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Gravity or Dummies? The Limits of Identification in Gravity Estimations

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  • Cecília Hornok

Abstract

Trade economists often estimate gravity equations of international trade with fixed effects. Anderson and van Wincoop (2003, American Economic Review 93, 170–192) have shown the importance of controlling for multilateral trade resistances when estimating a gravity equation. This can be done by including exporter-time and importer-time fixed effects in a panel or exporter and importer fixed effects in a cross section estimation. I argue that this approach limits the identifiability of policy parameters that capture the effect of certain ”club memberships” (EU, NAFTA, euro area, WTO, etc.) on trade flows. I show that, in the baseline case, only one effect can be identified, which precludes, for example, the estimation of separate effects on the exporter and the importer side. The magnitude, and even the sign, of the estimated club effect are very sensitive to the precise identification assumptions, which are often left unspecified in empirical studies. The underlying problem is that club membership provides some, but very little bilateral variation. When heterogeneous club effects are to be identified, the membership dummies can become perfectly collinear with the fixed effects. Empirical researchers may not be aware of the lack of identification, because standard estimation techniques often permit them to run perfectly collinear regressions. I illustrate the findings with estimating the effect of EU enlargement in 2004 on the trade flows of new and old members. Finally, I discuss potential solutions.

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Paper provided by Department of Economics, Central European University in its series CEU Working Papers with number 2012_11.

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Date of creation: 20 May 2012
Date of revision: 20 May 2012
Handle: RePEc:ceu:econwp:2012_11

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  1. James E. Anderson & Eric van Wincoop, 2003. "Gravity with Gravitas: A Solution to the Border Puzzle," American Economic Review, American Economic Association, vol. 93(1), pages 170-192, March.
  2. Jacks, David S. & Meissner, Christopher M. & Novy, Dennis, 2011. "Trade booms, trade busts, and trade costs," Journal of International Economics, Elsevier, vol. 83(2), pages 185-201, March.
  3. Flam, Harry & Nordström, Håkan, 2006. "Euro Effects on the Intensive and Extensive Margins of Trade," Seminar Papers 750, Stockholm University, Institute for International Economic Studies.
  4. Richard Baldwin & Daria Taglioni, 2006. "Gravity for Dummies and Dummies for Gravity Equations," NBER Working Papers 12516, National Bureau of Economic Research, Inc.
  5. Baldwin, Richard E. & Skudelny, Frauke & Taglioni, Daria, 2005. "Trade effects of the euro: evidence from sectoral data," Working Paper Series 0446, European Central Bank.
  6. Novy, Dennis, 2008. "Gravity Redux : Measuring International Trade Costs with Panel Data," The Warwick Economics Research Paper Series (TWERPS) 861, University of Warwick, Department of Economics.
  7. I-Hui Cheng & Howard J. Wall, 2005. "Controlling for heterogeneity in gravity models of trade and integration," Review, Federal Reserve Bank of St. Louis, issue Jan, pages 49-63.
  8. Cecília Hornok, 2010. "Trade-Enhancing EU Enlargement and the Resurgence of East-East Trade," Focus on European Economic Integration, Oesterreichische Nationalbank (Austrian Central Bank), issue 3, pages 79-94.
  9. Shang-Jin Wei, 1996. "Intra-National versus International Trade: How Stubborn are Nations in Global Integration?," NBER Working Papers 5531, National Bureau of Economic Research, Inc.
  10. Hornok, Cecília, 2011. "Need for Speed: Is Faster Trade in the EU Trade-creating?," CEPR Discussion Papers 8451, C.E.P.R. Discussion Papers.
  11. Eicher, Theo S. & Henn, Christian, 2011. "In search of WTO trade effects: Preferential trade agreements promote trade strongly, but unevenly," Journal of International Economics, Elsevier, vol. 83(2), pages 137-153, March.
  12. Luca De Benedictis & Roberta De Santis & Claudio Vicarelli, 2005. "Hub-and-Spoke or else? Free trade agreements in the “enlarged” European Union," ISAE Working Papers 52, ISTAT - Italian National Institute of Statistics - (Rome, ITALY).
  13. Rose, Andrew K, 2002. "Do We Really Know that the WTO Increases Trade?," CEPR Discussion Papers 3538, C.E.P.R. Discussion Papers.
  14. McCallum, John, 1995. "National Borders Matter: Canada-U.S. Regional Trade Patterns," American Economic Review, American Economic Association, vol. 85(3), pages 615-23, June.
  15. Peter Egger & Michael Pfaffermayr, 2003. "The proper panel econometric specification of the gravity equation: A three-way model with bilateral interaction effects," Empirical Economics, Springer, vol. 28(3), pages 571-580, July.
  16. Baltagi, Badi H. & Egger, Peter & Pfaffermayr, Michael, 2003. "A generalized design for bilateral trade flow models," Economics Letters, Elsevier, vol. 80(3), pages 391-397, September.
  17. Combes, Pierre-Philippe & Lafourcade, Miren & Mayer, Thierry, 2005. "The trade-creating effects of business and social networks: evidence from France," Journal of International Economics, Elsevier, vol. 66(1), pages 1-29, May.
  18. Baier, Scott L. & Bergstrand, Jeffrey H., 2009. "Bonus vetus OLS: A simple method for approximating international trade-cost effects using the gravity equation," Journal of International Economics, Elsevier, vol. 77(1), pages 77-85, February.
  19. Davis, Peter, 2002. "Estimating multi-way error components models with unbalanced data structures," Journal of Econometrics, Elsevier, vol. 106(1), pages 67-95, January.
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Citations

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Cited by:
  1. Miroudot, Sebastien & Shepherd, Ben, 2012. "The paradox of “preferences”: regional trade agreements and trade costs in services," MPRA Paper 41090, University Library of Munich, Germany.
  2. Pierluigi Montalbano & Silvia Nenci, 2012. "Assessing the Trade Impact of the European Neighborhood Policy on EU-MED Free Trade Area," Working Paper Series 3112, Department of Economics, University of Sussex.
  3. László Balázsi & László Mátyás & Tom Wansbeek, 2014. "The Estimation of Multi-dimensional Fixed Effects Panel Data Models," CEU Working Papers 2014_1, Department of Economics, Central European University, revised 10 Feb 2014.
  4. László Mátyás & László Balázsi, 2012. "The Estimation of Multi-dimensional Fixed Effects Panel Data Models," CEU Working Papers 2012_2, Department of Economics, Central European University, revised 18 Feb 2013.
  5. Maria Cipollina & Luca Salvatici & Luca De Benedictis & Claudio Vicarelli, 2013. "A note on dummies for policies in gravity models: a Montecarlo experiment," Departmental Working Papers of Economics - University 'Roma Tre' 0180, Department of Economics - University Roma Tre.

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