Who Trades with Whom?
Figure 2-1 shows the total value of trade in goods—exports plus imports—between the
United States and its top 15 trading partners in 2008. (Data on trade in services are less
well broken down by trading partner; we’ll talk about the rising importance of trade in
International Trade Theory PART ONE
U.S. trade—measured as the sum of imports and exports—is mostly with 15 major partners.
Source: U.S. Department of Commerce.
services, and the issues raised by that trade, later in this chapter.) Taken together, these
15 countries accounted for 69 percent of the value of U.S. trade in that year.
Why did the United States trade so much with these countries? Let’s look at the factors
that, in practice, determine who trades with whom.
Size Matters: The Gravity Model
Three of the top 15 U.S. trading partners are European nations: Germany, the United
Kingdom, and France. Why does the United States trade more heavily with these three
European countries than with others? The answer is that these are the three largest
European economies. That is, they have the highest values of gross domestic product
(GDP), which measures the total value of all goods and services produced in an economy.
There is a strong empirical relationship between the size of a country’s economy and the
volume of both its imports and its exports.
Figure 2-2 illustrates that relationship by showing the correspondence between the size
of different European economies—specifically, America’s 15 most important Western
European Commission.
European trading partners in 2008—and those countries’ trade with the United States in
that year. On the horizontal axis is each country’s GDP, expressed as a percentage of the
total GDP of the European Union; on the vertical axis is each country’s share of the total
trade of the United States with the EU. As you can see, the scatter of points clustered
around the dotted 45-degree line—that is, each country’s share of U.S. trade with Europe—
was roughly equal to that country’s share of Western European GDP. Germany has a
large economy, accounting for 21 percent of Western European GDP; it also accounts for
19.9 percent of U.S. trade with the region. Sweden has a much smaller economy, accounting
for only 2.7 percent of European GDP; correspondingly, it accounts for only 3 percent
of U.S.–Europe trade.
Looking at world trade as a whole, economists have found that an equation of the following
form predicts the volume of trade between any two countries fairly accurately,
(2-1)
where A is a constant term, is the value of trade between country i and country j, is
country i’s GDP, is country j’s GDP, and is the distance between the two countries.
That is, the value of trade between any two countries is proportional, other things equal, to
the product of the two countries’ GDPs, and diminishes with the distance between the two
countries.
An equation such as (2-1) is known as a gravity model of world trade. The reason for
the name is the analogy to Newton’s law of gravity: Just as the gravitational attraction
between any two objects is proportional to the product of their masses and diminishes with
Yi Dij
Tij Yi
Tij = A * Yi * Yj /Dij,
CHAPTER 2 World Trade: An Overview 13
distance, the trade between any two countries is, other things equal, proportional to the
product of their GDPs and diminishes with distance.
Economists often estimate a somewhat more general gravity model of the following form:
(2-2)
This equation says that the three things that determine the volume of trade between two
countries are the size of the two countries’ GDPs and the distance between the countries,
without specifically assuming that trade is proportional to the product of the two
GDPs and inversely proportional to distance. Instead, , and c are chosen to fit the
actual data as closely as possible. If , and c were all equal to 1, Equation (2-2) would
be the same as Equation (2-1). In fact, estimates often find that (2-1) is a pretty good
approximation.
Why does the gravity model work? Broadly speaking, large economies tend to spend
large amounts on imports because they have large incomes. They also tend to attract large
shares of other countries’ spending because they produce a wide range of products. So,
other things equal, the trade between any two economies is larger, the larger is either
economy.
What other things aren’t equal? As we have already noted, in practice countries spend
much or most of their income at home. The United States and the European Union each
account for about 25 percent of the world’s GDP, but each attracts only about 2 percent of
the other’s spending. To make sense of actual trade flows, we need to consider the factors
limiting international trade. Before we get there, however, let’s look at an important reason
why the gravity model is useful.
Using the Gravity Model: Looking for Anomalies
It’s clear from Figure 2-2 that a gravity model fits the data on U.S. trade with European
countries pretty well but not perfectly. In fact, one of the principal uses of gravity models
is that they help us to identify anomalies in trade. Indeed, when trade between two countries
is either much more or much less than a gravity model predicts, economists search for
the explanation.
Looking again at Figure 2-2, we see that the Netherlands, Belgium, and Ireland trade
considerably more with the United States than a gravity model would have predicted. Why
might this be the case?
