The Theoretical Foundation of Gravity Modeling: What are the developments that have brought gravity modeling into mainstream economics?

Abstract

Gravity modeling is one of the most applied empirical methods to model and explain international trade flows. Besides the success gravity models experience in empirical research, a profound theoretical rationale of the model did not exist a decade ago. In its traditional form, the gravity equation puts bilateral trade flows in a positive relationship to the countries’ gross domestic products and links it negatively to the distance between them. Alluding to a concept in physics, it intends to explain trade flows in relation to the entities’ economic productivity or mass and the geographic distance parting them. Originally, the distance variable absorbed many different varieties of trade barriers. However, with the evolution of trade theory, research focused on a manifold of trade hindering and enhancing factors such as transport costs, tariffs, trade agreements, currency unions or cultural similarities. This work gives an overview of the theoretical development in gravity modeling. It aims to offer insights on the theoretical foundation within gravity modeling. The research question this work is based on can be summarized as following: The theoretical foundation of gravity modeling: What are the developments that have brought gravity modeling into mainstream economics? My findings indicate that during the last years a new research approach has been developed which concentrates on gravity model theory. The development of multilateral resistance terms by Anderson and van Wincoop (2003, 2004) allow a new interpretation of gravity modeling within international economics. Multilateral resistance represents the importing and exporting country’s average trade resistance between itself and every possible trade partner that could potentially be traded with. Thus, multilateral resistance does not solely take bilateral trade barriers into account as before, but sets country-pair trade into a multilateral context. The incorporation of inward and outward resistance terms results in an in depth understanding of empirical phenomena such as the border puzzle which was introduced by McCallum (1995). This suggests the structural gravity equation is a step towards a more comprehensive, holistic and context-sensitive analysis of international trade flows. Ensuring a general equilibrium setting which derives from the choice and comparison of opportunity costs, it features one of the main characteristics in international trade: a balanced state of markets around the world. This enriches a broad field within international economics, such as the modeling of migration, foreign direct investment or international capital movement. Due to its complexity in application, multilateral resistance is sometimes neglected in the empirical estimation. Reasons for this are often incomplete data because of missing observations or nonexistent industry specific information. Further research could focus on diverse assumptions and strive for a general theoretical justification which is more independent from the assumptions chosen.