Implications on Econometric Analysis of Trade Flows - Assignment Example

Economics Assignment 2 Student Name Institution Course Tutor Date Economics Assignment 2 Question Carefully explain in what way the theoretically derived gravity model as in Anderson and van Wincoop "Gravity with gravitas" (2003), is superior to the empirically based gravity model. What implications does this have for applied econometric analysis of trade flows? Introduction The use of gravity equations in inferring the effects of various trade flows among different institutional arrangements has been widespread. As Anderson and van Wincoop (2003) noted, this has been attributed to the fact that the gravity equation creates a relation of bilateral trade flows to the gross domestic product, the distance between countries as well as other factors that impose on trade barriers. The empirical gravity equations have been purported by many to have a theoretical connection. Anderson and van Wincoop argue against this perception. Their argument is based on the fact that there has to be some form of multilateral resistance as the average trade barrier. The trade barrier between two bilateral partners decreases with the increase in resistance with the other partners in the region. In this respect, the literature in empirical gravity does not incorporate multilateral resistance in its analysis. Therefore, the gravity model that has been theoretically derived by Anderson and van Wincoop (2003) is seen to be superior to the empirically based gravity model. This paper justifies this superiority and further explains the implications that are accompanied by this argument on the applied econometric analysis of trade flows. The development of the gravity model was intended to explain the concept of international trade. The model was named the gravity model because it has an analogy with the law of gravitation as stated by Newton. According to Deardoff (1998), the gravity equation best describes bilateral trade patterns by positively relating the trade between two countries to their incomes and by negatively relating them to the distance between the countries. This relation is done using a functional form that is similar to the gravitational law. In the equation, it is implied that trade between two countries is directly proportional to the GDPs of the countries and inversely proportional to the distance between the two countries. Whenever the distance between the countries is great, the trade barrier between the two countries increases. An analysis of the empirical model of the gravitational equation vis a vis the theoretical model as presented by Anderson and van Wincoop will indicate how superior the theoretical model is to the empirical one. To begin with, the empirical evidence of the gravity equation in analyzing international trade is stated by Chaney (2011) to be a strong model. This is because the role of distance and the role played by the size of the economy of the two countries are key factors that are stable over a long duration of time. These two are stable across various countries and when different econometric methods are used. Empirical applications analyze the border effect that exists in the framework of the gravity equation. Under this, it compares both inter-country and intra-country trade. The distance between these countries plays a key role in promoting the trade between these countries. Across the world, markets have moved closer together and have become more and more close to each other. In addition, the markets have become more independent of each other. This implies that there is need to model the trade flows that exist between the countries so as to yield a modeling method that is empirically common in estimating trade flows. This brings to perspective the reasoning behind the gravity equation: that the bigger the economies of the countries, and the smaller the distance between them, the more they are likely to trade. Traditionally, distance was related to the geographical position of the countries. However, recent developments have enhanced the concept of distance to factors such as tariffs, transportation costs, taxes, contracts, and distribution and information costs. Distance has been the most used factor in the empirical model of the gravity equation. This is because it has been seen as the best way to linking two economies or institutions that intend to carry out trade. This has been the reason behind the success of the empirical model of the gravity equation in estimating trade flows. In fact, McCallum (1995) contended that the empirical model has a dubious theoretical heritage. However, the most successful of gravity models have been the empirical models. In addition, they have been the basis for which tests of other propositions have been made. Across the world, national borders are in a state of fluctuation. These changes occur in both the physical border location as well as the economic significance of the countries. The significance of the national borders has been reducing with time. This can be attributed to the development of various trading blocs among the countries. This has made the impact of the national borders less significant. Deardoff (1998) contends that there have been various arguments on the lack of a theoretical foundation in the empirical model of the gravity equations. The various models that presented the empirical model such as the Heckscher-Ohlin model used in explaining international trade have been reported to have lacked the ability to provide a theoretical foundation and the model was not consistent theoretically. Whenever there is frictionless trade, trade is purported to be cheap. The general agreement amongst traders is that countries usually satisfy the demands of the domestic supply and import what is left. Even so, it is vital to think of the demanders as indifferent among the sources of supply that are equally priced, be it domestically or foreign. For this reason, the empirical approach has been seen to be insufficient theoretically. Anderson and van Wincoop (2003) argued that by following an all empirical approach in the gravity equation, there are two implications that are realized. To begin with, the results that are estimated using this model are biased. This is because there will be some variables that are omitted. The consideration of distance as the basis for promoting the gravity equation does not fully capture all the variables that should be covered in working out the factors that contribute to trade flows. The second implication that was noted was that conducting comparative static exercises was not possible even when the purpose was to estimate the