Gravity equations have been widely used to infer trade flow effects of various institutional arrangements. We show that estimated gravity equations do not have a theoretical foundation. This implies both that estimation suffers from omitted variables bias and that comparative statics analysis is unfounded. We develop a method that (i) consistently and efficiently estimates a theoretical gravity equation and (ii) correctly calculates the comparative statics of trade frictions. We apply the method to solve the famous McCallum border puzzle. Applying our method, we find that national borders reduce trade between industrialized countries by moderate amounts of 20-50 percent.

This paper surveys the measurement of trade costs: what we know and don't know but may usefully attempt to learn. Partial and incomplete data on direct measures of costs go with inference on implicit costs from trade flows and prices. Total trade costs in rich countries are large. The ad valorem tax equivalent is about 170 percent when pushing the data hard. Poor countries face even higher trade costs. There is a lot of variation across countries and across goods within countries, much of which makes economic sense. In our survey, theory provides interpretation and perspective and suggests improvements for the future. Some new results are presented to properly apply and interpret gravity theory and handle aggregation.

No abstract

JEL Codes: F1, D23, O17 Corruption and imperfect contract enforcement dramatically reduce international trade. This paper estimates the reduction using a structural model of import demand in which insecurity acts as a hidden tax on trade. We find that inadequate institutions constrain trade as much as tariffs do. We also find that omitting indexes of institutional quality biases typical gravity model estimates, obscuring a negative relationship between per capita income and the share of total expenditure devoted to traded goods. Finally, we argue that cross-country variation in the effectiveness of institutions and consequent variation in the prices of traded goods offer a simple explanation of the stylized fact that high-income, capital-abundant countries trade disproportionately with each other.

Gravity has long been one of the most successful empirical models in economics. Incorporating deeper theoretical foundations of gravity into recent practice has led to a richer and more accurate estimation and interpretation of the spatial relations described by gravity. Wider acceptance has followed. Recent developments are reviewed here, and suggestions are made for promising future research.