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Institute for International Integration Studies IIIS Discussion Paper - page 14 / 41

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the service, in some cases it will require movement of physical persons, but in others it may be communicated electronically. Consequently, the importance of distance in services trade may be low or even insignificant.

The standard measure of distance, also employed in this paper, is to measure the distance between the countries’ capitals. This has several problems associated with it: (i) it assumes no difference between air, sea and land transportation costs; and (ii) the capital city may not be the economic centre of the country or some countries may have several economic centres.15 To overcome some of these problems, different measures of distance have been developed (such as trade-weighted distances and distance measured relative to all other trading partners). However, given the possibility that distance is not particularly relevant for services trade as discussed above, the standard measure is used in this paper.

The final three regressors are dummy variables indicating whether the importing country a n d e x p o r t i n g c o u n t r y a r e a d j a c e n t ( β 6 A d j a c e n c y i j ) , s h a r e a c o m m o n l a n g u a g e ( β 7 L a n g u a g e i j ) , a n d w h e t h e r b o t h a r e m e m b e r s o f t h e E u r o p e a n U n i o n ( β 8 E U i j ) . A l l t h r e e

are expected to be positively related to the level of trade. Finally, θt are year dummies to control for any time trends in the data.

Language has been found to be significant in gravity model assessments of goods trade flows and this effect could be expected to be particularly strong in services, as common language should greatly facilitate many transactions. There is evidence to suggest that a common language variable may also capture other effects such as cultural or institutional similarities between countries. This should be borne in mind when interpreting the results of the model.

The final dummy variable is used to capture the effects of European Union membership on services trade flows. It is common in the literature applying the gravity model to goods trade to include a variable measuring the impact of Free Trade Areas (FTAs) but is not clear that this is appropriate for services trade as the majority of such agreements focus on the free movement of goods rather than services. The only agreement considered in this paper is the EU. Whilst trade in services within the EU is not fully liberalised, there are elements of EU policy that promote or facilitate trade in services and foreign direct investment, as opposed to EFTA for example, which provides only for free trade in goods. 16

4.2 Specification Testing

A number of estimation techniques are applied to the model. The results for total services imports using these estimators are shown in table 3. Initially, the observations are pooled over the three years in the dataset and the model is estimated with Ordinary Least Squares (OLS). However, it has been shown that OLS suffers from heterogeneity bias in the gravity model context (Cheng and Wall, 2005). Trade between any pair of countries is likely to be influenced by certain unobserved individual effects. If these effects are correlated with the explanatory variables, which an examination of the OLS residuals supports, this will lead to pooled OLS estimates being biased.

15 Consider the case of the US-Japanese trade for example: measuring the distance from Washington DC to Tokyo fails to consider the economic importance of numerous major cities on the Pacific coast of the US. The EU is taken to be the fifteen member states as of 1999-2001 (the period covered by the dataset). 16

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