DP9613 | The Gravity Equation in International Trade: An Explanation

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25/08/2013

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Abstract

The gravity equation in international trade is one of the most robust empirical finding in economics: bilateral trade between two countries is proportional to size, measured by GDP, and inversely proportional to the geographic distance between them. While the role of size is well understood, the role of distance remains a mystery. I propose the first explanation for the gravity equation in international trade, based on the emergence of a stable network of input-output linkages between firms. Over time, a firm acquires more suppliers and customers, which tend to be further away. I show that if, as observed empirically, (i) the distribution of firm sizes is well approximated by Zipf?s law and (ii) larger firms export over longer distances on average, then aggregate trade is inversely proportional to distance. Data on firm level, sectoral, and aggregate trade support further predictions of the model.