Determinants of Bilateral Trade in Manufacturing and Services : A Unified Approach

This paper studies the determinants of aggregate bilateral trade in two broad sectors, manufacturing and services. We build a unified theoretical framework that incorporates a demand bias towards services and a difference in the degree of national product differentiation between the two sectors. Demand bias implies two non-standard bilateral trade determinants: per capita income and income inequality in the importing country. Differences in national product differentiation yield a higher elasticity of bilateral trade in manufactures for the exporting country’s economic size than the trade in services. Our empirical model also includes two non-standard trade-cost variables: a measure of internet penetration and virtual proximity (the number of bilateral hyperlinks). The results support our unified model’s predictions and illustrate that virtual proximity—thus far ignored in most gravity models—is a strong predictor of aggregate trade in both services and manufacturing. We also find that physical distance is an important determinant of bilateral trade in manufacturing and services, even while controlling for virtual proximity