Trade and the location of industries: Some new results

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Abstract

We study a two-country two-sector model with free entry and monopolistic competition where both industries use labour to produce differentiated goods. The two countries are identical except for size. Labour is freely mobile across industries but it cannot move internationally. Transport costs affect both industries. The location of industries and the pattern of trade are the results of the interaction of two effects: the home market effect and the wage differential effect. The main results are: (i) if the two countries are sufficiently close in size and demand elasticities differ across industries (transport costs being equal), a continuous fall in transport costs from a prohibitive level to zero is associated with a reversal in the pattern of trade at some intermediate level. For large transport costs, the large country is a net exporter of the more differentiated good. For lower transport costs, the large country becomes a net exporter of the less differentiated good; (ii) if the two countries are very different in size and demand elasticities differ across industries (transport costs being equal), the larger country is always a net exporter of the less differentiated good.

Introduction

As nations move toward closer economic integration in recent decades, the role of country size on trade and the location of industries has become an important concern. The ongoing WTO negotiations stipulate in their principles that the process of liberalization shall take place “… with due respect for… the size of economies of individual members”1. An oft-cited example is Canada where many people worry about whether the much larger economy of the United States could de-industrialize their country through growth in trade and investment. Like Canadians, Europeans from small European countries may think that increased economic integration, through the enlargement of the European Union, could result in a move of their national industries toward larger markets. Whether or not these fears are founded still remains a lively debate. In this paper, we address this issue by re-examining the role of country size on trade and the pattern of trade.

The effects of country size differences have been a focus of attention for many years in the “new trade literature” (e.g. Ethier, 1979, Markusen, 1981, Markusen and Melvin, 1981, Krugman, 1980, Helpman and Krugman, 1985) and in the “new economic geography” (e.g. Krugman, 1991, Krugman and Venables, 1995). The most famous result in this area is the so-called “home market effect” (e.g. Helpman and Krugman, 1985): in which differentiated goods produced under increasing returns to scale incur transport costs, firms producing these goods tend to concentrate in the larger market in order to save on transport costs.

Some subsequent articles have tried to assess the robustness of the home market effect and to characterize the influence of this effect on the pattern of trade by using alternative assumptions. For instance, Davis (1998) investigates whether the assumption of zero transport costs for the homogenous good matters for the existence of the home market effect. He shows that the introduction of transport costs for both types of goods in the simple Helpman–Krugman model gives rise to a higher wage in the larger country and may lead to the absence of trade. Another notable contribution is Holmes and Stevens (2005). Holmes and Stevens (2005) depart from the standard Dixit–Stiglitz framework in order to allow for variations in the degree of scale economies across industries. They find that the large country exports the goods with high scale economies and imports the goods with medium scale economies2.

The ambition of this paper is to contribute to this literature by analyzing the determinants of the comparative advantages generated by market sizes. More specifically, we would like to answer the following questions: how does a difference in size between two countries affect the equilibrium wages of these countries? What is the impact of transport costs on the wages? Which country will export the more differentiated good? How does this depend on the relative size of the large country? Is complete specialization possible with equal positive transport costs?

Some of these issues are addressed in Amiti (1998). Amiti studies the relationship between country size and the characteristics of the industries such as factor intensities, transport costs and demand elasticities. The author uses a general equilibrium model with two countries, two imperfectly competitive industries and two factors of production. There is capital mobility across countries. The two countries are identical except for size. Transport costs affect both industries. A principal result is that close to free trade and autarky, the large country is a net exporter of ‘high’ elasticity goods, while the small country exports the ‘low’ elasticity goods.

In this paper, we explore some of the issues that Amiti addresses in a simpler one-factor framework. Thus, the model we develop is identical to Amiti's except that labor is the only factor of production, mobile across industries but internationally immobile. As in Amiti's paper, two effects interact in this framework. The first effect, already discussed, is the home market effect which makes firms locate in the large country in order to save on transport costs. The larger the relative size of the large country, the larger this effect. The second effect, that we call the “wage differential effect”, attracts firms to the small country because wages are lower there. The intensity of this effect depends on the value of transport costs and the relative size of the large country. The location of industries and the pattern of trade are the results of the interaction between these two opposite effects.

