The Gravity Equation in International Trade: An Explanation

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