Essays on Intra-Industry Trade

Transcription

1 University of Tennessee, Knoxville Trace: Tennessee Researc an Creative Excange Doctoral Dissertations Grauate Scool Essays on Intra-Inustry Trae Yanong Zang University of Tennessee - Knoxville Recommene Citation Zang, Yanong, "Essays on Intra-Inustry Trae. " PD iss., University of Tennessee, ttp://trace.tennessee.eu/utk_graiss/2382 Tis Dissertation is brougt to you for free an open access by te Grauate Scool at Trace: Tennessee Researc an Creative Excange. It as been accepte for inclusion in Doctoral Dissertations by an autorize aministrator of Trace: Tennessee Researc an Creative Excange. For more information, please contact trace@utk.eu.

2 To te Grauate Council: I am submitting erewit a issertation written by Yanong Zang entitle "Essays on Intra-Inustry Trae." I ave examine te final electronic copy of tis issertation for form an content an recommen tat it be accepte in partial fulfillment of te requirements for te egree of Doctor of Pilosopy, wit a major in Economics. We ave rea tis issertation an recommen its acceptance: Hui S. Cang, Mattew N. Murray, Halima Bensmail (Original signatures are on file wit official stuent recors.) Don P. Clark, Major Professor Accepte for te Council: Dixie L. Tompson Vice Provost an Dean of te Grauate Scool

3 To te Grauate Council: I am submitting erewit a issertation written by Yanong Zang entitle Essays on Intra-Inustry Trae. I ave examine te final electronic copy of tis issertation for form an content an recommen tat it be accepte in partial fulfillment of te requirements for te egree of Doctor of Pilosopy, wit a major in Economics. Don P. Clark Major Professor We ave rea tis issertation an recommen its acceptance: Hui S. Cang Mattew N. Murray Halima Bensmail Accepte for te Council: Anne Mayew Vice Cancellor an Dean of Grauate Stuies (Original signatures are on file wit official stuent recors.)

4 ESSAYS ON INTRA-INDUSTRY TRADE A Dissertation Presente for te Doctor of Pilosopy Degree Te University of Tennessee, Knoxville Yanong Zang May 2005

5 DEDICATION Tis issertation is eicate to my parents, Guanlang Zang an Ruxun Li, for teir love, encouragement an support. ii

6 ACKNOWLEDGEMENTS Tis issertation owns tanks to a number of scolars. I first woul like to express my gratitue to Dr. Don P. Clark, wo serve as my acaemic avisor an issertation cair. His excellent guiance an insigtful scolarly avice were extremely elpful in te wole process of issertation writing an mae its completion possible. I ten woul like to tank Dr. Hui S. Cang, Dr. Mattew N. Murray, an Dr. Halima Bensmaill for serving on my committee. Teir encouragement an teir constructive comments are inee invaluable. I also woul like to tank Donna Kemper, Susan Mcgee, an Amana Carter for teir secretarial services, wic were very muc neee to complete te process. Finally, I tank te Economics Department an te Center for Business an Economic Researc at te University of Tennessee for proviing me wit te necessary financial support uring my stay in te PD program. iii

7 ABSTRACT Intra-inustry trae (IIT) is one area in international trae tat interests me very muc. Te pattern of worl trae as been canging consistently over te last alf century, in wic te importance of intra-inustry trae as increase significantly. Suc a trae pattern cange as consequences on omestic real economic variables ue to te associate capital an labor ajustments. My issertation sets out to ientify te US static an ynamic trae patterns an investigate te eterminants of US intra-inustry trae. In te analytic part of te issertation, I introuce capital accumulation an an innovation process into a Nort-Sout quality-base prouct cycle moel. Te moel emonstrates tat prouct quality upgraing is an important cannel for FDI to affect Nort-Sout intra-inustry trae, wic explains te observe concurrence of FDI, prouct quality upgraing an Nort-Sout IIT. In te empirical part of te issertation, I first examine te pattern of te US intra-inustry trae, wit a separation of orizontal intra-inustry trae an vertical intra-inustry trae, an ten investigate te eterminants of te US IIT accoringly. Relevant panel ata an limite epenent variable tecniques are applie for estimation. Te results uncover meaningful information on te static an ynamic patterns of US IIT an provie irect evience for ypoteses propose by IIT teory. iv

