Efficiency gaps and Heckscher–Ohlin trade patterns
The determination of trade patterns is a central topic in trade theory. A large portion of the literature on trade theory seeks to explain them in terms of international differences in factor endowments, while assuming that preferences and technologies are identical among trading countries. The modern factor endowment theory is apparently divided into two strands. One strand asserts that differences in factor endowment ratios among countries matter, while the other holds that it is mainly differences in country size that determine trade patterns. The standard Heckscher-Ohlin theory and the now classical Helpman-Krugman (1985) monopolistically competitive model belong to the former strand, and Ethier’s (1982a) Ricardian model with increasing returns is a notable member of the latter. However, to our knowledge, there has been no attempt to study both ratio and size in a unified theoretical framework. More specifically, the following question is left unexplored: under what conditions can we identify whether differences in the ratio or size of factor endowments explain the pattern of international trade? To begin to study the problem, we develop a two-factor, three-good model of trade with technical heterogeneity among firms in a monopolistically competitive sector. Following Spence (1976), we introduce efficiency gaps in fixed production costs.2 Countries are identical in every respect except for the distribution of factors. With free entry, efficiency gaps among firms result in the endogenous determination of the industry structure. The cost-efficiency composition in the monopolistically competitive sector is determined within the model. By introducing efficiency gaps into a monopolistically competitive sector, we can emphasize the role of absolute factor endowments. Through a mechanism of competitive selection, inefficient firms in an absolutely factor-abundant country will be pushed out of the market. We show that, contrary to the monopolistically competitive model without efficiency gaps, trade patterns are determined by the interaction between relative factor endowments (i.e., a Heckscher-Ohlin aspect) and absolute factor endowments (i.e., the mechanism of competitive selection).3 In a recent contribution, Montagna (2001) investigated the mechanism of competitive selection in a monopolistically competitive trade model. However,
her focus was on a case in which there is only one factor, and efficiency gaps existed in variable costs. Her model had a Ricardian aspect and paid scant attention to the Hechscher-Ohlin theory. In contrast, in this study we focus on the interaction between relative factor endowments and competitive selection.4 The main result of the current chapter, which captures the interaction between relative factor endowments and absolute factor endowments, has not appeared in the existing literature. The rest of the chapter is structured as follows. Section 17.2 presents our analytical set-up, which is used in section 17.3 to analyze the trading equilibrium. In section 17.4, the link between relative factor endowment and absolute factor endowment is explored. Section 17.5 presents concluding remarks.