Gravity Models and Trade Flows - Essay Example

GRAVITY MODELS AND TRADE FLOWS Name: Course: Tutor: Institution: City and State: Date: Gravity Models and Trade Flows Introduction Gravity models are useful tools that analysts use to study a wide range of patterns and behaviours within the social sciences. Experts normally use the models to analyse the behaviour that show similarities to the laws of gravity that Isaac Newton developed. Ravenstein was the first person to use gravity models, doing so in 1884 to explain migration in the United Kingdom. Almost a century later, Tinbergen became the first person to apply a gravity model in economics. The use of gravity models to analyse trade has enabled experts to predict trade flows between multiple units based on a number of variables. Through this analysis, policy makers have been able to understand the impacts of different treaties signed in the international arena, as well as the effectiveness of international trade organizations such as the WTO (World Trade Organization). In the article, Gravity with gravitas: A solution to the border puzzle, Anderson and Van Wincoop argue that the lack of theoretical perspectives in the empirical models leads to various shortcomings within them. The authors develop a different model that is theoretical in nature and factors in variables that economists had previously failed to consider. For the new model, Anderson and van Wincoop draw most of their ideas from work McCallum’s research, which compared intra-national trade between provinces in Canada with international trade between Canadian provinces and American States. The theoretical gravity model that Anderson and Van Wincoop developed is better than the traditional empirical model, because it uses a holistic approach that covers all of the important variables involved. The Anderson and van Wincoop Model For the traditional gravity model, analysts derived equations from Isaac Newton’s law of universal gravitation. When applied to economics and international trade, the law implies that goods and labour from one point of origin are drawn to the demand for them at a specific destination (Salvatici, 2013, p. 3). However, a number of factors influence the movement of the goods and labour to the specific destination with distance being one of them. In addition to these omissions, analysts have faulted the models for failing to embed any real theoretical explanations. For this reason, Anderson and Van Wincoop resorted to the development of a new model that would place some emphasis on theoretical aspects. In their analysis of gravity models, Anderson and Van Wincoop (2003, p. 170) start by explaining that the equations have been quite successful in explaining various economic issues. Analysts can use these equations to connect bilateral trade flows to a number of important variables such as GDP (Gross Domestic Product) and distance. However, the authors are quick to state that the empirical equations that analysts have been using lack the necessary theoretical perspectives (Anderson and van Wincoop, 2003, p. 170). One theoretical issue lacking in the gravity models relates to multilateral resistance. In the equations, analysts make the incorrect assumption that the only real barrier to bilateral trade is distance and this makes the equations lack substance. In addition to this, Anderson and Van Wincoop (2003, p. 170) find two faults in the empirical gravity models. Firstly, the results that the models estimate are biased because the equations fail to take into account some variables. The second fault is that the models carry out comparative statics exercises something that the authors claim is not as straightforward as the equations make it look like it is (Anderson and van Wincoop, 2003, p. 170). Multilateral Resistance One of the things that Anderson and van Wincoop introduced into their model was multilateral resistance. The term multilateral resistance refers to costs of trading that go beyond the bilateral impediments of the two countries that are trading (Salvatici, 2013, p. 8). The resistance essentially refers to those factors affecting trade that are out of the control of the trading countries. Behar and Criville (2010, p. 2) outline the importance of considering multilateral resistance. They argue that both bilateral trade costs and multilateral resistance factors play a part in determining the trade flows between two countries. Examples of multilateral resistance include trade agreements, trade organizations and other international organizations. Different arguments have been made regarding the impact of multilateral resistance (MR) on trade flows. Behar and Criville (2010, p. 9) claim that the effects of MR on trade are less when the trade involves smaller countries. This means that MR impedes trade more in the context of North-South trade than in South-South trade. As the countries that are trading get larger, so do the impediments posed by MR. Analysts have come up with different factors that determine the trade relations between two countries. Economic similarity is one of the issues that encourage different states to form these partnerships because they are able to exploit existing economies of scale (Behar and Criville, 2010, p. 5). Differences in production