Why do Similar Countries Choose Different Policies? Endogenous Comparative Advantage and Welfare Gains

Abstract

Similar countries often choose very different policies and specialize in very distinct industries. This paper proposes a mechanism to explain policy diversity among similar countries from an open economy perspective. I study optimal policies in a two country model when policies affect determinants of trade patterns. I show that welfare gains from trade can provide sufficient incentive for asymmetric equilibrium policies, even if the two countries have identical economic fundamentals. Any asymmetric equilibrium exhibits greater production specialization than the common autarky optimum; this is the source of welfare gains. For this same reason, a more asymmetric Nash equilibrium Pareto dominates a less asymmetric one. I characterize necessary and sufficient conditions for existence of such asymmetric equilibrium. All equilibria are asymmetric if income is sufficiently convex in policy, and production technologies and consumer preferences are not strongly biased in favor of one of the factors of production. As an application, I consider a model where skill distribution is the determinant of trade patterns and the policy in question is education policy. When heterogeneous agents choose their skill levels optimally, optimal skill function is convex in government policy. In this application, the general sufficient condition requires that the education cost of agents is relatively inelastic with respect to skill.