costs). The equation shows great importance of
interpretation of the gravity un-constant since it is the source of large number of errors in
estimation.
Furthermore, during the estimation process of the gravity model we meet several potential
traps which can lead researchers to wrong results and false conclusions. Economic literature
(Baldwin & Taglioni, 2006) defined them as gold, silver and bronze medals.

2.1 Gold medal


The gold medal problem is referred to the bias which occurs when we estimate the gravity
model with the standard OLS procedure. This is due to fact that omitted terms are correlated
with the trade and cost terms. One of the standard OLS assumptions is that , but
in many cases the estimations become biased due to violating the previously mentioned
condition. In our estimation the expression becomes + . Researchers can
avoid gold medal by including dummy variables (sometimes in the literature referred as trade
resistance term) and estimating whole process with fixed effects estimator or LSDV.

2.2. Silver medal


The silver medal problem is defined as the problem of calculation of averages of the bilateral
flows. The theory tells us that averaging should be done after taking logs not before regarding
calculations because the sum of logs is just approximately log of the sum ( log log ). And
when we have unbalanced trade this differences become larger. This is an important issue for
the states like Croatia which have unbalanced trade flows.

2.3 Bronze medal


The bronze medal problem occurs when we compare the price indices of different countries.
The consequence is incorrect deflation of bilateral trade. It has severe impact on the
impetration of the results.

2.4 Fixed country effects


The economics literature defined a special group of models called fixed-effects models. Their
specification allows us to define a special variable for unobserved or misspecified factors that
explain the trade volume between two countries. In most cases the economic literature still
provides the GDP as proxy for expenditure on tradable goods.

2.5 Fixed and variable trade cost


In international trade research the economics literature has made clear that tariffs or
institutional barriers are a crucial impediment for firms to export their goods abroad. One
reason for the increase in trade in the recent years is that there has been enormous decline
in international trade costs. We have a wide range of trade cost components. Not just the
transportation costs and tariffs as two main categories of trade costs, but also other
components such as language barriers, informational costs and red tape.
In that manner we can distinguish between fixed and variable trade costs. Fixed trade costs
are those that are independent of the quantity. While on the other hand we have variable
trade costs that change with quantity (in literature sometimes referred to as Ad-Valorem costs
According to the value).
In particular, fixed export costs are those which firms have to overcome before they are able
to sell on the foreign markets. For example, in a recent study of 15,000 firms in 7 European
countries (Navaretti et al., 2010) estimate that big firms (>249 employees) are between 20
and 40 %-points more likely to engage in exports than small firms (with <10 employees).

3. TRADE OVERVIEW CROATIA


From 2002 until the financial crisis, Croatias GDP has been growing steadily. A maximum GDP
of approximately 70 billion USD was reached in 2009. Since then it declined a little, today
Croatias GDP is at 57,22 billion USD. Croatia is a country that gains income mainly from a
service-based economy. Tourism is the most important sector, followed by manufacturing,
and also international trade is a relevant contributor. Croatias top 20 main trading partners
are listed below. This trade consists mainly of industrial goods, this is the case for import as
well as export.

Italy

11

Poland

Germany

12

United States of America

Russian Federation

13

United Kingdom

China

14

Spain

Slovenia

15

Turkey

Austria

16

Netherlands

France

17

Japan

Hungary

18

Switzerland

Bosnia and Herzegovina

19

Serbia

10

Czech Republic

20

Belgium

Since 2004 Croatia has been candidate to enter the EU. SAA (Stabilisation and Association
Agreement) was a first attempt to improve trade between Croatia and the EU. On the 29 th of
October 2001 Croatia was the second Balkan country that signed the SAA. This is a sort of
agreement between the EU and the Balkan countries that is adapted for each different
member. The main target of SAA is to create free trade between EU and the member counties.
But it also supports common political and economic goals and encourages regional cooperation. After Croatia signed the SAA in 2001 it still had to wait until February 2005 for the
agreement to get into force. The SAA had a substantially positive influence on Croatias trade.
A second factor that changed Croatias trade substantially is the CEFTA 2006 also known as
Central European Free Trade Agreement. The first CEFTA was actually signed in 1992 in
Poland. It was a free trade agreement between non-EU countries in South-east Europe. As by

2006 many of the former members became part of the EU they had to finally leave the CEFTA.
Because of this in 2006 CEFTA had to be reformed, new countries entered the agreement. One
of them was Croatia that joined CEFTA 2006 in 2007. From 2007 to 2013 this free trade
agreement helped Croatia to expand its international trade. It eliminates trade barriers,
provides appropriate intellectual property protection, it also created stable rules. In 2013
Croatia left the CEFTA because it became member of the EU. Once member of the EU, a lot of
trade complications disappeared.