8 TABLE OF CONTENTS PART PAGE 1. INTRODUCTION.1 2. ESSAY ONE: FDI, PRODUCT QUALITY UPGRADING AND NORTH-SOUTH IIT: AN EXTENSION TO THE QUALITY-BASED PRODUCT CYCLE MODEL. 5 Introuction...6 Literature Review 8 A Quality-Base Prouct Cycle Moel..11 FDI an Prouct Quality Upgraing...23 Wiening Gap of Factor Enowment Difference...31 Conclusion..36 References...38 Appenix ESSAY TWO: A STUDY ON THE US INTRA-INDUSTRY TRADE: PATTERNS AND DETERMINANTS...44 Introuction.45 Literature Review 48 Aggregation an Measurements of Intra-Inustry Trae...55 Te Pattern of US Intra-Inustry Trae...64 Determinants of Intra-Inustry Trae an Teir Measurements.70 Moel Specification, Estimation Proceures an Data Description..82 Te Empirical Results Conclusion References Appenix CONCLUSION..116 VITAE v

9 LIST OF TABLES TABLE PAGE TABLE 1. SAMPLE STATISTICS OF US IIT SHARES...65 TABLE 2. THE US IIT PATTERN ACROSS 40 LARGEST INDUSTRIES, TABLE 3. DECOMPOSITION OF THE US IIT (IN PERCENTAGE OF TOTAL TRADE, 1997) 69 TABLE 4. CHANGES IN THE US IIT, TOP 20 COUNTRIES, TABLE 5. ONE-WAY RANDOM EFFECT MODEL ESTIMATES FOR STATIC IIT SHARES...93 TABLE 6. TOBIT MODEL ESTIMATES FOR STATIC IIT SHARES...97 TABLE 7. ONE-WAY RANDOM EFFECT ESTIMATES (DYNAMIC MODELS) 100 TABLE A 2.1. SAMPLE STATISTICS OF COUNTRY VARIABLES TABLE A 2.2. SAMPLE STATISTICS OF INDUSTRY VARIABLES TABLE A 2.3. LM TEST FOR COMMON INTERCEPT (STATIC IIT SHARES).111 TABLE A 2.4. LM TEST FOR COMMON INTERCEPT (DYNAMIC IIT SHARES) 111 TABLE A 2.5. HAUSMAN SPECIFICATION TEST FOR RANDOM EFFECT (STATIC MODELS) TABLE A 2.6. HAUSMAN SPECIFICATION TEST FOR RANDOM EFFECT (DYNAMIC MODELS)..112 TABLE A 2.7 RANDOM EFFECT TOBIT MODEL ESTIMATES (FOR STATIC MODELS).113 TABLE A 2.8 NON-LINEAR LEAST SQUARES ESTIMATES (DYNAMIC MODELS).114 TABLE A 2.9. VARIABLE DEFINITIONS vi

10 PART 1 INTRODUCTION 1

11 In te 1960s, researcers a notice tat a large portion of trae between inustrialize countries takes place in inustries tat fall into te same inustry classification, an is calle intra-inustry trae (IIT). Researcers ave propose tat since capital intensities for proucts witin an inustry are regare as similar, te ajustment costs involve in resource allocation cause by IIT woul be less tan te ajustment costs cause by inter-inustry trae (te Smoot Ajustment Hypotesis). Later stuies furter argue tat te Smoot Ajustment Hypotesis may only be vali for HIIT (trae in orizontally ifferentiate proucts), since teory for VIIT (trae in vertically ifferentiate proucts) allows capital intensities to iffer for te same ifferentiate prouct wit ifferent qualities. Trae pattern featuring te relative importance of IIT, HIIT an VIIT tus as irect welfare implications on omestic economy. It is important to stuy te status quo of a country s trae pattern, ow te trae pattern canges, an te eterminants of IIT, HIIT an VIIT. Te first essay sets out to provie teoretical explanations for te fast-growing Nort-Sout IIT, an observe feature of te US foreign trae, using a moifie Flam an Helpman (1987) quality-base prouct cycle moel. Te secon essay ientifies te US trae pattern an canges in its composition, an examines possible eterminants of ifferent components of US IIT empirically. Togeter, te two essays uncover meaningful information on te US IIT patterns an provie teoretical an empirical evience on factors affecting US IIT components. We ave observe for te past two ecaes tat te importance of Nort-Sout IIT as grown significantly, along wit FDI inflows an prouct quality upgraing taking place in major eveloping countries. Toug one woul intuitively consier FDI as one 2

