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    2.1 Multiple Equilibria and Latent Comparative Advantage

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    Ed Z
    This document discusses a model of trade and industrial policy for developing countries. It presents a simple model where diversification of an economy is linked to productivity gains. The model shows there can be multiple equilibria, with one equilibrium where the economy specializes completely in one good versus another equilibrium where it specializes in a different good. If there is a market failure that reduces diversification below the optimal level, a policy that encourages discovery and diversification could enhance welfare.

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    2.1 Multiple Equilibria and Latent Comparative Advantage

    Uploaded by

    Ed Z
    46 views1 page
    This document discusses a model of trade and industrial policy for developing countries. It presents a simple model where diversification of an economy is linked to productivity gains. The model shows there can be multiple equilibria, with one equilibrium where the economy specializes completely in one good versus another equilibrium where it specializes in a different good. If there is a market failure that reduces diversification below the optimal level, a policy that encourages discovery and diversification could enhance welfare.

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    This document discusses a model of trade and industrial policy for developing countries. It presents a simple model where diversification of an economy is linked to productivity gains. The model shows there can be multiple equilibria, with one equilibrium where the economy specializes completely in one good versus another equilibrium where it specializes in a different good. If there is a market failure that reduces diversification below the optimal level, a policy that encourages discovery and diversification could enhance welfare.

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    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    46 views1 page

    2.1 Multiple Equilibria and Latent Comparative Advantage

    Uploaded by

    Ed Z
    This document discusses a model of trade and industrial policy for developing countries. It presents a simple model where diversification of an economy is linked to productivity gains. The model shows there can be multiple equilibria, with one equilibrium where the economy specializes completely in one good versus another equilibrium where it specializes in a different good. If there is a market failure that reduces diversification below the optimal level, a policy that encourages discovery and diversification could enhance welfare.

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    Trade, Foreign Investment, and Industrial Policy for Developing Countries 4045

    In Section 2.4 we turn to IP aimed at “diversification.” This is something that is


    often stated as a goal by many countries. We present a simple model where diversifica-
    tion is linked to productivity and argue that if there is a market failure reducing the
    level of diversification below the optimal one (as in Hausmann & Rodrik, 2003), then
    a policy of encouraging discovery and diversification would indeed be welfare
    enhancing.
    2.1 Multiple equilibria and latent comparative advantage
    We first present a static model with exogenous prices, and then discuss the implications
    of the model when prices are determined by production costs in the rest of the world.
    2.1.1 Exogenous international prices
    There is a small economy, which we call “South,” two goods and one factor of pro-
    duction, labor, in fixed supply, L.3 Good 1 is produced with CRS and no aggregate
    externalities: a unit of labor produces l1 units of good 1. Good 2 is produced with
    CRS at the firm level, but there are aggregate externalities, so that labor productivity is:

    ! ; L 2 Þ%
    l2 ½1 þ aMinðL

    with a > 0. The term 1 þ aMinðL ! ; L 2 Þ captures Marshallian externalities that are
    increasing with industry-wide employment, L2, but that are exhausted once the labor
    force in a sector reaches the level L ! . The term y & 1 þ aL ! > 1 can be seen as the max-
    4
    imum benefits of clustering in sector 2. We assume that the total labor supply in South
    is higher than L! , so that if there is complete specialization in good 2 then productivity
    is yl2.
    Let p'i be the international price of good i and let p' & p'2 =p'1 . Let us derive a con-
    dition under which there are multiple equilibria, with one equilibrium characterized by
    complete specialization in good 1 and the other by complete specialization in good 2.
    We first check that specialization in good 1 is an equilibrium. Letting w denote the
    wage in South, then w ¼ l1 p'1 if South is specialized in good 1. The unit cost of pro-
    ducing good 2 in South given that all labor is devoted to production of good 1 (and
    hence no benefits of clustering are realized) is w/l2. Hence complete specialization
    in good 1 is an equilibrium if and only if l1/l2 ) p' . Similarly, complete specialization in
    good 2 implies p'2 ¼ w=yl2 , and hence this is an equilibrium if and only if l1/l2 * yp' .
    Thus, there is multiple equilibria if and only if the following condition holds,

    p' * l1 =l2 * yp' ð1Þ

    Without loss of generality, in the following discussion we restrict attention to the case in
    which this condition holds with strict inequalities. If there are multiple equilibria, which

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