4. ECONOMETRIC ANALYSIS

GDP 106
Mean
Standard error
Median
Standard
deviation
Sample variance
Kurtosis
Skewness
Range
Minimum
Maximum
Sum
Sample size

lngdp

Import
from

Export to Distance

1464303 13,11093 767403,8 362692,5 2056,803


528849,2 0,393707 160153,4 104744,3 641,5497
540855,4 13,19295 388349,5 144988 963,323
2365085
5,59E+12
12,48747
3,287556
10567742
11283,02
10579025
29286057
20

1,760712
3,100106
-0,15152
-0,52642
6,84333
9,331054
16,17438
262,2186
20

716227,9
5,13E+11
2,06503
1,696761
2505721
207403
2713124
15348075
20

468430,8
2,19E+11
3,020161
1,870022
1707322
14474
1721796
7253850
20

2869,098
8231721
2,46151
1,969221
9087,428
180,3356
9267,764
41136,06
20

The table above contain the descriptive statistics for the twenty best trade partners of Croatia
in 2007. There are some important things to notice. Firstly, the sample size n=20 is pretty low
for an econometric analysis. Due to this small sample size, it could be that some results are
not externally valid and reliable. Second, it is important to notice that there is a large
difference between the means and medians of all continuous variables. This is an indication
that these variables are not normally distributed but the distribution is skewed and contains
outliers. Therefore the natural logarithms are computed. In the example above, de mean and
median of lngdp are much closer to each other which indicates that this was indeed the right
decision.

4.1 Model for year 2002


VARIABLES
lngdp
lndistance
1.SAA
Constant

(1)
lnimport

(2)
lnexport

0.615***
(0.197)
-0.937**
(0.354)
-0.274
(0.358)
11.36***
(0.955)

0.492
(0.362)
-1.404**
(0.504)
0.00984
(0.669)
14.81***
(2.437)

Observations
20
20
R-squared
0.450
0.465
Robust standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1

Based on the trade flows of Croatia with 20 other trade partners, respectively their GDP,
geographical distance between the trade countries and dummy variable for SAA, the results
of the econometric analysis suggest the folowing conclusions. R-squared which measures the
goodnes of fit of the model is 0.45 and 0.465, respectively, which can be interpreated that
nearly half of the variation in overall data is explained with the above model. This is a pretty
good result considering the models for other time periods.
Furthermore, the values of explanatory variables are in the logarithmic form. It follows that
the variables lngdp and lndistance are in agreement with economic theory. In general, higher
GDP for the origin country reflects the positive outcome for Croatia in 2002, and more distant
country reflects in negative sign.
If we take, for example, lngdp for import which is significant on the 95% interval we can
interpret that result as if the GDP of the other tradable country with Croatia raise by 10%, then
import to Croatia will increase by 6.15%. The lnexport variable for export is not significant, so
we can not make any conclusion.
The last is the estimation of SAA (Stabilization and Assocation Agreement) dummy variable
which was signed in 2001 is more tricky to intrepret. The t-values for lnexport and lnimport
variables are also insignificent and have different signs. However, we have to take into account
that we have a relatively small sample of only 20 observations. With a larger sample we might
have come to more significant conclusions.

4.2 Model for year 2007


VARIABLES
lngdp
lndistance
1.SAA
1.FTA
Constant

(3)
lnimport

(4)
lnexport

0.558*
(0.274)
-0.772*
(0.372)
-0.527
(0.400)
0.256
(0.635)
11.46***
(1.726)

1.161***
(0.214)
-1.902***
(0.271)
-0.774*
(0.375)
2.964***
(0.726)
10.07***
(2.018)

Observations
20
20
R-squared
0.264
0.781
Robust standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1

To start off, the import part will be discussed. The explanatory variables lngdp and
lndistance are significant on a 90% level, meaning that the null hypothesis of no relation
between lnimport and those two variables individually can be rejected with a 90 percent
certainty. The R-Squared of 0.264 indicates that this model explains 26,4% of the total
variation in imports of Croatia in 2007. This is relatively low compared to the other models.
Quite surprisingly, the dummy variables FTA and SAA, respectively indicating whether Croatia
has a free trade agreement and stabilisation and association agreement with the trade
partner, are not significant. A possible explanation could be that the sample size is too small.
Only two countries in dataset were part of the CEFTA and had therefore a FTA with Croatia.
Another, but more unlikely explanation is that those trade agreements dont affect the
imports of Croatia. Assuming this is not very realistic.
Since the parameters of the dummies on the import part are not significant, they cannot be
properly discussed. On the other hand, the coefficients of lngdp and lndistance both have
expected signs: positive for lngdp and negative for lndistance. This indicates that if the
distance between Croatia and its trade partner is higher, there will be less imports. if the gdp
of the trade partner is higher, Croatia will ceteris paribus import more goods from that
country.
The values for both parameters lie within one standard deviation from the aggregated data,
so our findings are in line with earlier statistical evidence. Since the estimated model in in the
log-log format, the interpretation of the coefficients is quite straightforward. It goes as
follows: if the gdp in the origin country rises with ten percent, the Croatian imports for that
country will rise with 5,58%. This interpretation is analogue for all logged variables.
On the export side, the FTA and SAA dummies are significantly different from zero with a
respective significance level of .01 and .1. Furthermore, the gravity model for export in 2007
explains a lot more variation (78,1%) than it does for the imports. This is probably because the
exports were already to the EU were already totally liberalised but the imports went to a
transition period. The interpretation of the dummy parameters are not straightforward
anymore. For instance, to get the meaning of the FTA parameter, following equation has to
be computed: (e2.964-1)*100=1837.53%. Since this is an enormously high figure, its better not
to interpret it directly because that would mean that joining the CEFTA increases exports from
Croatia to that country with almost twentyfold. This outcome is not realistic. What is
important here is that the FTA has a positive impact on trade between countries. The SAA
coefficient has a contra intuitive sign due to the small sample size.
In comparison with 2002 the parameters on the import side remain approximately the same
while on the export side the absolute effects of gdp and distance become slightly larger and
therefore more elastic in 2007.

