Determinants of Bilateral Trade: Does Gravity Work in a Neoclassical World?

Abstract

This paper derives bilateral trade from two cases of the Heckscher-Ohlin Model, both also representing a variety of other models as well. First is frictionless trade, in which the absence of all impediments to trade in homogeneous products causes producers and consumers to be indifferent among trading partners. Resolving this indifference randomly, expected trade flows correspond exactly to the simple frictionless gravity equation if preferences are identical and homothetic, or if demands are uncorrelated with supplies, and they depart from the gravity equation systematically when there are such correlations. In the second case, countries produce distinct goods, as in the H-O Model with complete specialization or a variety of other models, and preferences are either Cobb-Douglas or CES. Here trade tends to the standard gravity equation with trade declining in distance, with departures from it that depend on relative transport costs. Conclusions are, first, that even a simple gravity equation can be derived from standard trade theories, and second, that because the gravity equation characterizes many models, its use to test any of them is suspect.