by Richard Baldwin, guest blogger
The economy is a lumpy place. Looked at from afar or up close, economic activity is not smoothly spread – a point that the 1000-word picture of the earth at night makes clearly. Most of our economic theories, however, assume that small changes in circumstances lead to small changes in outcomes.
This theory-practice gap is familiar to amateur readers of theoretical physics. For three centuries, Newtonian mechanics told us that mass and energy were smooth, continuous. And this worked impeccably at the level of aggregation available to empiricists of the time. In reality, however, the physical world – seen at the sub-atomic level – is mostly empty. Even the densest matter is mostly space. All the energy and mass are concentrated in lumps that are tiny relative the structures they constitute. Even more perplexingly, particles have distinct, discrete level energy level and they don’t switch smooth between them, they jump. At the sub-atomic level the modern theory for this is called quantum mechanics.
Back to economics. International trade in particular. The most empirically successful model in international trade – the so-called gravity equation – is based on Newtonian trade theory. The amount of trade between two nations varies with the product of the economic mass of the two nations and inversely with the distance between them. Strange as it may seem to students of Ricardo, Heckscher-Ohlin and the Krugman trade models, these three variables explain well over 50% of all variation in bilateral trade flows. No other trade model comes even close. The gravity model, in short, works impeccably at the level of aggregation available to empiricists – until recently.