Controlling for Heterogeneity in Gravity Models of Trade

simply on the basis of goodness of fit; i.e. a relatively high2R . 6The lack of attention paid to theempirical properties of the model is despite the fact that the strength of any baseline model lies inthe accuracy of its estimates. The aim of this paper is to begin to fill the gap regarding theempirical estimation of gravity models of trade. In particular, we demonstrate that standardmethods for estimating the gravity model produce biased estimates, tending to overestimate tradebetween low-trade countries, and to underestimate it between high-trade countries. We arguethat the primary source of this bias is the failure of standard methods to account for the pairwiseheterogeneity of bilateral trade relationships.The solution we propose uses simple panel data methods to allow for the intercepts of thegravity equation to be specific to each trading pair. We demonstrate how with this empiricalmodel the correlation between the residuals and the volume of trade disappears. To illustrate theempirical significance of our findings, we apply our model to the question of the effects ofregional integration on trade volumes. We find that standard methods find a strong negativerelationship between membership in a trading bloc and intra-bloc trade, whereas thiscounterintuitive finding is eliminated when heterogeneity is controlled for.Section 2 briefly sets out the various statistical models we examine. Section 3 presentsstandard empirical results for the basic and augmented gravity models, and illustrates the inherentestimation bias. In Section 4 we offer a solution to this, namely using a panel with fixed effectsto estimate the bilateral trade relationship. In Section 5 we compare our model to alternatives6 See Sanso, Cuairan, and Sanz (1993) for an examination of the predictive power of various specifications of theaugmented gravity model. Also see Oguledo and MacPhee (1994) for a survey of pre-1990 empirical results.3