Trade Flows and Spatial Effects: The Gravity Model Revisited
Paper number: 00/04
Paper date: 2000
Paper Category: Working Paper
Given its parsimony and often acclaimed empirical robustness, the gravity model of trade never lost its appeal over the nearly four decades since it was introduced by Tinbergen and Linnemann. Indeed, the late 1990s witnessed a revival in its application, with numerous authors employing it to assess the potential for trade between the European Union (EU) and the transforming economies of Central and Eastern Europe. Since Krugman (1991), the fact that geography matters where trade is concerned is no longer news. However, the empirical work on the gravity model of trade does not, to date, explicitly account for the role of location, neither does it take seriously Anselin and Griffith's (1988) exposition on ways in which standard econometric techniques fail to remain applicable in the spatial context.
This paper explores the empirical performance of the gravity model when the inherent spatial effects are explicitly accounted for within the framework of spatial econometrics. The emphasis is on the size and significance of the estimated parameters1, given the practical relevance of the calculated potential trade flows they generate. We find that, when the inherent spatial effects are explicitly taken into account, the magnitude of the estimated parameters changes considerably and, with it, the measures on the predicted trade flows. More specifically, the traditional formulation seriously overestimates the size of the trade flows to and from 'island' countries, while underestimating it for countries who have trading neighbours. Moreover, the large explanatory power of regional trading bloc membership dummy variables vanishes when spatial effects are included in the model specification. The overall performance of the alternative specification proposed is superior to the one of the currently prevailing formulation.