On the Specification of the Gravity Model of Trade: Zeros, Excess Zeros and Zero-inflated Estimation

Conventional studies of bilateral trade patterns specify a log-normal gravity equation for empirical estimation. However, the log-normal gravity equation suffers from three problems: the bias created by the logarithmic transformation, the failure of the homoscedasticity assumption, and the way zero values are treated. These problems normally result in biased and inefficient estimates. Recently, the Poisson specification of the trade gravity model has received attention as an alternative to the log-normality assumption (Santos Silva and Tenreyro, 2006). However, the standard Poisson model is vulnerable for problems of overdispersion and excess zero flows. To overcome these problems, this paper considers modified Poisson fixed-effects estimations (negative binomial, zero-inflated). Extending the empirical model put forward by Santos Silva and Tenreyro (2006), we show how these techniques may provide viable alternatives to both the log-normal and standard Poisson specification of the gravity model of trade.