12 force bein quality upgraing an Nort-Sout IIT growt, no rigorous efforts ave been mae to examine teir teoretical relationsips in a Nort-Sout trae moel. Essay one seeks to fill te voi by aressing te roles of FDI an prouct quality upgraing in Nort-Sout IIT growt in a moifie Flam an Helpman (1987) quality-base prouct cycle moel. It is sown tat prouct quality upgraing in te Sout is an important cannel for FDI to increase Nort-Sout IIT volume an Nort-Sout IIT sare. Te first essay tus contributes to te literature by proviing teoretical explanations for te observe concurrence of FDI, prouct quality upgraing an Nort-Sout IIT. Compare to stuies on European countries, empirical stuies on US IIT ave been relatively few, unparallel to te significance of te US trae in te worl. Furtermore, unlike most stuies on oter countries, in wic te separation of orizontal IIT sare (HIIT) an vertical IIT sare (VIIT) as been wiely use, no effort as been mae to stuy US IIT base on te separation of HIIT an VIIT. As a consequence, we know little about te composition of US IIT patterns, an ow te eterminants suggeste by teory affect te ifferent components of US IIT. Te secon essay firstly ientifies te static an te ynamic US IIT patterns base on te separation of HIIT an VIIT using a new separation meto propose by Kanogan (2003). Te US IIT pattern uncovere by te stuy is one caracterize by te ominance of HIIT at inustrial level an by te ominance of VIIT at country level. Te secon essay seconly investigates te eterminants of static an ynamic HIIT an VIIT empirically. Using panel ata moel tecniques an limite epenent variable moel tecniques, te estimate results provie irect evience to teoretical propositions regaring country-specific an 3

13 inustry-specific eterminants of HIIT an VIIT; especially, te teoretical link between FDI, prouct quality upgraing an Nort-Sout IIT is supporte by te empirical results. Te secon essay firstly contributes to te literature by proviing etaile information about te static US IIT pattern across inustries an te ynamic US IIT pattern across countries over time. Te information about te US IIT pattern elps one to evaluate te significance of te Smoot Ajustment Hypotesis. Seconly, te secon essay provies irect evience regaring eterminants of ifferent components of US IIT, ientifying te forces bein US IIT pattern canges. Following te en of te secon essay, a conclusion will be given to evaluate te finings from te two essays. 4

14 PART 2 ESSAY ONE FDI, PRODUCT QUALITY UPGRADING AND NORTH-SOUTH IIT: AN EXTENSION TO THE QUALITY-BASED PRODUCT CYCLE MODEL 5

15 I. Introuction It as been wiely recognize by researcers tat a large portion of worl s trae falls into te category of intra-inustry trae (IIT). 1 Te apparent ifference between IIT an inter-inustry trae as le to a consierable amount of literature on te causes, eterminants an welfare implications of IIT. Among tem, Nort-Sout IIT as receive an increasing attention as Nort-Sout IIT as become more significant over time. Tere are two kins of Nort-Sout IIT moels in te literature. One kin explains tat Nort-Sout IIT takes place ue to scale economies an orizontal prouct ifferentiation 2. Te oter kin argues tat Nort-Sout IIT in proucts ifferentiate by quality (vertical ifferentiation), can be explaine by factor enowment ifferences an tecnology ifferences, as suggeste by traitional trae teory 3. An issue emerging from te previous literature is tat te role of quality upgraing an resource allocation as not been torougly stuie. Casual observations suggest tat FDI, quality upgraing an Nort-Sout IIT often move in te same irection, as wat ave occurre in some East Asia countries for te last two ecaes. Altoug one woul intuitively consier FDI as one force bein quality upgraing an Nort-Sout IIT growt, no rigorous efforts ave been mae to examine teir teoretical relationsips in a Nort-Sout trae moel. In orizontal ifferentiation moels, FDI may affect IIT via te form of multinationals, but te effect of FDI on quality upgraing in te Sout is not clear, given 1 Intra-inustry trae refers to simultaneous imports an exports of proucts tat fall in te same inustry classification. 2 See Helpman an Krugman (1985) for emonstrations. 3 Representative stuies inclue Falvey an Kierzkowski (1987), Flam an Helpman (1987). 6

