International Trade

Lecture 2: Gravity

Thomas Chaney

Sciences Po

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Road map for this class

Gravity equation: first pass at empirics

Gravity equations: theory guided empirics

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Gravity equation

First documented by Tinbergen (1962).

Trade between country A and B,

t (GDPAt )a ⇥ (GDPBt ) b
XAB = lt g
distAB
t
ln XAB = ln lt + a ln GDPAt + b ln GDPBt + g ln distAB

Typical empirical estimates give a, b, g t 1.

Typical R 2 ⇡ 80%.

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Border effect

McCallum (AER 1995)

Trade between US States and Canadian provinces

ln Xij = ln l + a ln GDPi + b ln GDPj + g ln distij + dDUMMYij + # ij

with DUMMYij = 1 if i and j in Canada.

Implausible finding: e d t 22

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Gravity with Gravitas

Anderson and van Wincoop (AER 2003)

Theory grounded estimation of gravity.
Tariff equivalent of US-Canada border about 50% (large but not
implausible).

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Gravity with Gravitas

Simple theoretical model:

goods differentiated by country of origin (Armington assumption)
endowmend economy (may be relaxed).
identical homothetic preferences, approximated by CES.
multiplicative trade costs (Samuelson’s iceberg costs)
perfect competition

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Gravity with Gravitas

Optimal consumption by j’s consumers given by:

! ss1
s 1
max
qij
 qij s

i
s.t. Â pij qij = Yj
i

with s 1 the elasticity of substitution across goods.

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Gravity with Gravitas

Perfect competition ) pij = tij pi

Bilateral exports: Xij = pij qij
Market clearing: Yi = Âj Xij

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Gravity with Gravitas

Isoelastic demand:
✓ ◆1 s
tij pi
Xij = Yj
Pj
! 11s
1 s
with Pj = Â (tij pi )
i

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Gravity with Gravitas

Proposition
If trade costs are symmetric (tij = tji ) then,
✓ ◆1 s
Yi Yj tij
Xij = W
Y Pi Pj

with the price indices solution to,

✓ ◆1 s
tij
Pj1 s = Â si , 8j.
i Pi

Notes:
1 Xij , Yi , Yj , YW observable
2 (tij )1 s can be estimated through OLS with fixed effects
3 Then Pi ’s can be recovered
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Main predictions

Proposition
✓ ◆1 s
Yi Yj tij
Xij = W
Y Pi Pj

Size matters: larger (richer) countries import more and export more.
Trade barriers matter: bilateral trade barriers (tij large) reduce trade.
Novel prediction: for given bilateral trade barriers, more "remote"
countries import (and export) less.
Key ingredient: price indices depend on relative sizes and relative
trade barriers.

ln Xij = ln Y W + ln Yi + ln Yj (s 1) ln tij +(s 1) ln (Pi Pj )

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Border effect

Proposition
i and j are in the same country, k in another: tij = dij , tik = dik ⇥ b
⇣ ⌘1 s
Yi Y j tij ✓ ◆1 s ✓ ◆s 1
Xij YW Pi Pj Yj dij s 1 Pj
= ⇣ ⌘1 s
= b
Xik Yi Yk tik Yk dik Pk
YW Pi Pk

Canada is a small country that buys mostly (expensive) foreign goods.

The US is a large country that buys mostly (cheap) local goods.
PCa > PUS
Canada trades more with itself than the US does,
✓ ◆
XCa0 ,Ca /XCa0 ,US PCa 2(s 1)
= >1
XUS 0 ,US /XUS 0 ,Ca PUS
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Estimation strategy

Proposition
✓ ◆1 s
Yi Yj tij
Xij = W
Y Pi Pj

Assume only distance and border matter for trade costs,

(1 DUMMYij ) r
tij = bij ⇥ distij
Estimate the following equation,

Xij
ln =k (s 1) r ln distij + (1 s) ln bij (1 DUMMYij )
Yi Yj
ln Pi1 s
ln Pj1 s
+ # ij
r(1 s) (1 s)(1 DUMMYij )
s.t. Pj1 s
= Â si ⇥ distij bij ⇥ Pis 1
, 8j
i

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Note: alternative strategy
Proposition
✓ ◆1 s
Yi Yj tij
Xij = W
Y Pi Pj

Estimate t[1 s
ij = #bij from,
Xij
ln = a + ai + aj + # ij
Yi Yj
Solve for the Pi (tb)’s solution to,

Pj1 s
= Â si ⇥ t[1 s
ij ⇥ Pis 1
, 8j
i

Note: with Pbi = abi , possible to test:

Pi (tb) = Pbi
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Results

(s 1) r ⇡ .8, instead of 1.5 in McCallum.

Border effect:
8
< 50% for s = 5
s 1
bUS Can = 4.9 ) b US Can 1 = 20% for s = 10
:
10% for s = 20

Canada trades 10.7 times with itself than with the US (McCallum: 22
times)
US trades 2.24 times more with itself than with Canada.

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Gravity beyond trade

Gravity holds for trade in assets, bonds or equity (Portes and Rey
2005)
MktCapi ⇥ MktCapj
Invij = l
Distij
Gravity holds within countries (Combes, Lafourcade and Mayer 2005)
Gravity holds for FDI (Ramondo 2008)

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Gravity beyond distance

Other determinants of bilateral trade flows:

Common currency
Trade agreement
Common language, religion, legal system
Common border
Colonial ties
Social networks
Business networks
...etc

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