Determinants of Bilateral Trade

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Abstract
It has long been recognized that bilateral trade patterns are well described empirically by the so-called gravity equation, which relates trade between two countries positively to both of their incomes and negatively to the distance between them, usually with a functional form that is reminiscent of the law of gravity in physics. It also used to be frequently stated that the gravity equation was without theoretical foundation. In particular, it was claimed that the Heckscher-Ohlin model (HO model) of international trade was incapable of providing such a foundation, and perhaps even that the HO model was theoretically inconsistent with the gravity equation. This chapter argues that the HO model, at least in some of the equilibria that it permits, admits easily of interpretations that accord readily with the gravity equation. At the same time, developing these interpretations can yield additional insights about why bilateral trade patterns in some cases depart from the gravity equation as well. After describing the theoretical foundations for the gravity equation, the chapter examines frictionless trade and trade impediments.

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