Thomas Chaney, “The Gravity Equation in International Trade: An Explanation”, September 2011.
The gravity equation in international trade is one of the most robust empirical finding in economics: bilateral trade between two countries is proportional to their respective sizes, measured by their GDP, and inversely proportional to the geographic distance between them. While the role of economic size is well understood, the role played by distance remains a mystery. In this paper, I propose the first explanation for the gravity equation in international trade. This explanation is based on the emergence of a stable international network of importers and exporters. Firms can only export into markets in which they have a contact. They acquire contacts by gradually meeting the contacts of their contacts. I show that if, as observed empirically, (i) the distribution of the number of foreign countries accessed by exporters is fat tailed, (ii) there is a large turnover in exports, with firms often going in and out of individual foreign markets, and (iii) geographic distance hinders the initial acquisition of contacts in an arbitrary way, then trade is proportional to country size, and inversely proportional to distance. Data on firm level, sectoral, and aggregate trade support further predictions of the model.