Determinants of bilateral trade in manufacturing and services: A unified approach

This paper studies how and why the bilateral trades in manufacturing and services differ in their response to changes in the determinants—both theoretically and empirically. We build a unified theoretical framework that incorporates a demand bias toward services and a difference in the degree of national product differentiation between the two product groups. Estimation results support the theoretical predictions. The empirical model includes, among others, two non-standard trade-cost variables: a measure of internet penetration and virtual proximity (the number of bilateral hyperlinks). An important finding is that virtual proximity – thus far ignored in most gravity models – is a strong predictor of aggregate trade in both services and manufacturing. Also, physical distance is an important determinant of bilateral trade in manufacturing and services, even while controlling for virtual proximity.