Arguably one of the most exciting and innovative equations to be adapted by economists for international trade is the gravity equation. An analogy of Newton’s Law of Universal Gravitation, the gravity model works so well with international trade related data that its adaptation is nothing less than genius. It is also the only model to make it onto the front page of the financial times in 2016. Used extensively by the North American Free Trade Agreement (NAFTA) and the World Trade Organization (WTO) today, a popular academic paper describes it as “one of the most robust empirical findings in economics”.
It was first introduced by Walter Isard in 1954 and the reasoning behind it seems quite simple looking at the past
How did this come about to be and who came up with it? It was first introduced by Walter Isard in 1954 and the reasoning behind it seems quite simple looking at the past. In Newton’s equation, the gravitational force is determined by the masses of two objects as well as the distance between them and if one looks at the international trade patterns of the past decades, a pattern including these very familiar variables arises.
To understand how the gravity equation works here, it is important to understand the two major factors which influence international trade. Firstly, the size of the country. Bigger countries are bigger trading partners. Size can also refer to the ‘economic mass’ or more commonly the GDP of the country. It is natural that richer countries have more disposable income and hence have more rigorous trade activity.
Secondly, distance. Distance impacts which country trades with another. The shorter the distance, the more countries trade with each other. Countries closer together will trade much more with each other than a country geographically far from them – the closely intertwined economy of Europe would serve as a good example here. This makes sense if we look at the economic situation today, the lower transport costs, the common market agreements and proximal free trade make a shorter trade route much more attractive.
It bravely assumes that the variables it considers are the driving forces behind trade flows, yet it neglects the intricate web of cultural ties, technological advancements, and exchange rate fluctuations that shape our global commerce
Despite its valuable insights into trade patterns, the gravity equation, like any model, has its limitations. It bravely assumes that the variables it considers are the driving forces behind trade flows, yet it neglects the intricate web of cultural ties, technological advancements, and exchange rate fluctuations that shape our global commerce. However, there is still an opportunity to refine this model and unlock its full potential. By incorporating these often overlooked factors, we can supercharge the gravity equation, transforming it into an even mightier tool for explaining and predicting the complex dynamics of international trade flows. The journey to a more comprehensive understanding of global commerce has just begun, and the gravity equation stands poised to rise to the challenge.
The Gravity equation is an example of how learnings from extremely different disciplines can coincide and prove to be useful. It is a lesson in cross-disciplinary learning and serves as an inspiration to the blurry boundaries of knowledge.