Learning Unit 1 ECON452

Introduction to International Economics International Economics

Part 2: Gravity Model
Objectives

1. Explain that the value of trade between any two countries depends
on the size of these countries’ economies and inversely related to
the distance between two.
2. Understand how borders reduce trade.
3. Describe changes in amount of global trade over time and changes
in the mix of goods and services traded internationally.
Fig. 2-1: Total U.S. Trade with Major Partners, 2015

• The 5 largest trading partners

with the U.S. in 2015 were
China, Canada, Mexico,
Japan, and Germany.
• The largest 15 trading
partners with the U.S.
accounted for 75% of the
value of U.S. trade in 2015.
Size Matters
• 3 of the top 10 trading partners with the U.S. in 2015 were also the 3
largest European economies: Germany, the United Kingdom, and France.
– These countries have the largest GDP, the value of goods and services
produced in an economy, in Europe.
• China and Japan were the largest and fourth largest trading partners
with the U.S. in 2015.
– China and Japan were the second and third largest economies in the world.
Fig. 2-2: The Size of European Economies, and the Value of Their Trade with the
United States

Among America’s 15 most important

Western European trading partners
• Large economies like Germany and U.K. have
larger share of trade with the U.S.
• Small economies like Austria and Sweden have
small share of trade with the U.S.
• A strong positive correlation between size of
economy measured by GDP and volume of
trade between the U.S. and European countries.
List and Map of European countries by GDP
Distance Matters

• Canada and Mexico were the second and third largest trading
partners with the U.S. in 2015.
• European countries trade with each others (intra-EU trade) more than
with other countries outside of Europe.
• In general, countries tend to trade with nearby economies.
Fig. 2-3: Economic Size and Trade
with the United States

The United States does markedly more

trade with its neighbors than it does
with European economies of the same
size.
• Canada and Mexico were the largest and
third largest trading partners with the U.S.
in 2015.
• Their economies are smaller than Germany,
France, and U.K.
List and Map of Countries by GDP
The Gravity Model (Size of Economy)

• The size of an economy is directly related to the volume of imports

and exports.
– Larger economies produce more goods and services, so they have more to sell
in the export market.
– Larger economies generate more income from the goods and services sold, so
they are able to buy more imports.
• Trade between any two countries is larger, the larger is either country.
The Gravity Model (Distance)

• The distance between two economies is inversely related to the

volume of imports and exports between them.
– Distance between economies influences transportation costs.
– Distance is a proxy for more intangible aspects of a trading relationship such
as the ease of contact for firms.
• Trade between any two countries is larger, the closer are these
countries.
The Gravity Model – Formula
The gravity model assumes that size and distance are important for
trade in the following way:

A  Yi  Yj
Tij 
Dij

where
Tij is the value of trade between country i and country j
A is a constant
Yi the GDP of country I, Yj is the GDP of country j
Dij is the distance between country i and country j
The Gravity Model – Numerical Example
U.S. Trade with Canada and Mexico in 2012
GDP Distance Actual Trade Tij

U.S. $16.2 trillion

Canada $1.8 trillion 1,400 miles $617 billion
Mexico $1.2 trillion 1,000 miles $494 billion

Suppose A = 25, how much trade is the U.S. expected to have with these
countries according to the gravity model?
• Trade with Canada: 25 x $16.2 x $1.8 / 1,400 = $521 billion
• Trade with Mexico: 25 x $16.2 x $1.2 / 1,000 = $486 billion
General Form of Gravity Model
• More generally, the gravity model has the following form
Tij = A x Yia x Yjb /Dijc
When a, b, and c are equal to 1, this is exactly same as the simple gravity
model.
• Taking log in both sides,
ln(Tij) = lnA +a x ln(Yi) +b x ln(Yj) – c x ln(Dij)
Where a, b, and c are constant (coefficients to be estimated empirically).
Using the Gravity Model: Looking for
Anomalies
A gravity model fits the data on U.S. trade with European countries well
but not perfectly.
The Netherlands, Belgium and Ireland trade much more with the
United States than predicted by a gravity model.
• Ireland has strong cultural affinity due to common language and history of
migration.
• The Netherlands and Belgium have transport cost advantages due to their
location.
Impediments to Trade: Barriers and Borders
Other things besides size and distance matter for trade:
1. Cultural affinity: close cultural ties, such as a common language, usually lead
to strong economic ties.
2. Geography: ocean harbors and a lack of mountain barriers make
transportation and trade easier.
3. Multinational corporations: corporations spread across different nations
import and export many goods between their divisions.
4. Borders: crossing borders involves formalities that take time, often different
currencies need to be exchanged, and perhaps monetary costs like tariffs
reduce trade.
• Borders increase the cost and time needed to trade.
Trade Agreements
• Trade agreements between countries are intended to reduce the
formalities and tariffs needed to cross borders, and therefore to
increase trade.
• The U.S. signed a free trade agreement with Mexico and Canada in
1994, the North American Free Trade Agreement (NAFTA).
• Because of NAFTA and because Mexico and Canada are close to the
U.S., the amount of trade between the U.S. and its northern and
southern neighbors as a fraction of GDP is larger than between the
U.S. and European countries.
The Changing Pattern of World Trade: Has the
World Gotten Smaller?
• The negative effect of distance on trade according to the gravity
models is significant, but has grown smaller over time due to modern
transportation and communication.
• Technological advancement in transportation and communication
occurred in
– 17th century: Discovery of new world
– 19th century: Industrial revolution
– 21st century: Information technology revolution
Fig. 2-5: The Fall and Rise of World Trade