16 tat by assumption proucts are orizontally ifferentiate in nature. Vertical ifferentiation moels, eiter assuming tat prouct quality is exogenously etermine or ignoring te role of capital accumulation, cannot explicitly examine te role of FDI in quality upgraing as well as canges in IIT sare 4. Tese facts call for a furter teoretical stuy tat focuses on te link between FDI an quality upgraing as well as te sare of Nort-Sout IIT. Tis stuy extens a quality-base prouct cycle moel in wic te roles of FDI an prouct quality upgraing in Nort-Sout IIT can be aresse. Suc a stuy as two istinguising features. Firstly, unlike previous moels in wic te level of prouct quality is associate wit eiter capital intensity or tecnology level, tis stuy assumes tat quality of a ifferentiate prouct is associate wit bot capital intensity an tecnology level. Seconly, an imitation process in te Sout is introuce as a process tat utilizes labor an capital as factors an promotes labor efficiency. Tese two features enable one to investigate te teoretical relationsips among FDI, quality upgraing an Nort-Sout IIT in a typical quality base prouct cycle moel. Tere are tree main conclusions from tis stuy: i) FDI inflow provies more resources for imitation activity in te Sout an promotes its prouct quality upgraing; ii) a positive causal link between FDI an te sare of Nort-Sout IIT exists uner some reasonable assumptions, iii) a rise in te Nort s enowment in capital may lea to prouct quality upgraing in te Sout, an possibly lea to a iger sare of Nort- Sout intra-inustry trae. 4 For example, Falvey an Kierzkowski (1987) take prouct quality as exogenous. Flam an Helpman (1987) an Stokey (1991) ignore te role of capital accumulation. 7

17 Te results of tis stuy not only provie intuitive an rigorous explanations for te observe concurrence of IIT growt, FDI increases an prouct quality upgraing in eveloping economies, but also generate testable ypoteses, wic lea to potential empirical stuies. Te next part of tis paper reviews relevant literature on Nort-Sout IIT moels. Part III moifies a quality-base prouct cycle moel to accommoate investment an imitation process in te Sout. Part IV stuies ow FDI affect quality upgraing in te Sout an Nort-Sout IIT. Part V examines te trae pattern canges cause by a wier capital enowment ifference between te Nort an te Sout. Te last part conclues. II. Literature Review One stran of Nort-Sout IIT moels takes root in te new trae teory, wic explains IIT by scale economies an orizontal prouct ifferentiation. Te new trae teory was mainly evelope in Krugman (1979, 1980), Lancaster (1980), an Helpman (1981). Altoug ifferent in assumptions about iniviual s preference, te arguments presente are similar 5. Typically, eac firm is caracterize by internal scale economies, an tere are no barriers for entry. Since entry rives profits to zero, eac firm only prouces one ifferentiate prouct in te equilibrium. Consumers prefer variety an terefore gain from increase prouct ifferentiation. Scale economies an orizontal prouct ifferentiation tus lea to IIT wen trae is opene up. Helpman an Krugman (1985) evelop a moel to explain Nort-Sout IIT base on te new trae teory. 5 In Krugman s stuies, consumers prefer as many varieties as possible, tus tey ave a love of variety preference. Lancaster an Helpman s stuies assume tat eac consumer prefers one variety to te oter, tus te favorite variety preference. 8

18 Teir stuy preicts tat Nort-Sout trae will be of bot IIT an inter-inustry type, an tat IIT takes place in orizontally ifferentiate proucts. Te oter stran of moels was mainly evelope in Falvey (1981), Falvey an Kierzkowski (1987), Flam an Helpman (1987). In Falvey an Kierzkowski s moel, iniviuals are assume to ave ientical but non-omotetic preferences. Combining wit ifferent income levels, eman for variety is ensure at te aggregate level. Falvey an Kierzkowski sow tat trae equilibrium woul be one in wic te Nort will export te ig quality ifferentiate prouct an import te low quality ifferentiate prouct as well as te omogenous goo. Tus, Nort-Sout IIT of vertical ifferentiation nature (ifferentiate by quality) can be explaine by a moifie Heckscer-Olin moel, instea of by scale economies an orizontal prouct ifferentiation. Flam an Helpman (1987) use a quality-base prouct cycle moel to sow tat even wit ientical factor enowments, ifferences in tecnology levels can explain te existence of Nort-Sout IIT in vertically ifferentiate proucts. Flam an Helpman s stuy is similar in spirit wit Falvey an Kiezkowski s. Sake an Sutton (1984) sow tat Nort-Sout IIT of vertical ifferentiation can be explaine by linking prouct quality wit Researc an Development (R&D) in an oligopoly content moel. However, te role of FDI an prouct quality upgraing in Nort-Sout IIT as not been torougly stuie in bot kins of moels. Especially, in orizontal ifferentiation moels, proucts are not ifferentiate by quality. As a result, orizontal ifferentiation moels are not suitable to aress te issue of prouct quality upgraing. Falvey an Kierzkowski s moel as te potential to stuy FDI s effect because capital is inclue as 9

