Basic Gravity Model

Gravity force equation:

MiMj
Fij=G
Dij 2

Gravity force between two objects depends on their masses and inversely proportional to the
square of distance between them.

Intuitive gravity for trade:

YiYj
Xij=C
tij

Xij= Export from i to j

C= Constant

Y= Economic mass

t= Trade cost between two country

Export (or trade) between two countries depends on their economic masses and negatively
related to trade costs between them.

Gravity model

Gravity model is a very popular econometric model in international trade. The name came from
its utilizing the gravitational force concept as an analogy to explain the volume of bilateral trade
flows. Model was proposed by Tinbergen in 1962. Initially, it was not based on theoretical
model, but just intuition only. Later on, a range of rigorous theoretical foundation has been
given.

Intuitive gravity for trade:

YiYj
Xij=C
tij

Xij= Export from i to j

C= Constant

Y= Economic mass

t= Trade cost between two country

Export (or trade) between two countries depends on their economic masses and negatively
related to trade costs between them.

 Larger countries trade more than smaller ones .

 Trade costs between two trade partners reduce trade between them.

Empirical equation for basic gravity model

ln Xij= b0+b1 ln (Yi)+b2 ln (Yj)+b3 ln (tij)+ eij

b1, b2>0; b3<0

A 1% change in Yi associated with a b1% change in Xij

Proxies for trade cost

Distance

•Adjacency

•Common language

•Colonial links

•Common currency

•Island, landlocked

•Institutions, infrastructure, migration flows

•Bilateral tariff barriers

Effect on trade costs due to these proxies -

Distance: If two countries are geographically close, trade will increase and trade cost will
decrease. And if the countries are geographically far, trade will decrease and trade cost will
increase.

Adjacency: If geographical border between two countries are close, trade will increase and trade
cost will decrease. On the other hand, if geographical border between two countries are far, trade
will decrease and trade cost will increase.

Common language: Countries having same language will have more trades and trade cost will
decrease As it is easier to communicate. And cultures are usually also similar.

Colonial links: Countries having colonial links will have more trades and less trading cost.
Common currency: If two countries own same currency then it reduces the cost of currency
conversion which increases trade and decreases trade costs. And having different currencies
increases the conversion cost which decreases the trade and increases the trade costs.

Island, landlocked: Island and landlocked countries increases the transport cost which
ultimately decreases trades and increases trade costs.

Institution, infrastructure, migration flows: Positive work of trade policy makers, properly
maintained port infrastructure and their way of providing facilities and positive migration flows
(large number of migrant people moving to that country) decreases the trade cost between
countries and increases the trade and vice versa.

Bilateral tariff barriers: As tariff increases, the prices of imported goods between countries
also rises which increases trade cost and decreases trade. On the other hand, reduction of tariff
barriers decreases trade cost and increases trade.