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Understanding the Gravity Model in Trade

Sep 8, 2024

International Economics Lecture: The Gravity Model

Introduction

  • Focus on chapter two of the textbook.
  • Topic: Gravity Model in international trade.

Origins of the Gravity Model

  • Derived from Newton's law of universal gravitation.
  • Force of attraction between two bodies (e.g., Earth and Moon) is:
    • Directly related to the mass of the objects.
    • Inversely related to the distance between them.
  • First adapted for international trade by Jan Tinbergen in 1962.
  • Used for various interactions: migration, tourism, foreign direct investment, etc.

Structure of the Gravity Model

  • Level of trade between countries I and J (T<sub>ij</sub>):
    • T<sub>ij</sub> ∝ (GDP<sub>I</sub> * GDP<sub>J</sub>) / Distance<sup>c</sup>
    • Can model one-way trade or two-way trade.
  • More massive (higher GDP) countries are likely to trade more, but distance reduces trade levels.
  • Common estimates:
    • A and B (GDP powers) typically between 0.7 and 1.1.
    • C (distance power) generally around 1.*

Importance of Distance

  • Distance serves as a proxy for transportation costs:
    • Unknown shipment origins complicate exact distance calculations.
  • Distance affects:
    • Transportation Risk: Longer distances increase the risk of damage/loss during transport.
    • Shipment Time: Longer times can lead to market changes, risks with perishables.
    • Communication: Longer distances hinder face-to-face interactions, impacting transactions.
    • Cultural Differences: Greater distances often mean more cultural dissimilarities.

Limitations of the Gravity Model

  • Not a perfect model; can be augmented/modified:
    • Per Capita Income: Higher income correlates with higher trade levels.
    • Adjacency: Countries sharing borders (e.g., US-Canada, US-Mexico) generally trade more due to proximity.
    • Language and Colonial Links: Shared languages and historical ties ease trade.
    • Border Effects: Physical borders still create barriers despite free trade.

Case Study: Belgium

  • Surrounded by significant economies (France, Netherlands, Germany).
  • High per capita income due to proximity to larger markets.
  • 90% of GDP is exported; benefits from adjacency effects and shared languages.
  • Home to the second-largest port in Europe (Antwerp), reducing transportation costs.

Conclusion

  • Understanding the Gravity Model and its adaptations enhances predictive capabilities for international trade.

Full transcript