When the two industries have similar demand elasticities but different transport costs, we find that the large country exports the good incurring the larger transport costs. These results are similar to Amiti's conclusions. However, when the two industries have equal transport costs but different demand elasticities, our results differ substantially from hers. We show that the magnitude of the difference in country size matters for analyzing the possibility of net trade and the pattern of trade. The pattern of trade depends on whether the large country is substantially larger than the small country. A clear illustration of this surprising result emerges when transport costs are equal in the two industries but demand elasticities differ. In this case, if the two countries are close in size, the direction of trade changes as transport costs decrease. For large transport costs, the large country is a net exporter of the more differentiated good. For lower transport costs, the large country becomes a net exporter of the less differentiated good. If the two countries are very different in size and transport costs are equal, the pattern of trade is such that the large country is always a net exporter of the less differentiated good.

Our results must be related to real processes of trade liberalisation such as those between the EU and Eastern European and Central Asian partner countries (i.e. between countries with large differences in country sizes and differences in demand elasticities) and to regional integration schemes such as the Grain And Feed Trade Association (GAFTA) or the Agadir process (i.e. between more similarly sized countries, and smaller differences in demand elasticities). We could also mention European Partnership Agreements which the EU is currently negotiating between itself and the Africa Caribbean and Pacific (ACP) countries. These are supposed to involve both regional integration among LDC (among similar countries) and integration between the EU and the ACPs (hence very different sized countries); this latter example contain both elements studied in this paper. We think that our conclusions shed some new light on the understanding of the pattern of trade between countries involved in such liberalization processes.

The Section 2 sets up the model. Section 3 studies the equilibrium of the model and derives the equilibrium balance of trade condition. Section 4 assesses the relative importance of the wage differential effect with respect to the country size difference and the values of transport costs. Section 5 analyzes the determinants of the pattern of trade with respect to the values of transport costs and the degrees of differentiation and provides some simulations. The Section 6 makes some concluding comments.

Section snippets

The model

We consider a world with two countries (A and B) and two industries (1 and 2) using labor. The two countries only differ in terms of fixed labor supply Li (i = A, B); without loss of generality, A is assumed to be the “large country” i.e. LA > LB. Each industry produces a continuum of varieties of a (different) horizontally differentiated good. Preferences and technology are the same in both countries.

Equilibrium analysis

In this section, we obtain the equilibrium distribution of firms as a function of the relative wage ω = wA / wB and then use the labor market conditions. We end up with a condition on ω which will be used later for studying the patterns of production and trade.

Assessing the importance of the wage differential effect

As we already said, there are two opposite effects in our model: the home market effect and the wage differential effect. The interaction between these two effects determines the pattern of production and the direction of trade. In this section, we would like to assess the relative importance of the wage differential effect.

To begin with, we introduce the “sectoral relative wages”3. We define the sectoral relative wage ωj(α) as the level of the

The pattern of trade

In this section, we want to study the pattern of trade and the structures of location and specialization. We provide some new results when the two countries are close in size (country A remains the “large country”) or, alternatively when the two countries are very unequal in size5.

Concluding remarks

In this paper, we have studied how country size differences can explain the direction of inter-industry trade in a two-country two-sector one-factor model with free entry and monopolistic competition. These issues were originally addressed in Amiti (1998) using a model with two factors of production.

We have shown that the equilibrium pattern of trade is the result of the interplay of two forces. The first one, the home market effect, was convincingly put forward by Helpman and Krugman (1985):

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We are specially grateful to Michael Gasiorek for extensive and insightful comments on several versions of this paper. We also thank the Editor for his extremely valuable suggestions, Jacques Thisse as well as two anonymous referees.

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