19 a factor, but prouct quality in teir stuy is assume to be etermine exogenously. Flam an Helpman s moel examines prouct quality canges in a quality-base prouct cycle, but capital is not inclue as a factor of prouction. As a result, FDI s role is left out. Te same practice occurs in Stokey (1991). Te rationale is tat capital is perfectly mobile, tus incluing a common factor woul complicate a moel unnecessarily. However, it may not be appropriate to ignore te role of investment in te presence of imitation even toug capital is perfectly mobile. If te imitation activity in te Sout contributes to labor efficiency an requires bot labor an capital as factors, FDI contributing to capital accumulation affects resource allocation in te Sout, an terefore as effects on labor efficiency, wic in turn affects quality upgraing an Nort-Sout IIT. Conventional stuies on FDI an trae often focus on multinationals (MNE) as a major form of FDI an MNE takes place to take avantage of scale economies an low prouction cost in te Sout. For example, Helpman an Krugman (1985) sow tat in te case of vertical MNE, MNE coul complements IIT or replace IIT epening on weter te capital ric country is te net exporter of manufactures. 6 Markusen an Venables (2000) sow tat orizontal MNEs coul be te form of FDI as prouction is move to oter countries to reuce trae costs an exploit scale economies. In tis case, MNEs isplace IIT but create intra-firm trae. However, besies te form of MNE in vertical or orizontal prouction, weter FDI affects trae pattern via oter cannel like quality upgraing as not receive muc attention. 6 Vertical MNE refers to te case tat a MNE geograpically separates its eaquarter services from prouction activities. 10

20 Tis essay aresses te issue of quality upgraing an Nort-Sout intra-inustry trae, in wic FDI is an important force bein quality upgraing. We expect tat suc a stuy elp to explain te observe penomenon tat FDI, quality upgraing an Nort- Sout IIT increase togeter, an yiel testable ypoteses for empirical stuies. III. A Quality-Base Prouct Cycle Moel In tis section, te quality-base prouct cycle moel erive by Flam an Helpman (1987) is moifie to inclue capital as a factor an imitation activity as a process. In a 2x2x2 moel, one country is capital abunant, calle te Nort; te oter is labor abunant, calle te Sout. Tere are two sectors: a omogenous prouct (y) sector, an a ifferentiate prouct (x) sector. 7 Te quality of ifferentiate prouct x is inexe by z. Labor is mobile witin a country but immobile between countries. Capital is perfectly mobile Te supply sie Te Nort carries out innovations an introuces te ifferentiate prouct wit iger qualities. Te Sout as te ability to imitate an prouce. Bot te omogenous prouct an te ifferentiate prouct sectors are caracterize by constant returns to scales, suc tat no internal scale economies nee to be consiere in tis case. Assuming tat one unit of labor an c units of capital are neee to prouce one unit of te omogenous prouct in bot countries, ten te supply prices of te omogenous prouct in te Sout an te Nort are te following: p( y) = 1+ rc (1) 7 Te prouct is ifferentiate by quality. 11

21 p ( y) w r c = + (2) were p( y ) an p ( y ) are supply prices of te omogenous prouct in te Sout an Nort respectively. Note tat we ave normalize te real wage rate of te Sout to 1, it follows tat r is te capital return in terms of real wage in te Sout. Similarly, w an r are real wage rate an capital return of te Nort in terms of real wage in te Sout. In te presence of trae, te market price for te omogenous prouct is given by [ ] p% ( y) = min 1 + rc, w + r c (3) By assumption, te Nort is more capital abunant tan te Sout, ten greater tan 1. Also by assumption, capital is perfectly mobile, ten r = w is r necessarily. It follows tat 1+ rc > w + rc always. Te Sout tus as a comparative avantage in proucing te omogenous prouct y. Let a ( z) an b ( z) be te labor input an capital input for one unit of quality output in te Nort. Let azan ( ) bz ( ) be te labor input an te capital input for one unit of quality output in te Sout. It is assume tat te unit labor an capital inputs functions are all twice ifferentiable an convex in z. An imitation process in te Sout is introuce. Te imitation activity utilizes bot labor an capital as factors. We efine te imitation level T as an increasing function of bot capital an labor allocate to imitation process, enote as Ten T = T( K, L ) as te properties tat T > 0, T > 0. T T K L K T an L T respectively. 12

