Increasing Returns and Economics Prosperity: How Can Size not Matter?

Models that feature ideas naturally lead to scale effects, and this results in the counterfactual implication that larger countries should be richer than smaller ones. Perhaps small countries are not poor because they beneï¬Ât from foreign ideas through trade. Quantitative trade models do imply that small countries gain more from trade than large countries, but the difference is too small to make a difference. There are two candidates to solve the puzzle: ï¬Ârst, there are additional ways besides trade through which countries are integrated to the rest of the world, and second, countries are not fully integrated domestically. In this paper we explore these two ideas by building a quantitative model of trade and multinational production with frictions to the domestic movement of goods and ideas. The resulting model comes close to solving the puzzle, but not fully.