factors also encourage states to trade with each other because they are able to take advantage of comparative advantages that they each enjoy. Both of these factors have different implications when applied in North-South trade and in South-South trade. According to Behar and Criville (2010, p. 5), Free Trade Agreements are some of the most important MR factors. Their research shows that the FTAs mostly affect trade flows in favour of the Northern countries despite the fact that most of them are structured in ways that are supposed to grant the Southern countries access to the Northern markets. The fact that Anderson and Van Wincoop also looked at the possible effects of third party involvement also makes their study, and the model they developed, superior to those that economists had carried out before. Specifically, Anderson and van Wincoop (2003, p. 176) investigated the effects of ignoring third parties when engaging in bilateral trade. Behar and Criville (2010, p. 3) argue that the potential involvement of a third party within a trade agreement complicates things to a certain extent. For instance, if two countries were to engage in a trade agreement, the trade between them would increase. A bilateral agreement would reduce the barriers between the two countries and the costs of trading as well. A reduction in the trading costs of the two countries would mean that the trade between the involved nations would increase. However, this would come at the expense of trade with other countries (Behar and Criville, 2010, 9). Salvatici (2013, p. 8) agrees that the omission of multilateral resistance resulted in a bias within the traditional gravity models. One of the MR factors that he looks at is price effects. Scholars have applied different approaches when dealing with price effects in the equations. Some dealt with the situation by using data on price indexes that had already been published, others made direct estimations and some studies used country fixed effects. Salvatici (2013, p. 8) finds that some of these techniques were faulted in one way or another mainly because of a lack of accuracy. The study carried out by Anderson and Von Wincoop used direct estimation to account for price effects (Salvatici, 2013, p.8). This is an improvement on the traditional models, which completely ignored such variables. This means that the model that they developed was more accurate in its inferences than the ones that analysts used previously. Older models also fail to pay attention to market clearing. Within an economical context, market clearing refers to the way that quantities in a market always adjust themselves such that supply matches demand. These adjustments normally result in market equilibrium. In their research, Anderson and van Wincoop (2003, p. 175) were interested in finding out the general equilibrium determination of prices, an issue that scholars had ignored in the past when coming up with the gravity models. In their study, price indices were considered one of many multilateral resistance variables. The authors theorized that by using a general equilibrium gravity model, they could carry out comparative statics exercises that establish the effect of trade barriers on trade flows. For instance, they could use the model to find out how borders affected trade flows between countries (Anderson and van Wincoop, 2003, p. 171). The thorough approach that the scholars applied in their study offered a fresh approach from past studies and made the model that they developed more accurate than the traditional ones. The model that Anderson and Van Wincoop developed is also superior because it considers the fact that consumers may consider certain goods to be substitutes. The scholars argue that their model is not completely conclusive because it contains only one elasticity (Anderson and van Wincoop, 2003, p. 181). The fact that some goods may be perfect substitutes while others are weak substitutes means that the researchers could not come up with an average elasticity that could apply. The effect of substitution could have a myriad of effects on the trade between different countries. Perfect substitutes could reduce the demand for a country’s export significantly. Alternatively, if a country is exporting a product that lacks any strong substitute, then it is possible that the demand for the commodity will remain high. Anderson and van Wincoop (Anderson and van Wincoop, 2003, p. 177) admitted that it would be difficult to completely integrate the elasticity of substitution into their study and that they used a price index instead, however, the issue can be factored in when dealing with a situation that is more simplified. The importance of multilateral resistance in analysing trade flows cannot be emphasised enough. Behar and Criville (2010, p. 3) outline that MR mainly entails the effects of the involvement of a third country or party. By focusing their attention on MR, Anderson and van Wincoop were able to offer a perspective that was needed to make the gravity models and the analysis of trade flows become more accurate. When countries make bilateral trade agreements, the arrangements affect the existing trade relationships with other states. The effect is smaller when the third party is a small country and