22 A iger level of imitation improves labor efficiency in te Sout s ifferentiate prouct sector. Rewriting te unit labor input function for z in te Sout as a ( z, T ), ten a ( z, T ) as te following properties: az(, z T) > 0, at(, z T) < 0, azt(, z T) < 0 (4) Te unerlying assumption is tat te iger quality of te ifferentiate prouct, te more labor inputs are require; te iger imitation activity level, te less labor inputs are neee. Te supply prices of quality z in te two countries can be written as p( z) = a( z, T) + rb( z) (5) p( z) = w a( z) + r b( z) (6) Te market price for te quality z is te following: p % ( z) = min a( z, T ) + rb( z), w a ( z) + rb ( z) (7) Assuming tat te labor in te Nort is more prouctive in proucing te ifferentiate prouct wit ig qualities, ten it follows tat azt (, )/ a() z increases in z. We furter impose te conition tat capital is equally prouctive in te two countries, ten b ( z) = b ( z) 8. Equation (8) tus implies tat te Sout as a comparative avantage in proucing x wit low qualities, an te Nort as a comparative avantage in proucing x wit ig qualities. As in Flam an Helpman (1987), tere exists a breakeven point z in te cain of comparative avantages tat satisfies azt (, ) = wa( z). 8 Te assumption is impose to simplify te moel, wic allows us to focus on te role of labor efficiency in affecting trae. 13

23 Innovation in te Nort is a graual process tat epens on te previous stock of knowlege. We can use z max to represent te available stock of knowlege. Let innovation take place by a constant spee 9 : z & = iz max (8) were i is a positive, constant coefficient Te eman sie We follow Flam an Helpman (1987) to assume tat consumers preferences are omogenous but non-omotetic. Wit ifferent income levels, eman for variety is generate. Eac consumer can consume te omogenous prouct y in any esirable amount, but can only consume one unit of te ifferentiate prouct x. Consumers can coose te qualities of te ifferentiate prouct available in te market. A typical consumer s problem is te following: Max U ( y, z) s.. t p% ( y) y + p% ( z) I (9) Te consumer s utility function is quasi-concave an increasing in bot arguments. Following Flam an Helpman (1987), te utility function takes te following form: U( y, z) = ye λz (10) Te solution yiels te eman functions for y an z as functions of income an relative factor prices. 9 Glass (1997) enogenizes te spee of innovation. Since te focus of tis stuy in on te Sout s imitation, I ecie to set te spee as exogenous. Tis makes te moel easy to anle an woul not affect its main finings. 14

24 3.3. Trae equilibrium In te trae equilibrium, given te specialization pattern an eman for variety in bot countries, consumers consume te varieties prouce by bot countries. Following conventional assumption, te omogenous prouct an te quality of te ifferentiate prouct are treate as normal goos. Wit a iger income, a typical consumer woul eman more quantity of te omogenous prouct an iger quality of te ifferentiate prouct. For a consumer wo purcases te ifferentiate prouct from te Nort, utility optimization yiels te equilibrium quality of te omogenous prouct y as follows: waz( z) + rbz( z) y% = (11) λ(1 + rc) Te corresponing income level of te consumer can be expresse as 1 I = ( wa( z) + rb( z)) + ( waz( z) + rbz( z)) (12) λ Similarly, for a consumer wo purcases te ifferentiate prouct from te Sout, utility optimization yiels te equilibrium quality of te omogenous prouct y as follows: az (, z T) + rb () z y% = (11a) λ(1 + rc) an te corresponing income level is 1 I = ( a( z, T) + rb( z)) + ( az( z, T) + rbz( z)) (12a) λ If tere exists an income level I, above wic consumers eman for Norternprouce qualities, an below wic consumers eman for Soutern-prouce qualities, te lowest Nortern prouct quality trae can be obtaine from equation (13) as follows: 15

25 z = z I w (13) + + (, ) z + It can be easily sown from equation (13) tat > 0. Similarly, te igest Soutern prouct quality trae is obtaine from equation (13a) z = z ( I, T) (14) I z z were > 0, > 0 I T can be obtaine from equation (14). Given tat I satisfies tat + I p% ( z ) + I p% ( z ) u, z = u, z, te iviing py %( ) py %( ) income level I in function of factor prices an te imitation activities can be solve as follows: I = I w T (15) (, ) z z were I rises wit T, given tat > 0, > 0. I T At te equilibrium, trae pattern is etermine by te two countries comparative avantages. Te Sout exports te omogenous prouct an te ifferentiate prouct wit qualities lower tan z, an te Nort exports te ifferentiate prouct wit qualities iger tan z +. Since trae is balance, te Nort is te net exporter of te ifferentiate prouct. 16

