Introduction

The measured effect of national borders on trade seems too large to be explained by the apparently small border-related trade barriers. This puzzle was first presented by McCallum (1995) and has gone on to spawn a large and growing literature on so-called border effects. The original finding was that Canadian provinces traded over twenty times more with each other than they did with states in the USA of the same size and distances. Subsequent studies of North American, European, and OECD trade also found somewhat smaller but still very impressive border effects. Obstfeld and Rogoff (2000) referred to the border effect as one of the “six major puzzles in international macro-economics.”

There are three basic ways to solve the border effect puzzle. First, one might discover that border-related trade barriers are actually larger than they appear. This approach might emphasize unconventional barriers such as the absence of good information. Second, it might be that there is a high elasticity of substitution between domestic and imported goods, leading to high responsiveness to modest barriers. Finally, the border effects may have been mismeasured in a way that leads to a systematic overstatement. This paper takes the third approach and argues that illusory border effects are created by the standard methods used for measuring distance between and within nations.

Hundreds of papers have estimated gravity equations to investigate the determinants of bilateral trade after controlling for the sizes of trading partners and the geographic distances separating them.