Globalisation, economic union and the number of countries

Since long before I studied any economics, I've been fascinated by the number and distribution of countries. In particular, I wondered why the world went through a period of consolidation in the 19th Century (such as the unification of Germany and of Italy) where the number of independent states decreased, followed by a period after World War II where the number of independent states increased, which has continued unabated. There are theories in the fields of history and economic history that appear to explain one of these phenomena (the decrease in nations, or the increase), but until now I don't think there was a compelling theory that explained both.

A 2016 NBER Working Paper (revised in July 2017; ungated version here) by Gino Gancia, Giacomo Ponzetto, and Jaume Ventura (all Universitat Pompeu Fabra) seems to fill this gap nicely. They start with the observation (similar to mine above) that:

In 1820, the world was made up of 125 countries and long-distance trade was very modest— less than 5% of world output. Over the following century, international trade grew more than four-fold while the number of countries fell to merely 54. The interwar period witnessed a reversal of these trends: trade collapsed and the number of sovereign states rose to 76 by 1949. Until then, political and economic integration had proceeded together. But the end of World War II marked the beginning of a new era. After 1950 trade between nations has flourished to levels never seen before. But this time the process of economic integration has been accompanied by different changes in the world political structure. On the one hand, the number of countries has risen to a record high of more than 190, so that more trade is now accompanied by political fragmentation.

The paper is purely theoretical (though includes a narrative section that demonstrates that the theory is consistent with empirical observation), and relies on four assumptions:

1. There are border effects - that is trade is more costly between localities that are in different countries, than between localities within the same country;
2. There is preference heterogeneity over public services - each locality receives public services from the government, and each locality has different preferences for those services, but every locality in the same country must share the same undifferentiated bundle of public services;
3. Government costs are subject to economies of scale - the larger the country, the lower the average cost of providing public services to each locality; and
4. Government costs are subject to economies of scope - running a government at a single level (where the same government provides both public services and market regulation) is less costly than running a government at multiple levels (e.g. where public services are provided at the country level, but market regulation occurs at the level of an economic union that is larger than the country).

They interpret globalisation as lowering the costs of trade between localities, and (without going into the maths) they find that their model shows:

At early stages of globalization, the gains from trade are small and the benefit of creating an economic union does not justify the loss of economies of scope. Thus, a single-level governance structure is optimal. As globalization proceeds, localities remove borders by increasing the size of countries. The number of countries declines and the mismatch between each locality's ideal and actual provision of public services grows. Eventually, this mismatch is large enough to justify a move to a two-level governance structure. The world political structure shifts from a few large countries to many small countries within a world economic union. The two-level structure is more expensive, but it is nonetheless desirable because it facilitates trade and improves preference-matching in the provision of public services. Our result of a shift from a single-level to a two-level architecture of government is consistent with the seemingly opposite reactions of the world political structure to the first and second waves of globalization.

They extend the model to consider the development of empires with colonies, and wars (between colonial powers and colonies, but not between colonial powers seeking to take over each other's colonies or home territories - these latter two cases would be useful extensions of the theoretical model). They also show that their model can explain stylised facts about the expansion of the United States to the west over time, and the breakup of new territories into smaller states.

Like the last two papers I blogged about earlier in the week (see here and here), I am interested in the business implications as well. The four assumptions (economies of scale, economies of scope, border effects, and preference heterogeneity) might equally apply to small business units as to localities. We've been observing an increase in large technology firms (or monopoly firms more generally) over time. Will we soon see a reversal into smaller firms?

One last point of interest is that the paper pointed me to the Interactive World History Atlas at geocron.com, which is very cool. It draws maps of countries/empires for each year from 3000 B.C. to now. It's not very interesting when you look at New Zealand (since the only points of change it picks up are in 1840 and 1908), but for other parts of the world (especially Europe, the Americas, Asia and Africa), it's very cool.

[HT: Marginal Revolution, back in August last year]