Gravity Model in Economics - Example

Gravity Model in Economics By Professor Class University City Date of submission The concept of Gravity Model in economics Globally, all businesses experience many challenges ranging from competition to business environment factors. Therefore, it is important to investigate factors influencing global trade through the use of sophisticated framework models. These models play important role in identifying the trade barriers within the global market. However, it is important to note that there are economic wide models and partial equilibrium models. Some equations use equation econometric models like the gravity models and import demand. Gravity model of trade helps in prediction of the bilateral trade flows with focus on the economic size and distance within the trading countries. Besides, the model been used in the evaluation of the effects of treaties signed amongst states in trade and to ascertain the effectiveness of the agreements (Anderson & National Bureau of Economic Research, 2010, 275). Gravity has been successful in most empirical models used in economics. The numerous changes in the international trade patterns are the major factors attracting the economic theorists to pay much attention in the development of theoretical consideration and empirical approaches that would assist in exploring international trade flows. The gravity model bases its foundation on the Newton’s law of gravity, which states that two bodies are subject to a force of attraction, which in most cases depends positively on the product of the masses and distances. The standard formulation of the gravity model relates to the models used in international trade and includes all the factors perceived to be affecting the relationship existing in bilateral trades. Some of the factors considered include common borders, tariffs, and regional trade agreements. Ever since the inception of the gravity model in 1962, it has been able to gain popularity in the empirical trade flow analysis (Fidrmuc, Karaja & Tichit, 2012, 157). Moreover, the model was derived from other broader classes of structural models in order to help address issues influencing international trade. Gravity model tends to explain the concept of bilateral trade using the national incomes of the countries involved and the distance between them. The equation of the model has been customized to serve different purposes. Since the gravity equation is bilateral, it tends to explain trade related independent variable by combining macroeconomic variable such as prices, market size, exchange rates, and Gross Domestic Income for the countries involved in the trading activities. Besides, other factor included in the calculations is the transportation cost, which depends on the distance between the two countries and market accessibility (Karasawa-Ohtashiro & Yanase, 2011, 109). Furthermore, the equation could also be used in estimating the determinants of volumes of sales and determinants of the nature of the trade flows. Theoretical justification of the gravity model Theoretical concept of the model presents a stronger foundation using rough indicators, which plays a crucial role in integrating a huge number of countries while sampling. Moreover, the concept presents numerous discrepancies in comparison with the ideal equation. There are factors responsible for jeopardizing the attempts of using the model for forecasting purposes (Anderson, Van & National Bureau of Economic Research, 2001, 189). Generally, the gravity model is used in explaining the underlying patterns between the involved countries. Initially, most economists used the models on empirical basis of market size and transportation cost. For many years, the mode has been successful in its accurate prediction of the trade flows between countries for the goods and services traded. However, most scholars believed that there were no existences of the theoretical justification for the gravity equation. In almost all the economic models, gravity relationship often arise including trade costs that tend to increase with distance. Besides estimation of the patterns involved in the international trade, gravity model presents utilizes factors that are closely related to geography and specialty. Theoretically, the model has been used in testing hypothesis based on pure economic theories of trade. However, through evolution of the model, most economists have been able to focus on studies that hinder and enhance international trade such as currency unions, cultural similarities, transport costs, and tariffs. According to the development of multilateral resistance terms by Anderson and van Win coop, analysis of the gravity model has become easier since the scholars have been able to come up with new methods of interpreting the model within international economics. Multilateral resistance represents the average imports and exports of a country compared to any other country it trades with (Fujita, 2007, 126). Therefore, it does not into consideration the trade barriers. Through incorporation of both inward and outward resistance terms, the economists have been able to establish a depth understanding of the empirical phenomenon including the border puzzle. Gravity model is criticized based on its weak theoretical base and poor micro-foundation. Consequently, the equation used in the model describes trade flows within several empirical literatures without attempting to justify it theoretically. Generally, the theoretical support for the gravity model was originally poor. However, there have been several theoretical developments used in filling up the gaps. Several literatures exist on the model justifying how the incomes of the trading countries are positively influenced by the exports. Nevertheless, the distances affect exports. In comparison to the Newton’s law of gravity, the trade version of the gravity model represents a reduction in the supply and demand factors and trade resistance factors. Anderson made the first attempt of deriving the gravity model equation by assuming product differentiation and theoretical determinants of the bilateral trade. In a bid to establish the accuracy of the model, Anderson incorporated the equation with simple monopolistic models (Bergeijk & Brakman, 2010, 97). Anderson and Win coop tried to derive the operational gravity model through manipulation of the CES (constant elasticity of substitutes) expenditure for estimation and solving border puzzles. The major concern of Anderson was to examine the properties of econometric from the equations rather than extracting the easily interpretable theoretical implications. Moreover, Anderson’s theoretical analysis resulted in a microeconomic foundation to the gravity model within the framework of a general equilibrium model of the international trade. It is important to note that theoretical deviation of the equation used in the model might result in frictionless trade and identical preferences (Lueth, Ruiz-Arranz, & International Monetary Fund, 2006, 132). However, for such conditions to occur, there must be random selection the trading partners by both the consumers and producers and assumption that trade impediments are unequal to the price factors. The main advantage of the model is that it assists in identification of the determinants influencing the volume of trade and factors that trigger trade. Empirical concept of the model Many researchers, especially the econometricians, have been able to explain the underlying issues on the gravity model. The most important area of that the model