Capital Goods Trade and Economic Development

Abstract

We embed a multi-country, multi-sector Ricardian model of trade into a neoclassical growth framework. We argue that international trade in capital goods is crucial to understand economic development through two channels: (i) capital formation and (ii) aggregate TFP. In our sample of 84 countries in 2005, over 80 percent of capital goods production in the world is concentrated in 9 countries; poor countries import most of their capital goods. Barriers to trade result in a misallocation of factors both within and across countries. We calibrate the model to bilateral trade flows. Our model accounts for 73 percent of the observed log variance in income per worker and matches the world distribution of capital goods production across countries. When the world moves to free trade in capital goods, the income per worker increases in every country, but countries in the bottom decile of the income distribution gain nearly thrice as much as the countries in the top decile. Shutting down trade in capital goods forces countries to allocate productive resources away from the sector of their comparative advantage, thereby reducing capital formation as well as TFP. The income loss from such a shut down is 9 percent for countries in the bottom decile of the income distribution.