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Part 1
International Trade, Technological Change and Economic Growth
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Chapter 1
Economic Integration and Endogenous Growth∗
1.1Introduction
Many economists believe that increased economic integration between the developed economies of the world has tended to increase the long-run rate of economic growth. If they were asked to make an intuitive prediction, they would suggest that prospects for growth would be permanently diminished if a barrier were erected that impeded the flow of all goods, ideas, and people between Asia, Europe, and North America. Yet it would be difficult for any of us to offer a rigorous model that has been (or even could be) calibrated to data and that could justify this belief.
We know what some of the basic elements of such a growth model would be. Historical analysis (e.g., Rosenberg [1980]) shows that the creation and transmission of ideas has been extremely important in the development of modern standards of living. Theoretical arguments dating from Adam Smith’s analysis of the pin factory have emphasized the potential importance of fixed costs and the extent of the market. There is a long tradition in trade theory of using models with Marshallian external effects to approach questions about increasing returns. More recently, static models with fixed costs and international specialization have been proposed that come closer to Smith’s description of the sources of the gains from trade [Dixit and Norman, 1980; Ethier, 1982; Krugman, 1979, 1981; Lancaster, 1980]. There are also dynamic models with fixed costs and differentiated products in which output grows toward a fixed steady state level [Grossman and Helpman, 1989a].
Recent models of endogenous growth have used these ideas to study the effects that trade can have on the long-run rate of growth. (See, for example, the theoretical papers by Dinopoulos, Oehmke, and Segerstrom [1990]; Feenstra [1990]; Grossman and Helpman [1989b, 1989c, 1989d, 1989e, 1990]; Krugman [1990, Ch. 11]; Lucas [1988]; Romer [1990]; Segerstrom, Anant, and Dinopoulos [1990]; and Young [1990]. Backus, Kehoe, and Kehoe [1991] present both theoretical models and cross-country empirical evidence that bears on their models.) These models permit a distinction between a one-shot gain (i.e., a level effect) and a permanent change in the growth rate (i.e., a growth effect) that is extremely important in making an order of magnitude estimate of the benefits of economic integration. Conventional attempts to quantify the effects of integration using the neoclassical growth model often suggest that the gains from integration are small. If these estimates were calculated in the context of an endogenous growth model, integration might be found to be much more important.
The papers written so far have already demonstrated, however, that the growth effects of trade restrictions are very complicated in the most general case. Grossman and Helpman [1989b, 1989c, 1989e, 1990] have been particularly explicit about the fact that no universally applicable conclusions can be drawn. There are some models in which trade restrictions can slow down the worldwide rate of growth. There are others in which they can speed up the worldwide rate of growth.
To provide some intuition for the conjecture described in the first paragraph, that trade between the advanced countries does foster growth, we narrow the focus in this paper. We do not consider the general case of trade between countries with different endowments and technologies. Instead, we focus on the pure scale effects of integration. To set aside the other “comparative advantage” effects that trade induces in multisector trade models, we consider integration only between countries or regions that are similar. Therefore, we do not address the kinds of questions that are relevant for modeling the effects that trade between a poor LDC and a developed country can have on the worldwide rate of growth.
In the early stages of our analysis of integration and growth, it became clear that the theoretical treatment of ideas has a decisive effect on the conclusions one draws. In many of the existing models, flows of ideas cannot be separated from flows of goods. In others, flows of ideas are exogenously limited by national boundaries regardless of the trade regime. In either of these cases, economic integration can refer only to flows of goods along cargo networks. We consider a broader notion of integration, one that assigns an effect to flows of ideas along communication networks.
Flows of ideas deserve attention comparable to that devoted to flows of goods, for public policy can influence international communications and information flows to the same extent that it influences goods flows. Governments often subsidize language training and study abroad. Tax policies directly affect the incentive to station company employees in foreign nations. Immigration and visa policies directly limit the movement of people. Telecommunications networks are either run by government agencies or controlled by regulators. Some governments restrict direct foreign investment, which presumably is important in the international transmission of ideas. Others have made the acquisition of commercial and technical information a high priority task for their intelligence agencies.
Although these are the only ones we consider, it should be clear that flows of goods and flows of ideas are not the only elements in economic integration. Under some assumptions about nominal variables and the operation of financial markets, economic integration will also depend on monetary and institutional arrangements. The growth models we consider are too simple to consider these effects. It should also be clear that economic integration is not synonymous with political integration. Firms in Windsor, Ontario, may be more closely integrated into markets in the United States than they are to markets in the neighboring province of Quebec. Moreover, the notion of full economic integration does not entail the abolition of citizenship distinctions that have taken place in Germany’s reunification.
The structure of the paper is as follows. Section 1.2 lays out the basic features of the production structure on which all arguments rely. It describes preferences, endowments, and the nature of equilibrium under the two specifications of R&D. Section 1.3 describes the equilibrium for both models in the closed economy and complete integration cases, and illustrates the scale effects that are present. Section 1.4 presents the three main thought experiments concerning partial integration. Sections 1.5 and 1.6 describe the general lessons that can be learned about the relation between the scale of the market and growth and discuss limitations of the models, extensions, and the relation to other models of endogenous growth.
1.2Specification of the Models
1.2.1Functional Forms and Decentralization in the Manufacturing Sector
The specification of the production technology for the manufacturing sector is taken from Romer [1990]. Manufacturing output is a function of human capital H, labor L, and a set x(i) of capital goods indexed by the variable i. To avoid complications arising from integer constraints, the index i is modeled as a continuous variable. Technological progress is represented by the invention of new types of capital goods.
There are two types of manufacturing activities: production of consumption goods and production of the physical units of the types of capital goods that have already been invented. A third activity, research and development (R&D), creates designs for new types of capital goods. This activity is discussed in the next section. Both manufacturing activities use the same production function. Let x(i) den...
