We derive a quantity-based structural gravity equation system in which both trade flows and error terms are cross-sectionally correlated. This system can be estimated using techniques borrowed from the spatial econometrics literature. To illustrate our methodology, we apply it to a well-known Canada-US trade dataset. We find that border effects between the USA and Canada are smaller than suggested by previous studies: about 7.5 for Canadian provinces and about 1.3 for US states. Hence controlling directly for cross-sectional interdependence among both trade flows and error terms reduces measured border effects by capturing multilateral resistance.
