De-industrialization and entrepreneurship under monopolistic competition

Abstract

This article offers a new mechanism to explain de-industrialization in response to a price increase of the manufactured good. In our trade model, one sector (agriculture) is perfectly competitive whilst the other (manufacturing) is monopolistically competitive. Both industries use skilled and unskilled labour as inputs. Entry into manufacturing requires a fixed cost in terms of skilled labour only. A rise in the market price for the differentiated goods raises both marginal revenue and the price of skilled labour, which affects the marginal cost of production and the entry cost. When short-run profits increase so that new manufacturing firms enter, fewer skilled workers are available for production purposes. This in turn may then lead to a decline in total manufacturing output. Our theoretical mechanism is jointly consistent with recent empirical observations on premature de-industrialization characterizing several Latin American and Asian countries and productive diversification as observed in various developing economies.