Estimating Gravity Equations with Endogeneous Trade Costs

A basic assumption of the gravity equation of international trade is that increasing trade costs lower exports. But intuition and theory imply that a high export volume lowers bilateral trade costs as well, because a fixed cost intensive trade sector probably bears lower average costs with more trade. In this case, standard gravity estimation might be biased due to simultaneity. This paper finds an empirical interdependency between exports and trade costs. Using a simultaneous equation model to face this problem improves the estimates compared to the standard gravity specification