26 3.4. Te volumes of trae an intra-inustry trae at te equilibrium Quality ranges Te set of income classes in bot countries is efine as te unit interval [0, 1]. Let te istribution of effective labor units across income classes be represente by te ensity function f ( ) an f ( ) for te Sout an te Nort respectively. Furter assume tat te istributions of capital enowments across income classes are te same as te istribution of effective labor units 10. Let L an an K an L be te total labor enowments, K be te total capital enowments for te Sout an Nort respectively. Te total incomes for people in income class ( [ 0,1]) in te Sout an te Nort are te following: f ( )( L+ rk) (16) f ( )( w L + r K ) (17) Furter efine te istribution of population over income classes as n() an n() respectively. Population sizes are N an N for te Sout an te Nort. It follows te income level of a Soutern iniviual in income class is f ( )( L+ rk) I ( ) = (18) Nn( ) Because consumers in one country consume te varieties prouce by bot countries, tere exists an income class in te Sout an in te Nort, suc tat iniviuals wo belong to te iviing income classes earn exactly I. Tose wit 10 It is more reasonable to assume capital enowments ave ifferent istributions. I aopt te assumption to simplify te moel manipulation. 17

27 income levels iger tan I eman qualities prouce by te Nort, an tose wit income levels lower tan I eman qualities prouce by te Sout. Te iviing income level I satisfies I f L rk f w L r K = = (19) ( )( + ) ( )( + ) Nn( ) N n ( ) Given income istributions, from equation (13) an (13a), te range of qualities emane by eac country can be erive as follows. f(0)( L+ rk) zmin = z, T Nn(0) (20) f(1)( L+ rk) zmax = z, T Nn(1) (20a) f (0)( w L + r K ) zmin = z, w Nn(0) (21) f (1)( w L + r K ) zmax = z, w Nn(1) (21a) Here, te prouct quality ranges consume by consumers in bot countries can be obtaine. Specifically, Soutern consumers in income class,1] eman nortern- prouce quality z +, z ]. Nortern consumers in income class [0, ) eman [ max soutern-prouce quality [ zmin, z ]. Base on te results erive in equation (13) an (13a), te following properties must ol: ( zmin z z z > > > > T T w w max min max 0, 0, 0, 0 18

28 Expeniture sares From equation (13), te sare of income an iniviual spens on Nortern proucts pz wa z rb z = I 1 λ ( ) ( ) + ( ) ( wa( z) + rb( z) ) + ( waz( z) + rbz( z) ) 1 = = α( z) 1 pz ( z) 1+ λ pz ( ) (22) were pz( z) w az( z) + r bz( z) = p( z) w a ( z) + r b ( z) Te expeniture sare a(z) is boune by quality range z +, z ] [ max in te Sout. Given tat p (z) is convex in z, an assuming tat first erivative effect ominates te secon erivative effect, pz ( z) p( z) ecreases in z an a(z) increases in z. Te intuition is as follows. Given everyting else, a typical Soutern consumer prefers iger quality ifferentiate prouct an spens a larger sare of is/er income on it. Te upper boun of te sare is a z ), wic is less tan 1. Similarly, te ( max expeniture sare a (z) for a typical Nortern consumer as an upper boun a z ). From equation (13a), te sare of income an iniviual spens on Soutern ifferentiate proucts: pz ( ) azt (, ) + rbz ( ) = I 1 z λ ( azt (, ) + rbz ( )) + ( a( zt, ) + rb( z) ) z ( max 1 = = β ( z) 1 pz ( z) 1+ λ pz ( ) (23) 19

29 were pz( z) az( z, T) + rbz( z) = p( z) a( z, T) + rb( z). It follows tat te upper boun for te income sare tat a typical nortern consumer spens on Soutern prouct is β ( z ) an te lower boun is β z ). ( min Te expeniture sare on te omogenous prouct for Nortern consumers wo purcase Nortern-prouce ifferentiate prouct is1 α ( z), were + z [ z, z ]. Te max expeniture sare on te omogenous prouct for Nortern consumers wo purcase Soutern-prouce ifferentiate prouct is1 β ( z), were z [ z, z ]. min Volumes an sares oftrae Since trae is balance, an te Nort only exports te ifferentiate prouct, wile te Sout exports te ifferentiate prouct as well as te omogenous prouct, te volume of trae can be efine as twice te exports of te Nort. Tat is 1 VT = 2( L + rk) α( z ) f ( ) (24) = Te trae volume can also be efine as twice te exports of te Sout 1 ( α = ) VT = w L + rk z f (24a) 2( ) 1 ( ) ( ) Te volume of intra-inustry trae is efine as twice te minimum of ifferentiate prouct exports by te two countries, wic is twice te ifferentiate prouct exports by te Sout β = 0 IIT = 2( w L + rk ) ( z ) f ( ) (25) Te total expeniture on omogenous prouct by Nortern consumers equals 20