bigger when the other country is larger than the two that have entered an agreement (Behar and Nelson, 2009, p. 6). This is because smaller countries have weaker effects on a states multilateral resistance. In contrast, large countries such as the United States bear a lot of influence on MR. This is the reason why MR is felt more when the trade is between North-South countries then when it entails South-South countries (Behar and Criville, 2010, p. 3). Implications of the Anderson and van Wincoop Model The additions that Anderson and van Wincoop made to the traditional models of analysing trade flows revamped the way that economists looked at the issue. The traditional models were mainly empirical, applying data with little regard for theoretical approaches to the issue. This was a continuation of the first model that Tinbergen applied in 1962. The additions that Anderson and van Wincoop made had several implications with regard to the analysis of trade flows. Firstly, the scholars introduced the concept of multilateral resistance. When looking at multilateral resistance, economists consider other issues that occur outside the bilateral agreement that two countries have. Anderson and van Wincoop showed that there is a need to look at the different ways that third parties can affect the trade between two countries even when they are not implicitly involved. Building on this research, other scholars have identified key issues concerning multilateral resistance. Behar and Criville (2010, p. 9) argue that the effects of multilateral resistance vary depending of a number of factors such as the sizes of the economies of the trading countries. Based on these factors, their study showed that countries are better of trading with other nations that have similar sized economies and against which they enjoy comparative advantages. This would allow both countries involved in the trade to benefit from the exchanges while reducing the multilateral resistance at the same time. In their analysis of trade flows, Behar and Criville (2010, p. 3) also identified different issues concerning the impact of MR. Their study pointed out that the effects of multilateral resistance could be mitigated by trading with smaller countries. For instance, the effects of MR would be lower when trading with a country like Uganda, than when trading with the United States. This is because the countries with larger economies had larger control over the international market and they could have some influence over bilateral deals even when they were not involved. In addition to this, Behar and Criville (2010, p. 3) argued that it was better for countries in the South to engage in South-South trade agreements as opposed to North-South trade arrangements. They claimed that in North-South trade agreements, the countries from the North always profited more from the South. This was the case even when the trade agreements were designed to open up Northern markets to Southern manufacturers (Behar and Criville, 2010, p. 3). Another implication of the Anderson and van Wincoop theoretically based gravity model is that it considers variables that economists had been ignoring such as substitutes of goods and market clearing. Equilibrium was an important factor in their study because the scholars used a general equilibrium gravity model to establish the effects of barriers on trade flows. In addition, to this Anderson and van Wincoop also considered the effect of consumers considering some good to be substitutes and therefore affecting ongoing trade. Conclusion The analysis of trade flows using gravity models started in 1962. Since then, the additions made by Anderson and van Wincoop have been the most significant. The most important thing about their addition was the attention that they paid to the importance of multilateral resistance. Multilateral resistance in the case of their study referred to trading costs that were beyond the involved countries. The introduction of MR into gravity models changed the way that scholars analysed trade flows. Research was carried out to find out how third parties affected trade in a bilateral agreement and to see which party gained or lost the most from different trade arrangements. Through MR, economists could also look at the effects of international trade agreements and blocs had on bilateral trade agreements. By applying a theoretical perspective to a field that had seen a mainly empirical approach, the scholars were able to make it more holistic. Through these additions, the theoretically driven model that Anderson and van Wincoop developed has emerged to be superior and better than the empirical ones that had been used before. References Anderson, JE & van Wincoop, E 2003. ‘Gravity with gravitas: A solution to the border puzzle’, The American Economic Review, vol 93, No. 1. Pp. 170-192. Behar, A & Criville, LC 2010, ‘The impact of North-South and South-South trade agreements on bilateral trade’, CSAE Working Paper, 2010-30. Behar, A & Nelson, BD 2009. ‘How multilateral resistance and firm heterogeneity affect trade elasticities’, Leverhulme Centre for Research on Globalisation and Economic Policy, Nottingham University. Salvatici, L 2013. ‘The gravity model in international trade’, AGRODEP, vol. 04, pp. 3-24. Read More