DP13634 How Britain Unified Germany: Endogenous Trade Costs and the Formation of a Customs Union
We analyze the foundation of the German Zollverein as an example of how geography can shape institutional change. We show how the redrawing of the European map at the Congress of Vienna 1815, notably Prussia's control over the Rhineland and Westphalia, affected the incentives for policymakers to cooperate. Our argument comes in three steps. First, we show that the new borders were not endogenous to trade. They were at odds with the strategy of Prussia in 1815, but followed from Britain's intervention at Vienna regarding the Polish-Saxon question. Second, we develop a theoretical framework, where state planners set tariffs on imports and transits to maximize revenue. We show that in a world with transit tariffs a revenue-maximizing state planner faces a trade-off between benefits from cooperation and the cost of losing geographical advantage. In a third step we calibrate the model combining historical data on prices, freight rates, and market sizes with GIS data on lowest costs routes under endogenous tariffs. We then run counterfactuals to show how borders affected incentives: if Prussia would have succeeded with her strategy to gain the entire Kingdom of Saxony instead of the western provinces, the Zollverein would not have formed. We conclude that geography can shape institutional change. To put it differently, as a collateral damage to her intervention at Vienna, Britain unifed Germany.