The ratio of world exports of

manufactured goods to world
industrial production
• rose in the decades before
World War I
• but fell sharply in the face of
wars and protectionism.
• It didn’t return to 1913 levels
until the 1970s but has since
reached new heights.
The Changing Pattern of World Trade: Political
Factors
• Political factors, such as wars, can change trade patterns much more
than innovations in transportation and communication.
• World trade grew rapidly from 1870 to 1913.
– Then it suffered a sharp decline due to the two world wars and the Great
Depression.
– It started to recover around 1945 but did not recover fully until around 1970.
• Since 1970, world trade as a fraction of world GDP has achieved
unprecedented heights.
– Vertical disintegration of production has contributed to the rise in the value
of world trade through extensive cross-shipping of components.
What Do We Trade?
• In 2015, most (about 57%) of the volume of
trade today is in manufactured products
such as automobiles, computers, and
clothing.
• Services such as shipping, insurance, legal
fees, and spending by tourists account for
about 24% of the volume of trade.
• Mineral products (ex., petroleum, coal,
copper) remain an important part of world
trade at 12%
• Agricultural products are a relatively small
part of trade at 8%.
 What Did We Trade?
In the past, a large fraction of the volume of trade came from agricultural and mineral
products.
• In 1910, Britain mainly imported agricultural and mineral products, while the U.S.
mainly imported and exported agricultural products and mineral products.
• In 2015, manufactured products made up most of the volume of imports and exports
for both countries.
Manufactured Goods as a Percent of Merchandise Trade
blank Exports of United Imports of United Exports of Imports of
Kingdom Kingdom United States United States
1910 75.4 24.5 47.5 60.7

2015 72.3 73.6 74.8 78.4

What Do We Trade? – Developing Countries
Over the past 50 years, the exports of developing
countries have shifted toward manufactures.
• In 1960, about 58% of exports from developing
countries were agricultural products and only
12% of exports were manufactured products.
• In 2001, about 65% of exports from developing
countries were manufactured products, and only
10% of exports were agricultural products.
• More than 90 percent of the exports of China, the
largest developing country and a rapidly growing
force in world trade, consist of manufactured
goods.
Outsourcing and Offshoring
• Outsourcing (vertical disintegration) is subcontracting a service, such
as product design or manufacturing, to a third-party company.
– Outsourcing can occur within an economy or across countries.
• Offshoring describes the relocation by a company of a business
process from one country to another -- typically an operational
process, such as manufacturing, or supporting processes, such as
accounting.
– Offshoring can be done by the same company or outsourcing to a third- party
company.
Service Offshoring
• Service offshoring occurs when a firm that provides services moves
its operations to a foreign location.
– Service offshoring can occur for services that can be transmitted
electronically.
Ex. customer service call centers.
• Service outsourcing is currently not a significant part of trade.
Offshoring vs. Non-Tradable

• Some jobs are “tradable” and thus have

the potential to be offshored.
• Most jobs (about 60%) need to be done
close to the customer, making them non-
tradable.
• Estimates based on trade within the United
States suggest that trade in services may
eventually become bigger than trade in
manufactures
Limitation of Gravity Model

Although the gravity model with various impediment factors explains a

volume of trade with other countries well, it does not explain a pattern
of trade (what to trade) and gains from trade.
• Why does the U.S. export services? Why do developing countries increasing
export more manufacture goods? Why service offshoring (import services)?
• Why do countries trade? What countries gain from trade?
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Dr. Ryoichi Sakano
Dr. Ryoichi Sakano
North Carolina A&T State University
North Carolina A&T State University