The Gravity Equation with Micro-Founded Trade Costs

Gravity Equations are broadly used to estimate the impacts of trade impediments on trade flows. It is often stated that results are implausibly high. In theoretical foundations of the gravity equation, trade costs usually enter as "icebergmelting-costs." This paper offers an alternative approach to model trade costs. From a microeconomic point of view, trade costs should depend on trade input prices and - which is new - the underlying trade volume. If trade costs are determined by the trade volume, and average trade costs are falling with the trade volume (e.g. due to economies of scale in the trade sector), empirical results from gravity equations are likely to be biased