the enduring significance of distance

One of the best-supported empirical economic models is known as the gravity equation. According to this equation, trade between two regions is proportional to the product of economic activity (GDP) in the two regions divided by the inter-region distance raised to about 0.9.[1] This relationship is formally similar to Newton’s law of universal gravitation, except that distance is raised to the power 0.9 rather than squared.

The effect of distance in the gravity equation is not just a matter of transportation costs. According to a recent study, the significance of distance for trade fell from 1870 to 1950, but then rose through to the present. The distance exponent was 24% larger in the 1990s than it was from 1870 to 1969. The variance of these estimates is such that this difference is significant at a 1% level of significance.[2] Changes in transportation costs are an unlikely explanation for this temporal pattern.

The gravity equation holds in some circumstances of zero transportation costs. For free, taste-dependent goods (music, games, and pornography) consumed over the Internet, the distance effect is similar to that in the general gravity equation. When acquiring those goods involves a financial transaction, the distance effect is much larger. In contrast, Internet-based acquisition of goods such as financial information, technology information, and software does not depend on distance.[3]

Increased physical distance is associated with greater taste difference and greater difficulty in establishing trust. Distance is thus relevant for communication networks even when distance does not drive communication service costs.

Notes:

[1] Disdier, Anne-Cèlia and Head, Keith (2004), “The Puzzling Persistence of the Distance Effect on Bilateral Trade,” Centro Studi Luca d’Agliano Working Paper No. 186, p. 24.

[2] Ibid., p. 18.

[3] Blum, Bernardo and Goldfarb, Avi, “Does the Internet Defy the Law of Gravity?” Journal of International Economics, forthcoming.

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