Trade Frictions and Welfare in the Gravity Model: How Much of the Iceberg Melts?

Abstract

A key element missing from the structural gravity literature is a legitimate validation of theory. By design the reduced-form gravity equation is adept at predicting bilateral trade flows. To make inferences beyond trade flows, however, theoretic models should be consistent with other observable facts. Structural econometric estimates from Anderson and van Wincoop (2003) allow us to evaluate the extensive form of their theoretical gravity model along several dimensions. Under the standard assumption of identical consumer preferences, we find that the model predicts 1) too large a difference between consumer and producer prices, 2) excessive variation in the geographic distribution of consumer price indices, and 3) an exceptionally large transport sector. Under plausible parameterizations of the model at least 50% of output "melts" in transit.

Keywords: Trade Frictions, Gravity Equation

JEL Classification: F10, F17