For Ireland, the answer lies partly in cultural affinity: Not only does Ireland share a
language with the United States, but tens of millions of Americans are descended from
Irish immigrants. Beyond this consideration, Ireland plays a special role as host to many
U.S.-based corporations; we’ll discuss the role of such multinational corporations in
Chapter 8.
In the case of both the Netherlands and Belgium, geography and transport costs
probably explain their large trade with the United States. Both countries are located near
the mouth of the Rhine, Western Europe’s longest river, which runs past the Ruhr,
Germany’s industrial heartland. So the Netherlands and Belgium have traditionally been
the point of entry to much of northwestern Europe; Rotterdam in the Netherlands is the
most important port in Europe, as measured by the tonnage handled, and Antwerp in
Belgium ranks second. The large trade of Belgium and the Netherlands suggests, in other
words, an important role of transport costs and geography in determining the volume of
trade. The importance of these factors is clear when we turn to a broader example of
trade data.
Figure 2-3 shows the same data as Figure 2-2—U.S. trade as a percentage of total trade
with Western Europe in 2008, versus GDP as a percentage of the region’s total GDP—but
adds two more countries: Canada and Mexico. As you can see, the two neighbors of the
United States do a lot more trade with the United States than European economies of equal
size. In fact, Canada, whose economy is roughly the same size as Spain’s, trades as much
with the United States as all of Europe does.
Why does the United States do so much more trade with its North American neighbors
than with its European partners? One main reason is the simple fact that Canada and
Mexico are much closer.
All estimated gravity models show a strong negative effect of distance on international
trade; typical estimates say that a 1 percent increase in the distance between two
countries is associated with a fall of 0.7 to 1 percent in the trade between those countries.
This drop partly reflects increased costs of transporting goods and services.
Economists also believe that less tangible factors play a crucial role: Trade tends to be
intense when countries have close personal contact, and this contact tends to diminish
when distances are large. For example, it’s easy for a U.S. sales representative to pay a
quick visit to Toronto, but it’s a much bigger project for that representative to go to
Paris. Unless the company is based on the West Coast, it’s an even bigger project to
visit Tokyo.
In addition to being U.S. neighbors, Canada and Mexico are part of a trade agreement
with the United States, the North American Free Trade Agreement, or NAFTA, which
ensures that most goods shipped among the three countries are not subject to tariffs or
other barriers to international trade. We’ll analyze the effects of barriers to international
CHAPTER 2 World Trade: An Overview 15
trade in Chapters 8–9, and the role of trade agreements such as NAFTA in Chapter 10. For
now, let’s notice that economists use gravity models as a way of assessing the impact of
trade agreements on actual international trade: If a trade agreement is effective, it should
lead to significantly more trade among its partners than one would otherwise predict given
their GDPs and distances from one another.
It’s important to note, however, that although trade agreements often end all formal barriers
to trade between countries, they rarely make national borders irrelevant. Even when
most goods and services shipped across a national border pay no tariffs and face few legal
restrictions, there is much more trade between regions of the same country than between
equivalently situated regions in different countries. The Canadian–U.S. border is a case
in point. The two countries are part of a free trade agreement (indeed, there was a
Canadian–U.S. free trade agreement even before NAFTA); most Canadians speak English;
and the citizens of either country are free to cross the border with a minimum of formalities.
Yet data on the trade of individual Canadian provinces both with each other and with
U.S. states show that, other things equal, there is much more trade between provinces than
between provinces and U.S. states.
Table 2-1 illustrates the extent of the difference. It shows the total trade (exports plus
imports) of the Canadian province of British Columbia, just north of the state
of Washington, with other Canadian provinces and with U.S. states, measured as a
percentage of each province or state’s GDP. Figure 2-4 shows the location of these
provinces and states. Each Canadian province is paired with a U.S. state that is roughly
the same distance from British Columbia: Washington State and Alberta both border
British Columbia; Ontario and Ohio are both in the Midwest; and so on. With the
exception of trade with the far eastern Canadian province of New Brunswick, intra-
Canadian trade drops off steadily with distance. But in each case, the trade between
British Columbia and a Canadian province is much larger than trade with an equally distant
U.S. state.
Economists have used data like those shown in Table 2-1, together with estimates of the
effect of distance in gravity models, to calculate that the Canadian–U.S. border, although it
is one of the most open borders in the world, has as much effect in deterring trade as if the
countries were between 1,500 and 2,500 miles apart.
Why do borders have such a large negative effect on trade? That is a topic of ongoing
research. Chapter 20 describes one recent focus of that research: an effort to determine
how much effect the existence of separate national currencies has on international trade in
goods and services.
