Scale Effects and Productivity Across Countries: Does Country Size Matter?
Models in which growth is driven by innovation naturally lead to scale effects. These scale effects result in the counterfactual prediction that larger countries should be much richer than smaller ones. We explore and quantify two candidates to solve the puzzle: First, countries are not fully isolated from each other; and second, countries are not fully integrated domestically. To such end, we build a quantitative model of trade and multinational production (MP) with frictions to move goods and ideas not only across, but also within countries. The calibrated model goes a long way to resolve the puzzle. The existence of domestic frictions, rather than openness to trade and MP, is what allows the extended model to come close to matching the data.
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