Specialization, gravity, and European trade in final goods

While empirical gravity approaches have been used with great success since the early sixties, their theoretical foundations have been somewhat slower to come. As a result, bilateral gravity frameworks for analyzing gross trade flows are still often set up as eclectic combinations of determinants to test for influences beyond partner incomes and trade barriers. As our first contribution we show that ad hoc augmented gravity equations, specifically those augmented by absolute supply-side country differences or similarities, run into conflict with the supposed theoretical foundations, i.e., they are mis-specified. As a remedy we extend the approach of Haveman and Hummels (2004) to formulate an estimable specification of bilateral gravity on the basis of partner incomes and country-specific supply-side differences relative to the world average. Our second contribution is that we apply our framework to analyze bilateral trade patterns in capital and consumer goods among old and new European Union (EU) members. Our interest in trade patterns among the old and new EU members is driven by the new opportunities for specialization and trade created by the European integration process.

Final goods exports from 1992 to 2008 are from the UN COMTRADE database. We use two types of final goods—capital and consumer goods.

We estimate our model specification on unbalanced panel data with a mean length of time dimension of about 10 years. In order to obtain consistent estimates we employ a dynamic panel-data model. The estimator is implemented in STATA 12 as the command xtdpd and it uses moment conditions in which lagged levels of the dependent and predetermined variables serve as instruments for the differenced equation.

Our results show that trade in final goods between Western and Eastern Europe is driven by countries’ multilateral specialization incentives that are expressed by supply-side country differences relative to the rest of the world. In addition, more trade between new and old Europe in response to supply-side country differences is realized in an increased number of different products rather than more trade in established products. At the same time, for the majority of European bilateral trade relationships, insignificant or comparatively very small specialization coefficients indicate that specialization incentives do not play much of a role in final goods trade. Hence, many of the final goods traded between Western and Eastern Europe are still different products rather than differentiated products, despite the gradual catching-up process of the new EU members.