Figure 2-1 shows the total value of trade in goods—exports plus imports—between the
United States and its top 15 trading partners in 2008. (Data on trade in services are less
well broken down by trading partner; we’ll talk about the rising importance of trade in
International Trade Theory PART ONE
U.S. trade—measured as the sum of imports and exports—is mostly with 15 major partners.
Source: U.S. Department of Commerce.
services, and the issues raised by that trade, later in this chapter.) Taken together, these
15 countries accounted for 69 percent of the value of U.S. trade in that year.
Why did the United States trade so much with these countries? Let’s look at the factors
that, in practice, determine who trades with whom.
Size Matters: The Gravity Model
Three of the top 15 U.S. trading partners are European nations: Germany, the United
Kingdom, and France. Why does the United States trade more heavily with these three
European countries than with others? The answer is that these are the three largest
European economies. That is, they have the highest values of gross domestic product
(GDP), which measures the total value of all goods and services produced in an economy.
There is a strong empirical relationship between the size of a country’s economy and the
volume of both its imports and its exports.
Figure 2-2 illustrates that relationship by showing the correspondence between the size
of different European economies—specifically, America’s 15 most important Western
European Commission.
European trading partners in 2008—and those countries’ trade with the United States in
that year. On the horizontal axis is each country’s GDP, expressed as a percentage of the
total GDP of the European Union; on the vertical axis is each country’s share of the total
trade of the United States with the EU. As you can see, the scatter of points clustered
around the dotted 45-degree line—that is, each country’s share of U.S. trade with Europe—
was roughly equal to that country’s share of Western European GDP. Germany has a
large economy, accounting for 21 percent of Western European GDP; it also accounts for
19.9 percent of U.S. trade with the region. Sweden has a much smaller economy, accounting
for only 2.7 percent of European GDP; correspondingly, it accounts for only 3 percent
of U.S.–Europe trade.
Looking at world trade as a whole, economists have found that an equation of the following
form predicts the volume of trade between any two countries fairly accurately,
(2-1)
where A is a constant term, is the value of trade between country i and country j, is
country i’s GDP, is country j’s GDP, and is the distance between the two countries.
That is, the value of trade between any two countries is proportional, other things equal, to
the product of the two countries’ GDPs, and diminishes with the distance between the two
countries.
An equation such as (2-1) is known as a gravity model of world trade. The reason for
the name is the analogy to Newton’s law of gravity: Just as the gravitational attraction
between any two objects is proportional to the product of their masses and diminishes with
Yi Dij
Tij Yi
Tij = A * Yi * Yj /Dij,
CHAPTER 2 World Trade: An Overview 13
distance, the trade between any two countries is, other things equal, proportional to the
product of their GDPs and diminishes with distance.
Economists often estimate a somewhat more general gravity model of the following form:
(2-2)
This equation says that the three things that determine the volume of trade between two
countries are the size of the two countries’ GDPs and the distance between the countries,
without specifically assuming that trade is proportional to the product of the two
GDPs and inversely proportional to distance. Instead, , and c are chosen to fit the
actual data as closely as possible. If , and c were all equal to 1, Equation (2-2) would
be the same as Equation (2-1). In fact, estimates often find that (2-1) is a pretty good
approximation.
Why does the gravity model work? Broadly speaking, large economies tend to spend
large amounts on imports because they have large incomes. They also tend to attract large
shares of other countries’ spending because they produce a wide range of products. So,
other things equal, the trade between any two economies is larger, the larger is either
economy.
What other things aren’t equal? As we have already noted, in practice countries spend
much or most of their income at home. The United States and the European Union each
account for about 25 percent of the world’s GDP, but each attracts only about 2 percent of
the other’s spending. To make sense of actual trade flows, we need to consider the factors
limiting international trade. Before we get there, however, let’s look at an important reason
why the gravity model is useful.
Using the Gravity Model: Looking for Anomalies
It’s clear from Figure 2-2 that a gravity model fits the data on U.S. trade with European
countries pretty well but not perfectly. In fact, one of the principal uses of gravity models
is that they help us to identify anomalies in trade. Indeed, when trade between two countries
is either much more or much less than a gravity model predicts, economists search for
the explanation.
Looking again at Figure 2-2, we see that the Netherlands, Belgium, and Ireland trade
considerably more with the United States than a gravity model would have predicted. Why
might this be the case?
