Gravity Equation Flashcards
what is the gravity equation?
The gravity equation is a theory of bilateral trade flows.
In its simplest form, the gravity equation predicts that bilateral trade (Xij) is proportional to the product of importer and exporter GDP (Y) over distance (d):
facts
exports/imports increase with the economic size of destination and origin country
physical distance reduces trade
geographic distance also matters within countries
hat is the multilateral resistance term
how easily can a country purchase other countries’ goods
explain sigma-1
is the so-called ‘trade elasticity’ (the larger, the more trade reacts to changes)
fact about MRT
The larger a country, the smaller the effect of a universal increase in cross-border trade costs on its multilateral resistance term (see j above)
Intuition: larger countries tend to have a higher fraction of goods bought and sold domestically (less dependent on international trade)
goals of Eaton-Kortum Model
We want a framework that can be confronted with worldwide trade data at the exporter-importer level:
there are many countries and goods
countries’ relative productivities vary substantially across goods
factor rewards are far from equal across countries
trade diminishes with geographic distance (and trade costs in general)
prices vary across locations
The goal of the EK model is to provide a framework that can capture all five points.
Eaton-Kortum setup
Economic environment in EK:
many countries and a continuum of goods z ∈ [0, 1]
CRS production technology using labor as only input
each household inelastically supplies 1 unit of labor
perfect competition in all markets
Iceberg trade costs:
ij1 units of a good need to be shipped from country i (exporter) for one unit to
arrive in country j (importer)
Eaton-Kortum key assumptions
Country i’s productivity producing good z is the realization of a random variable which is drawn independently for each good.
A higher Si implies that a high-efficiency draw is more likely – thus Si reflects country i’s absolute advantage across the continuum of goods.
A lower generates more heterogeneity and hence creates a stronger comparative advantage (and force for trade against the resistance imposed by trade costs).
Prices in Eaton-Kortum
j summarizes:
states of technology around the world
input costs around the world
trade barriers (from import perspective)
⇒ the larger j, the higher the likelihood of observing low prices in j
Eaton-Kortum trade
International trade enlarges each country’s effective state of technology with technology available from other countries, discounted by input costs and trade barriers.
Two extremes:
With zero trade costs (ij=1i,j), is the same everywhere and the law of one price holds for each good.
With prohibitive trade costs (ijij), j reduces to Sjwj-
(country j’s own technology down-weighted by input cost).
Chaney model asseumption
Pareto distribution for firm productivities
This assumption allows for closed-form of many expressions of the Melitz model and to consider trade among many heterogeneous countries.
explain welfare in all 3 gravity equations
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