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Gravity model is a popular econometric model that plays a crucial role in international trade. According to basic gravity model, the bilateral trade between two countries largely depends on the size of the economy and the distance between the two. More specifically, the bilateral trade between the country X and country Y directly depends on the size of both the countries X and Y measured in terms of GDP and inversely related to the distance between the two. This model which is very much different than the previous model has robust empirical findings. Several trade related data and trading patterns support the theoretical prediction of the Gravity model. (Assaf Almog, 2019)
Gravity model was first introduced by a Nobel laurate Dutch Economist Jan Tinbergen. The simplest equation used in the Gravity model of trade is derived from Newton’s Gravity equation that states the gravitation force between the two objects directly depends on the size of the economy and inversely related to the square of the distance. Tinbergen has used similar type of equation to describe the trading patterns between the countries. The simplest form of Gravity equation can be illustrated as:
Where i and j are two different countries ( I, j = 1,2 3, 4, ……..N)
GDPi is the GDP of the country i and GDP j is the GDP of the country j
RIj is nothing but the distance between country I and country j.
C βαγ are the global parameters
In order to make the equation simple, in case of bilateral trade it can be assumed the wij=wji
Or α=β (Assaf Almog, 2019)
The gravity equation in international trade clearly states that the trading flows between two countries directly depends on the GDP of the two countries and inversely related to the geographical distance between them. The simplest form of Gravity model supports the observed flows of the trading countries. The recent trading pattern of Britain can also be explained by the Gravity model. Recently Britain has shifted its focus from distant North American, Latin American or Asian countries to the near neighboring countries for trade. One possible explanation is the trading cost that is significantly higher for the distant countries. For Britain, it is cheaper to trade with other EU countries and distance effect definitely plays a vital role in trade cost. However, trading cost with neighboring countries are less because of the similarity in culture, language, preference, tax structure, and business climate. As the prediction of the Gravity model, the top export markets for Britain are influenced by a combination of the market size and geographical proximity. But the dominance of distance effect is more prominent for the differentiated products not for the different and innovative products. (BIS, 2010)
Ricardian model and the H-O theory are recognized as the most fundamental models in international trade theory. Ricardian model states that a country can specialize and export the commodity in which it enjoys the comparative advantage. While defining the comparative advantage, Ricardian model explains a country can only achieve comparative advantage if it can produce the commodity at a lower opportunity cost than the other. Ricardian model suggest that every nation would benefit from trade. Ricardian model reveals that a country cannot achieve comparative advantage even though they have the absolute advantage. For example, Australia currently achieves a comparative advantage in service industries and exports service to the global market. The fundamental assumption is that both the countries differ in production technology. Ricardian model is one of the oldest models but still relevant today.
H-O model, on the other hand, postulates the fact that trade occurs between the countries because of differences in factor endowments. In a two-country model, H-O theory predicts that labor and capital are two mobile factors used by the countries in their production process. Factor endowments differ across the countries. While some countries like US or Japan are capital abundant, many others like Ghana or Bangladesh are labor abundant country. H-O model advocates that a country produces and exports the goods that uses its abundant factor most and imports the commodity that uses its scarce factor. For example, being a labor abundant country, Ghana is the largest producer and exporter of cocoa, a labor-intensive product. Similarly, Japan is a capital abundant country thus exports automobiles, a capital-intensive product. Automobile is said to be capital intensive product because the use of capital per unit of labor in automobile is greater than cocoa. On the other hand, Cocoa is labor intensive if the use of labor per unit of capital is greater in cocoa than in Automobile. We can illustrate in the following form:
One striking difference between the Ricardian model and H-O model is that while Ricardian model assumes a difference in production technology, H-O model assumes the production technology can be the same in both the country. H-O model explains even if the production technology is same, trade can occur because of differences in factor endowments. H-O model is based on the assumption of perfect competition and constant returns to scale. Since relative factor endowments are not same across the countries and different industries use labor and capital in different proportion, trade occurs and becomes advantageous for both the nations. (Marios Katsioloudes, 2007)
Comparative advantage theory and the H-O model provides an economic rationale behind international trade. Trade occurs either because of comparative advantage or because of the relative differences in factor abundance between the countries. But economies of scale can also offer a better explanation of trade patterns. According to this theory, countries can also engage in trade when they achieve economies of scale in production or increasing returns to scale. Economies of scale occurs when larger volume of production reduces the per unit cost of production. This theory is only applicable only when we assume the imperfect market mainly monopolistically competitive market and...