4.3 Model for year 2014

VARIABLES
lngdp
lndistance
1.Diagcum
1.Eumember
Constant

Observations
R-squared

(1)
lnimport

(2)
lnexport

0.560***
(0.187)
-1.751***
(0.437)
-1.623
(0.977)
0.591
(0.479)
18.59***
(2.338)

0.450*
(0.244)
-1.526***
(0.403)
-0.513
(1.193)
-0.433
(0.879)
17.68***
(2.594)

20
0.680

20
0.635

As for the 2014, Croatia had experienced the first year of being a member of the EU which
reflected on its import and export. Model analysis shows that the R-squared indicator 0.680
in 2014 which presents 68% of the total variation in imports and its the highest R-square of all
three observed models in this paperwork. Following dummy variables that have been used in
the model diagcum and Eumember didnt show any significance which was unexpected since
the theory alludes advantages and benefits of economic integration (implying on Eumemeber
dummy variable). This, third analysis has even more confirmed the doubt that the sample size
isnt good enough to get true results.
Furthermore, coefficients of lngdp and lndistance behave as they should, positive sign for
lngdp and negative for lndistance. Positive indicator shows that if the GDP of specific Croatias
trade partner is higher Croatia will do more import from it, under the condition that nothing
changes. As for the lndistance which has a negative sign, this can only mean the longer
distance is the less import will be done. Coefficient interpretation would go for an example: if
the gdp in the origin country changes for a positive one percent the Croatian import for that
specific country will be increased by 0.56%. Third gravity model for 2014 shows that there are
almost no differences between import (68%) and export (63%) sides. (not sure! Because you
were saying when there are three *** then it is 1% etc...)

5. CONCLUSION
The gravity model of the trade is used to predict trade flows between some specific countries
based on the size and distance between them. Usually the basic model uses two countries as
the example that are marked with i and j and it has been established on the law of gravity
in physics, furthermore that means that the gravity between two objects is proportional to
the product of masses of two objects divided by the square of the distance that is between
them. The first use of the econometrical model was used in 1962 by the dutch economist Jan
Tinbergen, among him there are Pyhnen (1963) and Linnemann (1966) who have proposed
and tested similar models into their analysis in international trade flows. Recent years a lot of
papers are published by empirical trade economists, the methodological advances in these
papers have been generally ignored in wider literature as they are typically viewed as
contributions to narrow empirical topics.
As it has been mentioned in the paperwork, gravity model contains famous gold, silver and
bronze medal mistakes. The gold medal mistake refers to a mistake that comes out from
correlation of the variables that have been left out and so called trade cost. The silver medal
mistake is defined through the problem of average calculation of the bilateral flows, so
practically this theory points out that averaging should be done after taking particular logs and
not before regarding calculations, because the sum of logs is just approximately log of the
sum. Bronze medal mistake is the kind of the problem that happens when the prices of
different countries are compared, which has severe impact on the impetration of the result.
Croatias GDP has been growing steadily from 2002 until the financial crisis, where the
maximum of the GDP was reaches in 2009 which was approximately 70 billion USD. Since that
time Croatia has faced many problem and rapidly declined over the years, todays GDP is
around 57,22 billion USD. Croatia is a country that gains income mainly from a service based
economy which is actually the source of problems, for the example tourism is the most
important sector followed by manufacturing and international trade as third most important
element and very relevant contributor in development.
Econometric analysis included the sample size of twenty countries (n=20) which is pretty low
for doing a structural and valid analysis. Due to this small sample size there is a high possibility
that some of the results are not valid and reliable as the would when the sample size would
be e. g. over 50 countries. Another noticeable thing is that there is a large difference between
the means and medians of all continuous variable which points out on indication that these
variable are not normally distributed but the distribution is skewed and contains outliers.