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Objectives

Understanding the impact of distance andeconomy size on trade using the gravitymodel

Apply the gravity model for the cases of FDI,and migration

See how people use the gravity model toevaluate economic policy issues

1

2

3

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Newtons Law of Universal Gravitation (1687):The attractive force (Fij) between iandj

Mi, Mjare the masses

D is distance between two objects

G is gravitational constant

The Origin of

the Gravity Equation

2ij

ji

ij D

MM

GF

MjMi

D

F

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Model many social interactions (migration,tourism, trade, FDI)

Fijis the flow from itoj Ms are measure of economic mass

D is the distance

Economists and Gravity

ij

jiij

DMMGF

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Estimation of the Gravity Equation

Take logs:

ijijjiij DMMRF lnlnlnln

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The role of economic mass

Usually measured using GDP

Most theoretical explanations predict coefficientequal to one

Estimates often not significantlydifferent from 1,but range is from 0.7 to 1.1

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The role of distance

Distance usually measured using great circledistance based on latitude and longitude

Head (2000) averages results from 62regressions in eight papers, for sample years

ranging from 1928 to 1995

Average distance effect is 1.01

Doubling distance halves trade

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Distance and trade costs

Trade costs: Direct (transport)

Indirect (government policy; language)

Is distance just capturing the effect of trade costs(acting as aproxy) or does it play an additionalrole?

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Data on trade costs

IMF bilateral data of total exports from A (free onboard) to imports of B (cost-insurance-freight) Composition of trade depends on t.c.

National customs data for a few countries

Direct industry/shipping company info Ocean shipping prices/air freight from trade

journals (Hummels)

Quotes from shipping standard container from

Baltimore (Venables)

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Magnitude

Wide dispersion of trade costs US 3.8% value of imports (1994)

Brazil 7.3%

Paraguay 13.3%

Unweighted (get rid of composition effect)

Median cif/fob ratio 1.28 (28% t.c.)

2 to 3 times higher than weighted

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EmpiricalResults

Shipping 40container ($000)

Shipping 40container ($000)

Land locked dummy 3.45

(4.75)

2.17

(2.94)

Distance(000km)

0.38(2.60)

Dist. Sea 0.19

(2.12)

Dist. Land 1.38(4.66)

R2 0.32 0.47

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Effect of distance on t.c.

Mean cost if not landlocked $4,620

Landlocked increases cost by $3,450

Overland 7 times more expensive than sea

For cif/fob ratios Elasticity w.r.t distance 0.2 to 0.3

Common border reduces substantially

R2= 0.45

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Distance and gravity

Distance explains around 45% variation intransport costs

Regressions of trade flows on both distance andt.c. still gives significant coefficient on distance

(although magnitude lower)

Distance must be a proxy for both t.c. and otherinformation costs.

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Using gravity to test for border effects.

Home bias: preference towards home products; Comparison between intranational trade and

international trade;

The borderless worldNational borders haveeffectively disappeared

Use gravity to test:

McCallum (1995) using data on trade flows betweenUS and Canadian provinces (dummy=1 if in the samecountry)

eDUMMYDdMcMbaX ijjiij )(lnlnlnln

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Using gravity to test for border effects.

McCallum: Data referring to 1988 (before FTACanada-USA was signed): Intra-national data flowsonly referred to Canada (exports from a province toother Canada provinces: DumCA=1); International:Exports from Canada provinces to USA states

(DumCA=0) Developments: addiction of data referring to 1993:

intra-national data for both CA and USA. Anotherindicator=DumUSA=1 for trade between two USAstates;

Dij is the distance between any two provinces orstates;

Results

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Empirical results

lnyi 1.21

(0.03)

lnyj 1.06(0.03)

lndistij -1.42

(0.06)DUMMY 3.09

(0.13)

R

2

0.811

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Using gravity to test for border effects.

Data referring to 1988 (before FTA Canada-USA wassigned): Intra-national data flows only referred toCanada (exports from a province to other Canadaprovinces: Dummy=1); International: Exports fromCanada provinces to USA states (Dummy=0)

Data referring to 1993: intra-national data for both CAand USA

Dij is the distance between any two provinces orstates;

Results

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The importance of borders

1988 or 1993: Coefficient on cross-provincial trade isquite high (3.09 to 2.75). Exp(3.09)=22; Exp(2.75)=15.7

1988: Canada-Canada province trade approx. 22 timesCanada-US state trade; 1993: reduced to 15,7

Border effects (all impediments to trade across borders) Ontarios shipments to British Columbia should be 0.6 times

shipments to Washington (US) [Washington is richer]

BC receives 12.6 times more goods from Ontario thanWashington

Border effect = 12.6/0.6 = 21

Fallen to 12 since FTA implemented

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The importance of borders

Anderson and Wincoop (2003): border effects have anasymmetric effect on countries of different size. Moreprecisely have a larger effect on small economies.

Example: US is 10 times bigger than Canada (economic size)

Without frictions to trade, Canada exports 90% of its GDP to US andsells 10% internally; US exports 10% of GDP

Suppose border effects reduce trade of a factor of

=> Canada exports 45% to US and sells internally 55%

Its internal trade has increased of a factor 5.5, cross-border has

decreased by 0.5 => 5.5/0.5=11: internal trade has increased 11 timesmore than cross-border trade

=>US exports now 5% and sells internally 95%. Cross-state trade hasincreased only slightly more than 2 times cross-border trade

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Alternative approach: taking into account

of different prices in different countries

Anderson and Wincoop (2003):

Imposes restrictions on the parameters of M;

Inverse indicator: DUMMY=1 for international (cross-border) trade 0

for internal trade; No distinction between Canadian or US cross-border trade (under a following assumption);

Introduces 2 new variables: price terms of the two countries (whosedifference has a meaning). The two variables can be:

1. Constructed from Price Indexes data;

2. Estimated as a function of trade costs, where trade costs are afunction of distance and other factors (intercept). (N.B. If trade costsare symmetric, then there cannot be a distinction between Canadianand US trade) => this methodology is quite complicated, because itinvolves the estimation of a recursive model of multiple equations.

)ln()1()ln()1()(lnlnlnln jiijjiij PPeDUMMYDdaMMX

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Alternative approach: taking into account

of different prices in different countries

Anderson and Wincoop (2003):

3. Introduce fixed-effects: two dummies one for the origin

country and another one for the destination country:Di=1 if i is the exporter, 0 otherwise;

Dj=1 if j is the importer, 0 otherwise;

The two dummies are both equal to 1 only for cross-border

trade observations.

This implies: Di=(1-)lnPiand Dj=(1-)lnPj

)ln()1()ln()1()(lnlnlnln jiijjiij PPeDUMMYDdaMMX

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Conclusions

Distance matters for trade Consistent with both new trade theory and old

trade theory

Theory has helped refine the gravity relationship

Gravity can be used to test other hypotheseseven if we dont know what drives gravity