Chaney, Thomas (2011) The Gravity Equation in International Trade: An Explanation.

Preview

Text Download (968kB) | Preview

Abstract

The gravity equation in international trade is one of the most robust empirical finding
in economics: bilateral trade between two countries is proportional to their respective sizes,
measured by their GDP, and inversely proportional to the geographic distance between them.
While the role of economic size is well understood, the role played by distance remains a mystery.
In this paper, I propose the first explanation for the gravity equation in international
trade. This explanation is based on the emergence of a stable international network of importers
and exporters. Firms can only export into markets in which they have a contact. They
acquire contacts by gradually meeting the contacts of their contacts. I show that if, as observed
empirically, (i) the distribution of the number of foreign countries accessed by exporters is fat
tailed, (ii) there is a large turnover in exports, with firms often going in and out of individual
foreign markets, and (iii) geographic distance hinders the initial acquisition of contacts
in an arbitrary way, then trade is proportional to country size, and inversely proportional to
distance. Data on firm level, sectoral, and aggregate trade support further predictions of the
model.