Trade Costs, Wage Difference, and Endogenous Growth

In this paper, we develop an endogenous growth model with two countries in which the international trade of differentiated goods requires trade costs and equilibrium wages in the two countries are different. With this model, we show that both wage differences and market size have important effects on the location of manufacturing firms and the innovation sector as well as on economic growth. First, when trade costs are high, the share of manufacturing firms in the large country increases with a decline in trade costs because of market size. However, the share of firms then decreases with a decline in trade costs when trade costs are low because of wage differences. Finally, all firms agglomerate in the small country, since production costs there are low. In this process, the innovation sector shifts its location from the large-market, high-wage country to the small-market, low-wage country. In this globalization process, growth rates first increase, then decrease, and finally increase with the reduction of trade costs. These results explain the process of the initial high growth of developed countries, location shift of manufacturing firms, and innovation sector from developed to developing countries, which has been observed in recent years.