01 Mar 2005

A Gravity Model under Monopolistic Competition

Kari E.O. Alho

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European Network of Economic Policy Research Institutes (ENEPRI) Working Paper No. 33, 14 pages

This paper presents an alternative derivation of the gravity equation for foreign trade, which is explicitly based on monopolistic competition in the export markets and which is more general than previously seen in the literature. In contrast with the usual specification, our model allows for the realistic assumption of asymmetry in mutual trade flows. The model is estimated for trade in Europe, producing evidence that trade flows and barriers do indeed reveal strong asymmetry. We then carry out a simulation, based on the estimated model, of the general equilibrium effects (through trade) of the UK’s possible entrance into the economic and monetary union.