International Trade Efficiency, the Gravity Equation, and the Stochastic Frontier

Abstract

In the gravity equation of international trade, bilateral trade flows are regressed on trading partners' income and the distance that separates them along with other variables. This widely used equation is traditionally estimated by the ordinary least squares method. We employ an alternative technique of stochastic frontier estimation to assess the potential bilateral trade flows from the same gravity equation. Countries are shown to have low efficiencies in their international trade as the predicted trade from frontier estimation is generally far greater than actual trade. Trade efficiencies are computed and ranked for individual countries, ten geographical regions, and eleven regional trade agreements.

Keywords: Efficiency coefficients, OLS residuals, trade gravity, trade potentials

JEL Classification: F10, F14, C13