Gravity Channels in Trade

Abstract

Gravity variables such as distance, adjacency, colony, free trade agreements or language are used to capture the effects of trade costs in empirical studies. By using actual data on trade costs, this paper decomposes the overall effects of such variables on trade into those through three gravity channels: duties/tariffs (DC), transportation-costs (TC), and dyadic-preferences (PC). When PC is ignored as is typical in existing studies in the literature, it is shown that nearly all gravity effects are due to distance, 29 percent through DC and 71 percent through TC. The tables turn as the additional channel of PC is introduced and shown to dominate other channels, with adjacency contributing about 45 percent, distance about 32 percent, colony about 14 percent, free trade agreements about 7 percent, and language about 2 percent. It is implied that gravity variables mainly capture the effects of demand shifters rather than supply shifters (as implied by the existing literature). The results are further connected to several existing discussions in the literature, such as welfare gains from trade and the distance puzzle.