Trade, Domestic Frictions, and Scale Effects

Abstract

Because of scale effects, idea-based growth models have the counterfactual implication that larger countries should be much richer than smaller ones. New trade models share this same problematic feature: although small countries gain more from trade than large ones, this is not strong enough to offset the underlying scale effects. In fact, new trade models exhibit other counterfactual implications associated with scale effects -in particular, domestic trade shares and relative income levels increase too steeply with country size. We argue that these implications are largely a result of the standard assumption that countries are fully integrated domestically, as if they were a single dot in space. We depart from this assumption by treating countries as collections of regions that face positive costs to trade amongst themselves. The resulting model is largely consistent with the data. For example, for a small and rich country like Denmark, our calibrated model implies a real per-capita income of 81 percent the United States's, much closer to the data (94 percent) than the trade model with no domestic frictions (40 percent).

Do city–county mergers in China promote local economic development?

“…Similar to municipal mergers in many other countries, city–county mergers in China typically involve the integration of governments in different jurisdictions and thus potentially reduce jurisdictional barriers. Many find significant intra‐national and inter‐jurisdictional barriers that impede the mobility of factors and commodities in many countries (Agnosteva et al ., ; Ramondo et al ., ; Tombe and Winter, ; Wolf, ) . In a transition economy like China, jurisdictional barriers are becoming a relevant policy issue.…”

The Decades‐long Dispute Over Scale Effects in the Theory of Economic Growth

“…For example, Ramondo et al . () show how trade frictions partially tame the predicted scale effect. More specific mechanisms such as transport prices, port capacities, and congestion costs also likely contribute to mitigating scale effects at some functional economic area level.…”

“…For example, while Ramondo et al . () do not remove scale effects, domestic trade costs partially offset the scale effect, representing a potential mechanism to counteract the scale effect and any nonlinearities. That is, excessive increasing returns to innovation are diminished by congestion and other costs that increase as a result of and in response to the increased economic activity that is associated with such nonlinearities.…”

“…Instead, these semi‐endogenous models are really predicting a “weak”‐scale effect for incomes at either a global level or a functional economic area level. Accounting for domestic trade frictions partially counteracts the scale effect (Ramondo et al ., ) implying a functional area‐level result, but endogenous growth is not the only theory to predict divergences in per capita incomes by scale. Alternatively, mechanisms such as trade (Krugman, ; Eaton and Kortum, , ; Melitz, ) and spatial mechanisms (Bond‐Smith et al ., ) can also drive scale effects by functional economic area.…”

Estimating Distribution Costs with the Eaton–Kortum Model

“…For example, Donaldson () estimates the domestic trade costs in India with prices of a homogeneous good with price data. Ramondo et al () use the Eaton–Kortum model to calibrate the domestic transportation costs of the USA. Xing and Li () examine the integration of the internal market in China.…”