An important argument in the case for the U.K.’s split with the European Union is redefining trade relationships. Free from membership ties to a European community of nations, the U.K. will be able to exploit trade opportunities in more dynamic regions. Figures on GDP fit this narrative neatly: research I carried out at the London School of Economics’ Department of Management in collaboration with the Beedie School of Business finds that during the period 1990-2017, Europe saw average GDP growth of 1.6% whereas South Asia saw an increase of more than 6%, and Sub-Saharan Africa has been growing at 5.4% since 2000. Surely then, it is better for British firms to target these growth markets?
The problem with this argument is that trading relationships are never random: distance matters. It matters because distance increases transport costs; costs caused by legal and administrative differences; and costs generated by cultural and organisational differences. And evidence shows that distance, or what economists call gravity, almost always makes trade with distant locations less profitable than with closer ones.
Economists have long been aware that trade is driven by the forces identified by Isaac Newton in his Law of Gravity – mass (GDP) and distance (trade). The gravity model argues that trading relationships will be determined by the economic mass (GDP) of both the importing and exporting economy and the distance between them.
At first sight, this seems to support the quest for larger or faster-growing markets, because bigger economies will buy more of your products. This explains the business excitement ten years ago around China and other so-called BRIC (Brazil, Russia, India, and China) economies, while in recent years the emphasis has moved to upcoming large economies like Nigeria and Indonesia. However, our research finds that as trade expands to further and further locations, negative distance effects quickly outweigh the benefits of market size. Trade with an economy which is five times larger will indeed be associated with exports approximately five times larger, but the effects of distance – accounting for the full scale of additional costs incurred by operating in an overseas rather than a domestic jurisdiction – can be much larger.
For example, consider the U.K.’s trading relationships with France and China. The Chinese economy is approximately five times larger than the French, so the size effect of trading with China increases by five. But while London to Paris is approximately 300 miles, London to Beijing is approximately 5,000 miles and this distance effect reduces trade between the U.K. and China, relative to that between the U.K. and France, by around 277 times. The impact of distance, therefore, can greatly offset the benefits of trading with larger or faster-growing economies for both firms and countries.
Thus, in practice, it is much cheaper to trade with neighbors. Interestingly, we observe little evidence that recent developments in information technology have fundamentally altered this. In the short term, there will be no easy way for firms in the U.K. to make up the losses from Brexit by the development of new trading partnerships with more distant partners. And we may find it’s not very long before gravity brings the debate on trade post-Brexit down to earth with a very uncomfortable bump.