On theories explaining the

success of the gravity

equation
Evenett and Keller (2002)
Motivation
Empirical success of gravity equation which can be explained by
various theories model identification problem

Check whether variants of the gravity equation derived from the

Heckscher-Ohlin and IRS (Helpman and Krugman) trade models
fit the data and which does best in different circumstances

Addressing the identification problem using:

Patterns of trade (intra vs inter-industry trade)
Bilateral differences in factor proportions
 Assumptions for all models: 2x2x2 (2 countries i and j, 2 goods X and Z, 2 factors
of production K and L), balanced trade for each country, no trade and transport
costs, identical production technologies, identical homothetic preferences
Models with perfect specialization
1. IRS X and Z both come in different varieties and are identically produced
using IRS technology. With preferences valuing product diversity, we get
perfect specialization of production for every variety. Country is imports from j
are then:
i j
Y Y
M w
ij

2. Heckscher-Ohlin with perfect specialization (multicone) X and Z are

homogeneous and produced under CRS. Requires countries relative
endowment ratios to differ by at least as much as the goods relative input
ratios. Generates same gravity equation (1)
 Models with imperfect specialization
3. IRS/unicone Heckscher-Ohlin one sector (Z) produces a
homogeneous good under CRS, the other (X) produces a
differentiated good under IRS. WLOG assume that the
homogeneous good is labour-intensive and that country i is capital-
i

abundant. Let be the share of good

i Z in country is GDP i.e.
Z
i
px X i Z i

. It is assumed that the endowments in each country (1 are

)Yi sufficiently
similar such that factor price equalisation through trade is achieved
country i will only export the capital-intensive X varieties
i j
(produced in amount ). The Y Y
gravity equation becomes:
M ij (1 i ) w
Y
4. Unicone Heckscher-Ohlin both goods are homogeneous and
produced using CRS technology (factor proportionsi are such that
Y
production is imperfectly specialized). Country
px [ X i is
imports
w X w
] from j are
then . Rearranging this gives the Y gravity equation:
i j
Y Y
M ij ( j i ) w
Y
. Model identification Grubel-Lloyd index measuring share of
intraindustry trade: M gij M gji
GLij 1 g


M
g
ij
g M
g
ji

Equal to 0 for only interindustry trade and 1 for only intraindustry trade.
. Data since 1985 covers 58 countries (amounting for 67% of world
imports and 79% of world GDP)
 Model Gravity equation Grub Class Comments
estimated el- sorted
Lloyd after
YviYv j index
1 IRS M
ij
v ij
v High
Yw

2 IRS/unicone High Share of Predicts higher

YviYv j
Heckscher- M 1
ij
v
i
v ij
v intraindus estimates for higher v
Ohlin Yw try trade (a higher share of
(GL index) differentiated goods in
GDP should increase the
share of intraindustry
i j trade in total trade)
Yv Yv
3 Multicone M v w vij
ij
Low
Heckscher- Y
Ohlin
(perfect
specialization
) Difference
i j
YY
M vij vj vi
s in factor
vij
v v
w proportion
4 Unicone Y Low Predicts higher
s (K/L
Heckscher- ratio) estimates (of the
Ohlin difference between the
Conclusions
High GL sample: specialization and trade are increasing
as the share of intraindustry trade in total trade rises.
Also, the share of intraindustry trade moves together
with the size of the differentiated goods sector. This
provides support for the IRS models (especially the
imperfect specialization one) in explaining the volume
of North-North bilateral trade
Low GL sample: trade volumes increase with greater
differences in factor proportions. The relative size of the
labor-intensive goods sector is negatively correlated
with the relative capital endowment. This suggests that
factor abundance is important in explaining the volume
of North-South trade