gravity equations. To better carry out a comparative statics exercise like enquiring on the effects of removing some trade barriers, it is vital to have a solution of the general equilibrium model before removal of the trade barriers and after their removal. Development of a method that efficiently and consistently estimates the theoretical gravity equation and using a general equilibrium model that has been estimated in conducting comparative statics exercises is what makes the theoretical model proposed by Anderson and van Wincoop a superior model. Having a theoretical approach to the gravity equations gives a different model that can be used in estimating while providing an interpretation that is more useful. For goods that have been differentiated by their region of origin, Anderson and van Wincoop (2003) refer to a theoretical foundation that was based on constant elasticity of substitution (CES). For this reason, they manipulated the CES expenditure system and derived a gravity model that was simple in form and operational. The decomposition of trade resistance has been derived into three components that are intuitive. These include the bilateral barrier of trade that existed between two regions or institutions; the resistance of one region with all other regions and the resistance of the region with all the other trade regions. To develop the foundation of the gravity model, it is vital to note that the place of origin of all goods differentiates the goods. This implies that the supply of every good is fixed when every region that trades with the other specialized in producing one good. Another building block to the theoretical model is the use of a CES utility function. When each region sets its price for the good to the other region, a model is developed that encompasses all factors related to the trade they carry out. These factors include the prices set by the region to the other trade region and vice versa. In addition, the elasticity of substitution that exists between the gods has to be factored in the estimation. In addition, the nominal income of each of the regions is factored in the equation. It is vital to note that the prices vary from one region to another. This is because of the trade costs that cannot be observed directly. With this regard, it is the function of the empirical work to identify the costs. The gravity equation proposed by Anderson and van Wincoop provides an implicit solution to price indices and presents them as a function of bilateral trade barriers as well as income shares. Such a composition brings equilibrium in the determination of prices as well as in the comparative statics where the prices will change. The theoretical approach brought forward in their argument through the use of market clearing constraints in obtaining equilibrium price indices makes the theory innovative and allows for the estimation of the gravity equation hence making it operational. The price indices in this case are seen to be multilateral resistance because they are dependent on all bilateral resistances inclusive of those that do not directly involve any of the regions among the two trading partners. When the trade barrier with any of the trading partners rises, there will be a rise in the price index. The price indices used in their equation do not necessarily indicate the interpretation of the indices generally. This is because the trade costs could be non-pecuniary and this implies that one could easily derive the same gravity equation. When size is controlled, the gravity equation indicates that for bilateral trade, there is a relation between the trade barriers existing between the two regions in trade. This is dependent on the product of their multilateral resistance indices. The equation implies that for a bilateral barrier that exists between two countries, an increase of barriers between one region and other regions will result in a decrease in the price of goods from the other trading region and raise the number of imports received from the trading region partner. High trade barriers that are faced by an exporting partner lower the demands for the goods it supplies and hence lowers the price at which it supplies. For any bilateral barrier between two regions, the level of trade between them is raised. From the analysis done by Anderson and van Wincoop, it has been shown that while the empirical model of the gravity equation have a good fit to data, they lack a theoretical foundation. This makes them generate a biased estimation as well as a comparative statics analysis that is incorrect. In addition, it lacks an understanding that drives the results. The theoretical model developed fills in on the shortcomings of the empirical model and therefore makes it more superior. Implications on econometric analysis of trade flows The significance of the theoretical model of the gravity equations can be seen in various developments. To begin with, the existing persistence in flow of trade shall be accounted for. This implies that there will be a clear understanding of how trade flows are affected by the various parameters including commodity prices, distance and how a change in price in the general market can affect the trade partnerships of two regions. In addition, a consistent econometric treatment of multilateral resistance terms has been introduced in a gravity setting that is dynamic. Data from trade flows is intrinsically dynamic and the theoretical model is dynamic, implying it can cope with the dynamic nature of trade flows. Further, Olivero and Yotov (2010) noted that since policy applications in the gravity model needs treatment of panel data, there is bound to be a wide payoff with the development of the theoretical model. The theory of gravity has only been static. Therefore, the new developments have filled this gap by providing literature on the theory of gravity through development of equilibrium effects of protecting trade, a concept that has been absent in the standard gravity equation. Bibliography Anderson, J. & van Wincoop, E., 2003, Gravity with Gravitas: A Solution to the Border Puzzle, The American Economic Review, Vol. 93, No. 1, pp. 170-192. Chaney, T 2011, The Gravity Equation in International Trade: An Explanation, USA: University of Chicago. Deardorff, A., 1998, Determinants of Bilateral Trade: Does Gravity Work in a Neoclassical World? The Regionalization of the World Economy, pp. 7-32. McCallum, J., 1995, National Borders Matter: Canada-U.S. Regional Trade Patterns, The American Economic Review, Vol. 85, No. 3, pp. 615-623. Olivero, M. & Yotov, Y, 2010, Dynamic Gravity: Theory and Empirical Implications, Philadelphia, Drexel University. Read More