Approximating general equilibrium impacts of trade liberalizations using the gravity equation

Abstract

Introduction For nearly half a century, the gravity equation has been used to explain econometrically the ex post effects of economic integration agreements, national borders, currency unions, immigrant stocks, language, and other measures of “trade costs” on bilateral trade flows. Until recently, researchers typically focused on a simple specification akin to Newton's Law of Gravity, whereby the bilateral trade flow from region i to region j was a multiplicative (or log-linear) function of the two countries' gross domestic products (GDPs), their bilateral distance, and typically an array of bilateral dummy variables assumed to reflect the bilateral trade costs between that pair of regions; we denote this the “traditional” gravity equation. This gravity equation gained acceptance among international trade economists and policy makers in the last twenty-five years for (at least) three reasons: formal theoretical economic foundations surfaced around 1980; consistently strong empirical explanatory power (high R values); and policy relevance for analyzing numerous free trade agreements that arose over the past fifteen years. However, the traditional gravity equation has come under scrutiny. First, the traditional specification ignores that the volume of trade from region i to region j should be influenced by trade costs between regions i and j relative to those of the rest of the world ( ROW ), and the economic sizes of the ROW 's regions (and prices of their goods) matter as well. Second, applications of the traditional gravity equation to study bilateral trade agreements often yielded seemingly implausible findings.