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Institute for International Integration Studies IIIS Discussion Paper - page 9 / 41

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explanatory variable measuring NTBs in the gravity equation. The variable in question is often based on the frequency index and price based approaches discussed above. This is the approach followed in this paper. The precise specification of the gravity model used is described in later sections, as is the methodology used to calculate tariff equivalents of NTBs based on a comparison of actual and predicted trade flows.

  • 3.

    The Gravity Model and Services Trade

    • 3.1

      Historical Development

The concept of the gravity model is based on Newton’s Law of Universal Gravitation relating the force of attraction between two objects to their combined mass and the distance between them. The application of gravity to the social sciences was first proposed by James Stewart in the 1940s (Fitzsimons et al., 1999). Originally applied to international trade by Tinbergen (1962), the gravity model predicts bilateral trade flows between any two countries as a function of their size and the distance between them.

Economic size is measured as Gross Domestic Product, population or per capita income. Distance is typically measured as the distance between the countries capital cities. In some studies this is replaced by measures of remoteness, that weight distances by GDP or measure bilateral distances relative to the country’s average distance from all trading partners.

The gravity model has been widely applied in international trade studies. Its popularity is due to the simplicity of the concept, the fact that it appears to fit the available data well and the ease with which models can be estimated econometrically.8 Increasingly, the model specification has been augmented through the addition of other variables that are thought to impact on trade flows such as dummy variables for a common language, common borders or historical relationships between countries. The gravity model is also used for policy analysis, for example the effects on trade flows between countries of membership of trade agreements or common currency areas can be assessed. A common extension of the gravity approach is to calculate the trade cost of different types of barriers and various other restrictions (observed and unobserved) on trade flows by comparing predicted and actual levels of trade.

As the empirical applications of the gravity model have grown, the theoretical foundations of the model have also been developed. Beginning with Anderson (1979), who showed that the gravity framework is consistent with a model of world trade in which products are differentiated by the country of origin (the Armington assumption), a series of papers have shown the gravity model framework to be consistent with a number of standard trade theories such as Heckscher-Ohlin and monopolistic competition.9 Deardorff (1995, p8) goes as far as to state that “just about any plausible model of trade would yield something very like the gravity equation, whose empirical success is therefore not evidence of anything, but just a fact of life.”

Anderson and van Wincoop (2003) show that the estimation of the gravity model can be greatly improved by incorporating what they refer to as multilateral resistance measures. Trade between any two regions depends negatively on the trade barriers of each region

8 Traditionally the gravity model has been estimated using Ordinary Least Squares (OLS). As is discussed later in this paper, it is increasingly the case that more sophisticated estimation techniques are employed. See Anderson (1979), Bergstand (1985, 1989), Helpman and Krugman (1985) and Deardorff (1995). 9

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