In static trade models with no market imperfections, the aggregate income and welfare of a small country grow when it opens to trade. In endogenous growth models, trade liberalization boosts the growth effect generated by non-diminishing returns to factors of production, or learning-by-doing, or knowledge spillovers, or other forms of endogenous technological change. Although important insights into the relationship between trade and growth can be derived from these models, the mechanism through which this process takes place is still not well-understood. One promising perspective is offered by new trade models that focus on how the production choices made by heterogeneous firms affect growth.
The first set of models in the literature on growth with trade and heterogeneous firms is underpinned by the Melitz model. Growth is driven by endogenous technology diffusion and trade is one of the components influencing firms’ technology choices. In one study for example, given changes in trade costs, firms have to decide whether to upgrade their technology, taking into account the fixed costs of upgrading. In another study, firms have to choose between process innovation (raising productivity) and product innovation (increasing variety). In both approaches, static gains from trade are offset by a reallocation of labor from the production of goods to activities centred on market entry and product adoption. Even though there is a loss in varieties produced and consumed, reductions in trade costs increase the rate of technology adoption and economic growth.
A second branch of the literature includes models that build on a Ricardian framework to analyze the effects of trade liberalization on the creation and diffusion of ideas. This setting highlights the role of intermediate goods in the growth process in an environment with many asymmetric countries. The setting also makes it possible to separate gains from trade into static and dynamic components. The static component is based on the gains from specialization, underpinned by comparative advantage, whereas the dynamic component is derived from the gains through the flow of ideas. This dynamic component of gains from trade is found to play an important role in explaining growth miracles in countries such as South Korea. This result brings about a significant advance in our understanding of the relationship between trade openness and growth. However, other growth channels are still open to investigation. For example, in both branches of literature identified above, foreign direct investment was not part of the analyses but it clearly plays a role in knowledge transfer.
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