On Theories Explaining the Success of the Gravity Equation

Examining the accuracy of the monopolistic competition theory's predictions for import volumes, we assess whether this theory accounts for the empirical success of the gravity equation. Since certain factor-endowment based theories have the same prediction for import volumes, we employ resampling techniques to address this model identification problem. We use extraneous information on the allocation of factor endowments in a given sample to identify which model is driving trade flows. We find that the accuracy of the monopolistic competition theory's prediction improves in samples where the factor endowment allocations generate a higher share of differentiated goods trade. By an analogous criterion, the Heckscher-Ohlin models make a much less accurate prediction. We conclude that the monopolistic competition theory is more likely to account for the gravity equation's success, especially in explaining trade among industrial nations.