Increasing Returns and the Specific Factors Model

Abstract

In recent years, trade theorists have been increasingly interested in the role of economies of scale in international trade models.' Yet the literature to-date seems to lack simple treatment of income-distribution and related issues in the presence of economies of scale. The present paper attempts to fill this gap by incorporating increasing returns to scale (IRS) into the standard specific-factors model. Trade theorists have begun to view the specific-factors model as the favored vehicle for analyzing the economy-wide effects of changes in commodity prices, factor endowments and other exogenous variables. The strongest case in favor of this model has been presented by Neary [16] who argues that the model provides a rigorous general equilibrium foundation for partial equilibrium analysis as far as the supply side of the economy is concerned, whereas with partial equilibrium reasoning will frequently be misleading.2 He further conjectures that ICM is the source of all the paradoxes which are peculiar to international trade theory, with the exception of those which arise from the failure to adopt first-best policies . In light of these views in the literature, it is of interest to investigate how robust the predictions of the specific-factors model are in the presence of economies of scale. The analysis in this paper has important implications for the literature on IRS as well as that on the specific-factors model. The more important of these implications may be summarized as follows. First, in small open economy characterized by national intraindustry IRS, the condition for local dynamic stability is equivalent to the condition for normal output-price response.3 Moreover, in contrast with the findings of the IRS models based on free intersectoral mobility of all factors as exemplified in Herberg and Kemp [6], this condition may be satisfied everywhere along the production possibilities frontier. Second, stability of an equilibrium in the presence of IRS is not sufficient to guarantee the validity of many results of the standard specific-factors model. Responses of small