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Institute for International Integration Studies IIIS Discussion Paper - page 13 / 41

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4. Model Estimation and Results

4.1 Model

The initial gravity model estimated in this paper is (1), in which all continuous variables are expressed in logarithms. Data sources for each variable are fully documented in the

appendix.

i j t i j 1 i t 2 j t 3 i t 4 j t 5 i j 6 i j 7 i j 8 i j t i j t l n M = + l n G D P p c + l n G D P p c + l n P o p + l n P o p + l n D i s t a n c e + A d j a c e n c y + L a n g u a g e + E U + + α β β β β β β β β θ ε

(1)

The dependent variable Mijt is imports of services from country i into country j at time t. The OECD (2003) data used covers imports between 27 OECD countries and up to fifty of their trading partners over a three year period (1999-2001). The gravity model is estimated with total services, government services, transport services, travel and other commercial services as dependent variables. Whilst the OECD (2003) database on services trade has been employed in gravity based studies before, as discussed in section 3.2, previous research has focussed on the total services category. 14

As explanatory variables, five continuous variables and three dummies are included. In the literature on gravity models, three variables are used as measures of the size of a country: Gross Domestic Product (GDP), GDP per capita and population. Clearly all three can not be included simultaneously due to multicollinearity. In this paper the latter two are included. As countries tend to consume more service commodities as they become richer, GDP per capita is of more relevant than GDP itself. The choice of population over GDP also facilitates the interpretation of the model results (Fitzsimons et al., 1999).

The first two continuous variables are real GDP per capita of the exporting and i m p o r t i n g c o u n t r i e s a t t i m e t ( β 1 l n G D P p c i t a n d β 2 l n G D P p c j t r e s p e c t i v e l y ) . T h e

c o e f f i c i e n t s β 1 a n d β 2 a r e e x p e c t e d t o b e p o s i t i v e . A h i g h e r l e v e l o f i n c o m e i n t importing country should indicate a higher level of demand for services (produced domestically or imported), whilst a higher income level in the exporting country should be positively related to that country’s ability to produce more services for export. Mirza and Nicoletti (2006) show that the supply of services to foreign markets is strongly linked to the availability of inputs in both domestic and foreign markets. h e

The coefficients on lnPopit and lnPopjt, the population in the importing and exporting countries at time t, may be expected to take either a negative or positive sign. As Martinez-Zarzosa and Nowak-Lehmann (2002) show, population size may have a negative effect on exports if countries export less as they become larger (as they rely more on internal trade) or a positive effect if they export more as they become larger as they are able to achieve economies of scale. Population size will have a similar effect on imports.

A l t h o u g h d i s t a n c e b e t w e e n t h e i m p o r t e r a n d e x p o r t e r ( β 5 l n D i s t a n c e i j ) i s t y p i c a l l expected to have a negative impact on trade in goods, it is not clear from the review of the existing literature that this is necessarily the case for services. Service products do not have to be physically transported from location to location. Depending on the nature of y

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Kox and Lejour (2005) consider the other commercial services sector, but not the other three.

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