International trade gravity model report with examples by AXEL Cirotteau

International Trade Report

Using the gravity model of world trade, explain with examples why although two countries may have similar populations, trade as proportion of GDP may be different in the two countries.

Introduction:

Globalisation and technological progress may have led to a decline in transport costs and other barriers to trade, but this has not prevented the end of the distance constraint in international trade. Distance is still decisive in the distribution of economic activities and flows of goods, services, capital, workers, etc. In this case, geographical constraints continue to shape international trade in a powerful way. Historically, each country has favoured the territories close to it for the exchange of goods and services. While trade with distant countries has increased over time, trade with nearby countries has increased even more rapidly.

Walter Isard first used Newton's law of universal gravitation to describe the dynamics of bilateral trade in 1954. In physics, any two bodies are attracted to each other as a direct result of their mass and as an inverse function of the distance between their centres of gravity. According to the gravity equation of international trade, the volume of trade (C) between two countries I and J is proportional to their gross domestic product (GDP) ( M here)  and inversely proportional to the distance (D) between them.

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In other words, the greater the economic size of the partners is, the more they trade with each other; or, the further apart they are, the less bilateral trade they have.  Anne-Célia Disdier compiled 1,467 estimates of the gravity equation from 103 papers and found that a 10% increase in distance results in an average 9% decrease in bilateral trade. These various coefficients were found to be stable over time and space, making the gravity model equation one of the most stable empirical regularities in economy.

The role that the size of economies plays on their foreign trade is well understood. For example, Paul Krugman , a pioneer in the new theories of international trade, shows how the volume of trade a country has with the rest of the world is proportional to its size and negatively affected by trade barriers. Due to increasing returns and transport costs, firms have an incentive to concentrate their production as close to their market as possible. Since consumers have a taste for variety, each country has an incentive to specialise in a given variety of a good (in order to benefit from economies of scale) and to import its other variants (in order to increase the welfare of the population), so relatively similar countries still have an incentive to trade.

The growth of international trade and the resulting increase in competition between territories is a major feature of economic globalisation.

Since the end of World War two, economies have become increasingly open and trade has grown considerably. Between 1950 and 1973, world trade grew twice as fast as world production.

Many factors contributed to this development. These include the falling cost of transport and telecommunications, and the development of free trade ( goods, services and capital) promoted by international organisations such as the World Trade Organisation (WTO), the World Bank and the International Monetary Fund.

According to the WTO, the share of international trade in world GDP, which was about 40% in 1992, has now risen to over 40%. Today, according to the World Bank and the OECD, it exceeds 60%.

The example of France

To support our argument, we will take the economic example of France. First of all, France's last highest trade surplus (€2.6 billion) was in 2002. Since then, France has been facing a foreign trade deficit. The record deficit reached in 2011 (€75bn) was reduced in 2012 (€67.2bn) thanks to increased exports in the key sectors of aeronautics and pharmaceuticals and a slowdown in imports.

In mid-2015, the trade deficit fell below €50bn, in cumulative terms over 1 year. A positive balance indicates that exports exceed imports in value (trade surplus). A negative balance indicates that imports exceed exports in value (trade deficit).

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France's trade balance as % of GDP by year ( source: world bank data )

France is the fifth largest exporter in the world, but its market share has been declining since the 1990s. Its share of world trade fell from 5.8% in 1995 to 3.1% in 2012. It has stabilised and exports of goods and services represented 3.5% of world exports of goods and services in 2018. France's main trading partners today in terms of imports and exports are Germany, the United States, Italy, Spain, Belgium and the United Kingdom respectively. For most of them, we can already see that those are mainly the closest countries to France.

Trade in goods slowed down somewhat in 2018 after the strong growth of 2017 (+4.6%, after +5.8%).  The world demand for France is growing more moderately than in the previous year, but remains dynamic after that.

In 2020, it will be the 6th largest exporter in the world and the 5th largest for its imports.  

It is the 6th largest economy in the world, according to the World Bank and the IMF, and the 2nd largest economy in Europe behind Germany but ahead of the United Kingdom. There is therefore a clear link between the fact that the volume of exports and imports influences the size of a country's economy.

This is perfectly in line with the gravity model: France's main trading partners are those whose economic importance ( related to their imports and exports) is in the world top. In the equation, multiplying the high economic importance of countries A and B will result in a greater number of trade volumes.

This is not the only factor influencing the volume of trade, as this graph below shows: although world foreign trade (trade: imports and exports) has increased by a factor of 6.8, world GDP has increased by a factor of 3.5. There are therefore other factors to take into account than the size of an economy, which is why we can assume distance plays an important role in the equation, and we will see that the proximity factor is linked to the greater or lesser volume of trade between two countries. Let us compare the trade of countries with equal populations with France: Tanzania and the United Kingdom.

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