has been able to analyze is evaluation of the Trade-Policy Issues. Trade barriers have several negative effects on the international trade. Through the years, the model has been able to undergo through many remarkable evolution especially in terms of empirical specification. There have been extensive and successful uses of the gravity model in supporting international trade. Furthermore, the model has become an elemental instrument for simulating international trade flows (Bhattacharya & Bhattacharyay, 2007, 131). Considering the model in its simplest form, the model states that bilateral trade existing between two countries is directly relative to their economic sizes. Consequently, the nature of the bilateral trade varies inversely proportional to the geographic distance between the trading countries. In order to measure the frictions to trade between the trading countries, the basic requirement of the equation used in the model is often augmented empirically through inclusion of the other variable assumed to be allied to the consensual volume of trade. These variables include anything that captures the elements involved in sharing of a common border through a common language or membership through an integration agreement. Other studies have refined the gravity model in relation to explanatory variable. Linneman conducted the earliest empirical studies on the model in 1966, which was ambitious but successful. The empirical studies extended the model through incorporation it with population variables to indicate the economic scale. Additionally, other researchers used the gravity model approach in explaining the flows of the bilateral trade econometrically using variable such as transport cost and income levels between the trading partners. According to the AvW, the empirical gravity model presents econometrics that is estimated in a bias manner since it omits several variable. Moreover, the counter-factual simulation often produce biased results since it do not take into consideration the general equilibrium effects existing in two multilateral resistance terms. Besides, such biasness might result from the poorly estimated parameters. Fixed effects might be used, as it does not give unbiased parameter estimates like the counter-factual that does not into consideration of the general equilibrium effects originating from the multilateral resistance terms. The nonlinear approach presented by the AvW models could also assist in the approximation and reduction in the level of biasness (Bernhofen, 2010, 114). In most cases, the empirical specification of the model is in log-linear form implying that that the acquired coefficients used in the equation are estimates from the elasticity. The basic specifications used in the gravity model include exchange rate volatility measures as the average of the exporter and importer. However, it is significant to note that the impact of time invariant variable like distances and contiguity are not estimated as separate entities but captured by the fixed effects and included in the final value of the constants. Implications of the gravity models on econometric analysis of trade flows Since the models depend on estimate values, the results from the simulation process are often inaccurate. However, the econometrics has been able to put across certain measures to remedy the undesired complications arising during the simulation process. In order to account for the potential heteroscedasticity and autocorrelation, the researchers have been able use several methods of standardization. These standards aim at detecting any form of multicollinerarity existing between the explanatory variable. Gravity model has been able to allow introduction of large number of trade flows determinants (Davidson & Matusz, 2004, 152). Moreover, there have increasing acknowledgement of the findings related to the econometrics and the interpreted results incorporated into the model for empirical and theoretical development. Many countries have been have been signing the free trade agreement (FTA) with an aim of developing trade amongst them. Therefore, the gravity model has been utilized in analyzing the data from the bilateral trade against the variables. Through the use of the regional variables in the gravity model has been on the rise mainly to determine whether some of the FTA contribute to market creation or trade diversion among the involved countries. The factors that contributed to the search for theoretical expansion of the gravity model were its extraordinary stability and power to explain the bilateral trade flows. Besides, the gravity model has been able to gain popularity that most of the trade models require it to function effectively. The work of Anderson provided the most important theoretical basis of the gravity model. Anderson differentiated the goods by their countries of origin and assumed that the consumers had their preferences defined for a particular product. The trade costs are often modelled based on the fraction of the goods shipped into the country. Besides being an econometric tool without proper theoretical foundation, the gravity models could result from a wider range of trade models or theories. The econometric approaches of estimating the model of trade have been able to change the traditional literature of economics. In international trade, the gravity model is often motivated by New Trade Theory Models, which in most cases aim at increasing the returns. From the empirical point of view, the gravity model has been successful; however, many reservations have been coming up regarding the theoretical justification that most theorists have put across in favor of the model. Although the gravity model was designed to cover areas relating to specialty and geography, it has also been able to test the matters relating to pure economics. Through incorporation of the theoretical foundation of the gravity model, there have been richer and more accurate estimates and analysis of the trade issues. References Anderson, J. E., & National Bureau of Economic Research. 2010. The gravity model. Cambridge, MA: National Bureau of Economic Research. Anderson, J. E., Van, W. E., & National Bureau of Economic Research. 2001. Gravity with gravitas: A solution to the border puzzle. Cambridge, MA: National Bureau of Economic Research. Bergeijk, P. A., & Brakman, S. 2010. The gravity model in international trade: Advances and applications. Cambridge: Cambridge University Press. Bernhofen, D. M. 2010. Empirical international trade. Cheltenham, UK: Edward Elgar. Bhattacharya, S. K., & Bhattacharyay, B. N. 2007. Gains and losses of India-China trade cooperation: A gravity model impact analysis. Munich: Univ., Center for Economic Studies. Davidson, C., & Matusz, S. J. 2004. International trade and labor markets: Theory, evidence, and policy implications. Kalamazoo, MI: W.E. Upjohn Institute for Employment Research. Fidrmuc, J., Karaja, E., & Tichit, A. 2012. Reform, uncertainty, and spillovers: A gravity model approach. München: CESifo. Fujita, Y. 2007. Toward a new modeling of international economics: An attempt to reformulate an international trade model based on real option theory. Physica A-statistical Mechanics and Its Applications, 9(5), 125-132. Karasawa-Ohtashiro, Y., & Yanase, A. 2011. A Dynamic International Trade Model with Endogenous Fertility. Asia-pacific Journal of Accounting & Economics, 12(5), 101-115. Lueth, E., Ruiz-Arranz, M., & International Monetary Fund. 2006. A gravity model of workers' remittances. Washington, DC: International Monetary Fund. Read More