Controlling for Heterogeneity in Gravity Models of Trade and Integration

been common to instead specify the augmented model using per capita income, which captures the same effects.3 Whichever specification of the augmented model is used, the purpose is to allow for non-homothetic preferences in the importing country and to proxy for the capital/labor ratio in the exporting country (Bergstrand, 1989). The gravity model of trade has been used widely as a baseline model for estimating the impact of a variety of policy issues, including regional trading groups, currency unions, political blocs, patent rights, and various trade distortions.4 Typically, these events and policies are modeled as deviations from the volume of trade predicted by the baseline gravity model and, in the case of regional integration, are captured by dummy variIn the 1860s, H. Carey first applied Newtonian physics to the study of human behavior, and the so-called “gravity equation” has since been widely used in the social sciences. In economics, gravity model studies have achieved empirical success in explaining various types of inter-regional and international flows (including labor migration, commuting, customers, hospital patients, and international trade). The gravity model of international trade was developed independently by Tinbergen (1962) and Pöyhönen (1963). In its basic form, the amount of trade between countries is assumed to be increasing in their sizes, as measured by their national incomes, and decreasing in the cost of transportation between them, as measured by the distance between their economic centers.1 Following this work, Linnemann (1966) included population as an additional measure of country size, employing what we will call the augmented gravity model.2 It has also This paper compares various specifications of the gravity model of trade as nested versions of a general specification that uses bilateral country-pair fixed effects to control for heterogeneity. For each specification, we show that the atheoretical restrictions used to obtain them from the general model are not supported statistically. Because the gravity model has become the “workhorse” baseline model for estimating the effects of international integration, this has important empirical implications. In particular, we show that, unless heterogeneity is accounted for correctly, gravity models can greatly overestimate the effects of integration on the volume of trade.