For Ireland, the answer lies partly in cultural affinity: Not only does Ireland share a
language with the United States, but tens of millions of Americans are descended from
Irish immigrants. Beyond this consideration, Ireland plays a special role as host to many
U.S.-based corporations; we’ll discuss the role of such multinational corporations in
Chapter 8.
In the case of both the Netherlands and Belgium, geography and transport costs
probably explain their large trade with the United States. Both countries are located near
the mouth of the Rhine, Western Europe’s longest river, which runs past the Ruhr,
Germany’s industrial heartland. So the Netherlands and Belgium have traditionally been
the point of entry to much of northwestern Europe; Rotterdam in the Netherlands is the
most important port in Europe, as measured by the tonnage handled, and Antwerp in
Belgium ranks second. The large trade of Belgium and the Netherlands suggests, in other
words, an important role of transport costs and geography in determining the volume of
trade. The importance of these factors is clear when we turn to a broader example of
trade data.
Figure 2-3 shows the same data as Figure 2-2—U.S. trade as a percentage of total trade
with Western Europe in 2008, versus GDP as a percentage of the region’s total GDP—but
adds two more countries: Canada and Mexico. As you can see, the two neighbors of the
United States do a lot more trade with the United States than European economies of equal
size. In fact, Canada, whose economy is roughly the same size as Spain’s, trades as much
with the United States as all of Europe does.
Why does the United States do so much more trade with its North American neighbors
than with its European partners? One main reason is the simple fact that Canada and
Mexico are much closer.
All estimated gravity models show a strong negative effect of distance on international
trade; typical estimates say that a 1 percent increase in the distance between two
countries is associated with a fall of 0.7 to 1 percent in the trade between those countries.
This drop partly reflects increased costs of transporting goods and services.
Economists also believe that less tangible factors play a crucial role: Trade tends to be
intense when countries have close personal contact, and this contact tends to diminish
when distances are large. For example, it’s easy for a U.S. sales representative to pay a
quick visit to Toronto, but it’s a much bigger project for that representative to go to
Paris. Unless the company is based on the West Coast, it’s an even bigger project to
visit Tokyo.
In addition to being U.S. neighbors, Canada and Mexico are part of a trade agreement
with the United States, the North American Free Trade Agreement, or NAFTA, which
ensures that most goods shipped among the three countries are not subject to tariffs or
other barriers to international trade. We’ll analyze the effects of barriers to international
CHAPTER 2 World Trade: An Overview 15
trade in Chapters 8–9, and the role of trade agreements such as NAFTA in Chapter 10. For
now, let’s notice that economists use gravity models as a way of assessing the impact of
trade agreements on actual international trade: If a trade agreement is effective, it should
lead to significantly more trade among its partners than one would otherwise predict given
their GDPs and distances from one another.
It’s important to note, however, that although trade agreements often end all formal barriers
to trade between countries, they rarely make national borders irrelevant. Even when
most goods and services shipped across a national border pay no tariffs and face few legal
restrictions, there is much more trade between regions of the same country than between
equivalently situated regions in different countries. The Canadian–U.S. border is a case
in point. The two countries are part of a free trade agreement (indeed, there was a
Canadian–U.S. free trade agreement even before NAFTA); most Canadians speak English;
and the citizens of either country are free to cross the border with a minimum of formalities.
Yet data on the trade of individual Canadian provinces both with each other and with
U.S. states show that, other things equal, there is much more trade between provinces than
between provinces and U.S. states.
Table 2-1 illustrates the extent of the difference. It shows the total trade (exports plus
imports) of the Canadian province of British Columbia, just north of the state
of Washington, with other Canadian provinces and with U.S. states, measured as a
percentage of each province or state’s GDP. Figure 2-4 shows the location of these
provinces and states. Each Canadian province is paired with a U.S. state that is roughly
the same distance from British Columbia: Washington State and Alberta both border
British Columbia; Ontario and Ohio are both in the Midwest; and so on. With the
exception of trade with the far eastern Canadian province of New Brunswick, intra-
Canadian trade drops off steadily with distance. But in each case, the trade between
British Columbia and a Canadian province is much larger than trade with an equally distant
U.S. state.
Economists have used data like those shown in Table 2-1, together with estimates of the
effect of distance in gravity models, to calculate that the Canadian–U.S. border, although it
is one of the most open borders in the world, has as much effect in deterring trade as if the
countries were between 1,500 and 2,500 miles apart.
Why do borders have such a large negative effect on trade? That is a topic of ongoing
research. Chapter 20 describes one recent focus of that research: an effort to determine
how much effect the existence of separate national currencies has on international trade in
goods and services.
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