Monday, 24 September 2018

International Trade
Lecture 1 — The Gravity Model and the Border Effect
- Introduction

• World trade as a share of world GDP has increased by 20% since 1990 until
2011, from 40% to 61%.

• The Great Trade Collapse — It took place the year after the Financial Crisis
- The Gravity Model

• Example: Brexit debate — Brexiteers need to respect gravity models of

international trade. What does this mean? (The Economist Article:
https://www.economist.com/finance-and-economics/2016/09/29/down-to-
earth )

- Theresa May thinks Britain could and should become a global leader of free
international trade.
- Britain’s membership of the customs union prevents it from making trade
deals with fast-growing economies such as India and China. Even now the UK
is not allowed to sign any deals with any countries until it has exited the EU.
- Brexiteers say that if Britain quit the EU it could forge new deals wherever
it liked, boosting trade even without a new agreement with the EU.

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- Mainstream economists argue that turning away from the EU, far from
boosting Britain’s trade, would restrict it, due to the Gravity model of
international trade.

• The Gravity Model is a statistical model, or regression equation, that can

explain the flows of trade between countries.  simply and powerful

• The gravity force: the force between two objects (from physics) and it is
stronger when the objects are heavy and the distance is small. This also
applies to countries and trade. Their mass represents their GDP and their
distance – their geographical distance.

- Firstly, the bigger the GDP of the countries involved in a bilateral trading
relationship, the more they trade with each other. Larger economies have
more demand for goods and services and offer more products, supplying a
broader range of consumers (large economies = higher income = higher
consumption of imports from abroad; large economies = high production of
goods and services = many exports)
- Secondly, the farther away two countries are from each other, the smaller
the volume of trade. That is partly related to transport costs: sending a
parcel from Britain to France costs half as much as sending one to India.

• Newton’s Law: Any two bodies in the universe attract each other with a force that is
directly proportional to the product of their masses and inversely proportional to the
square of the distance between them.

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• The gravity model also explains international trade! — Size (GDP) and distance
determine bilateral trade across countries.
- X are exports from n to i
ni

- Y and Y are exporter and importer GDPs

i n

- D is distance from i to n
ni

- G is a constant
- In most estimations a ≈ b ≈ c ≈ 1
- With GDP & distance we are able to understand 80% of international trade

• Gravity models have produced some of the clearest and most robust findings in
economics. It explains 80% of international trade.

• The variables in the Gravity model:

- GDP Size —> The straight line explains almost all the deviation — Japan exports
more to Germany and the UK, rather than to Slovenia or Malta. This is because
Germany and the UK are two of the three biggest EU economies. Consequently, their
incomes are higher, which increases their spending on imports.

• Slope — 1% increase in GDP = 1% increase in trade

• Fit —> 85% fit, meaning 85% accuracy

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- Distance —> France imports more from countries that are closer to France, rather
than from countries that are far away. This has to do not only with lower transport
costs, but also French producers have a much better feel of the market nearby and
can meet suppliers more easily.

- Using this model you can also identify outliers, and then try to explain why they do
not fit the gravity model.

- However, there are countries from which France imports a lot, but they are far away
from France. Language and cultural similarities is another very strong predictor of
international trade —> Many ex-French colonies.

Another example:

- Germany’s exports —> Germany exports also a lot to its neighbours, rather than to
big economies that are far away.

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- So, the effect of distance is a powerful force in international trade.

• What does the gravity model have to do with international trade? —> Reading a batch
of rather shallowly optimistic ‘progressive’ books, I was struck by the automatic way in
which people go on repeating certain phrases which were fashionable before 1914.
Two great favourites are ‘the abolition of distance’ and ‘the disappearance of
frontiers.’

• If the world is becoming smaller, distance does not matter anymore for international
trade.

• There have been several waves of globalisation, the first of which came before WWI
with the emergence of the steam engine, steamships, railroads. People were assuming
back then that frontiers are going to disappear. However, data shows that distance
matters nowadays almost as much as it mattered in the beginning of the 21st century.

- The Border Effect

• Trade between countries is harder than trade between regions within a country —>
Despite the fact that two countries may be integrated, trade imports from within the
country is much higher than between countries.

• Economists have coined how harder it is “the border effect”, as it involves crossing an
international border

• The border effect is the empirical regularity that trade is much higher within countries
than across country borders.

• How many borders between countries reduce the amount of trade between countries.

• To estimate the border effect we need to know how much regions/cities within a
country trade with each other, and compare that with how much trade there is with
cities/countries outside the borders.

• Example:
- Do US States and Canadian provinces trade as much between them as gravity
predicts?

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- We control for gravity forces —> It is no longer about gravity; it is whether you have
to transport goods through a border.

- The border effect is stronger than the language or cultural effect —> British
Columbia trades more with Quebec, than with the state of New York. The border
effect is stronger than the language effect.

- Data: The border reduces trade by a factor of 3 (1st row)

- It is difficult to calculate the border effect, because data on trade within countries is
difficult to obtain. Even when it exists it is not a good estimate of the actual amount
of trade.

- Below we can see how EU integration has reduced the border effect. In 1979 the
border effect was about 12. In 1990 the border effect was around 7. Removing the
border to trade reduces the border effect. This helps explain the extent of global
integration.

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- When we calculate the border effect, we have to control for gravity forces: to
control for GDP and for distance.

• Why do borders reduce trade? (more in seminar)

- Tariffs —> Foreign economic policy
- Administrative barriers —> E.g. Food safety, number of documents to obtain a trade
license.

- Currency exchange —> Brings about uncertainty about a country’s ability to

purchase the exports from the country with the different currency.

- Cultural barriers —> Some countries have cultural similarities, which facilitate better
trade relations. (the example with France and former colonies)

- …? (For the seminar)

- The usefulness of the gravity model

• It can explain trade patterns

• It allows us to isolate the countries that are special cases (deviations)

• Helps identify the geographic location of lost cities —> Explanatory power beyond
international trade.