Gravity model, border effects and home market effect: An ownership-basis approach

International commerce is performed via cross-border trade and via transactions of foreign affiliates of multinational enterprises (MNEs). Throughout all the theoretical frameworks used in the literature to derive the gravity equation, the location-basis criterion in defining international transactions is adopted. The location-basis criterion dismisses the implications associated with the transactions of foreign affiliates of MNEs in the theoretical derivation of the gravity equation. As a result, conceptual and computational defects accompany the conventional measurement of the border effects as a reflection of the magnitude of the international economic integration. Adopting the ownership-basis criterion in defining international transaction, this paper retrieves the gravity equation from a framework that encompasses the transactions of foreign affiliates of MNEs and allows for the non-engagement in any form of international commerce. The ownership-basis gravity equation is applied for the OECD countries reporting the inward activities of the foreign affiliates of MNEs. The empirical results show significant overestimation in the magnitudes of border effects when using the conventional gravity equation. The results also suggest that more opportunities await to be exploited through FDI liberalization.; The ownership-basis gravity equation allows us to build measures of effective current barriers in cross-border trade, transactions of foreign affiliates of MNEs and aggregate international commerce relative to barriers in intranational commerce. These effective measures encompass the direct transactional effects of the barriers and the indirect effects of the barriers on the configuration of international commerce. The empirical application examines the effects of Canada-U.S. free trade agreement (CUSFTA) in the aggregate manufacturing industry from the U.S. perspective. The effects of CUSFTA are examined by probing for the occurrence of structural breaks in growth rates of these measures between the post-CUSFTA period and the pre-CUSFTA period. The results highlight the trade creation effect of CUSFTA between the U.S and Canada and show no significant effect of CUSFTA on the transactions of foreign affiliates of MNEs between the U.S and Canada. The results also demonstrate that CUSFTA has indeed promoted further economic integration between the U.S. and Canada. With supplementary results showing non-significant effects of CUSFTA on the international transaction between the U.S. and the outsiders, the outcomes are suggestive in terms of positive welfare implications of CUSFTA for the U.S. in the manufacturing industry.; The final exploitation of the ownership-basis theoretical framework is to study the implications on the home market effect phenomenon. Our study shows that the home market effect occurs for two different criteria: location-basis and ownership-basis. The location-basis home market effect implies that an increase in relative market size of a given economic entity induces more than one for one increase in the share of total production within this economic entity. The ownership-basis home market effect implies that an increase in relative market size of a given economic entity induces more than one for one increase in the share of total production by firms owned by this economic entity. Our study also investigates the various effects of cross-border trade barriers and FDI barriers on the magnitude of the location-basis home market effect and the ownership-basis home market effect.