Accounting for Pairwise Heterogeneity in Bilateral Trade Flows: A Stochastic Varying Coefficient Gravity Model

Abstract

This paper suggests an alternative way for estimating the gravity equation that takes into consideration country-pair heterogeneity in bilateral trade flows. Specifically, a stochastic varying coefficient gravity model based on Hildreth and Houck’s (1968) random coefficient regression is proposed, that eliminates heterogeneity bias inherent in standard econometric methods. The results indicate that the standard gravity estimates can differ substantially from what is obtained when heterogeneity is accounted for.bilateral trade, gravity equation, stochastic varying coefficient gravity model.