30 1 ( wl + rk ) 1 β( z ) f ( ) ( ) ( ) 0 α z f = = (26) Te sare of intra-inustry trae in total trae is given by SIIT β ( ) ( ) = α( ) ( ) = IIT z f = = VT z f (27) Te expression inicates tat te sare of intra-inustry trae epens on te relative importance of te nortern expeniture sares on soutern prouce ifferentiate prouct an te omogenous prouct. An important implication is tat wat matters is te istribution of income classes, instea of total income Comparative statics Te total expeniture on Nortern ifferentiate prouct equals te total income of nortern workers, tus we ave te following equation 1 1 α α = = ( L + rk ) ( z ) f ( ) + ( w L + r K ) ( z ) f ( ) = w L + r K Rearrange terms, we ave te following 1 1 α α = = (28) ( L + rk ) ( z ) f ( ) = ( w L + r K )(1 ( z ) f ( ) ) Recall tat equation (17) an (19) also must ol in te equilibrium, we ave a system of equations for four unknowns: I, w,, : I = I w T (17) (, ) I f L rk f w L r K = = (19) ( )( + ) ( )( + ) Nn( ) N n ( ) 1 1 α α = = (28) ( L + rk ) ( z ) f ( ) = ( w L + r K )(1 ( z ) f ( ) ) 21

31 We furter efine tat 1 A = α( z ) f ( ) an A = α( z ) f ( ) for te = 1 = convenience of escription. Tey are te total soutern expeniture sare an te total nortern expeniture sare on Nortern ifferentiate prouct. By total ifferentiation, we ave te following: I w I 1 0 ε 0 w f L 1 0 ε Nn 0 (1 A ) L ( L rk) α( z ) f ( w L rk ) α( z ) f + + I ( TK K + TL L ) T f( L+ rk) = Nn f ( w L + rk ) Nn AL ArK + A w L + r K (1 )( ) were ε an signs. 11 ε are partial erivatives of I wit respect to an Te eterminants of te coefficient matrix is te following, an ave positive I f L I = (1 A ) L ( εε ) ( L+ rk) α( z ) f ( ε ) ( w L + rk ) α ( z ) f ( ε ( + )) w N n w We impose te conition tat I f L nn <, it follows tat > 0, given tat w f < 0. We are now reay to stuy comparative statics cause by exogenous sifts. 11 Please see te appenix 3 for etaile explanations. 22

32 IV. FDI an Prouct Quality Upgraing In tis section, te effects of FDI on prouct quality upgraing in te Sout an te sare of Nort-Sout IIT are consiere. In a two-country worl, te Sout receives FDI from te Nort an allocates te wole amount of FDI into imitation activities. Tat is K K K = T = > 0. Tis sift of resources as effects on te equilibrium system. By Cramer s rule, we can solve for canges on relative wage in Nort, iviing incomes classes in bot country an te iviing income level. 12 w I I < 0, > 0, > 0 or < 0, > 0 or < 0 K K K K K K T T T T T T We only can ecie te signs for te relative wage in te Nort an iviing income class in te Nort. Te flow of FDI from te Nort to te Sout promotes labor efficiency in te Sout, wic reuces relative wage in te Nort. Te fall of relative wage in te Nort tens to sift te Nort s comparative avantage in proucing lower quality prouct. Te improve labor efficiency in te Sout, on te oter an, expans te Sout s comparative avantage in proucing iger quality ifferentiate prouct. Base on te same assumption we use in etermining te sign of te eterminant in te equilibrium system, te iviing income class in te Nort is expecte to rise. Te sign on te iviing income class in te Sout is ineterminate. On te one an, a iger income tens to lower te iviing income class. On te oter an, iger labor efficiency tens to raise te iviing income class. Overall te net effect is ineterminate. As for te iviing income level, in te Nort, te total income falls an 12 See Appenix A 1.1 for etaile erivations. 23

33 te iviing income class rises. In te Sout, te total income rises, but te iviing income class coul eiter move upwar or ownwar. Overall, te sign of te cange in te iviing income level is uncertain. Proposition 1 FDI in te Sout improves te quality of ifferentiate proucts exporte by te Sout. Proof: FDI inflow increases capital stock in te imitation activity in te Sout. By T assumption, te imitation function in te Sout increases in capital, > 0. K Take erivative of z over T in equation (12a) T 1 at(, z T) + a azt(, z T) 1 z z zz zz z = > 0 T a + rb + a ( a ( z, T ) + rb ( z) Evaluating it at z = z, te igest ifferentiate prouct quality exporte by te Sout T z rises wit imitation level. Given tat > 0, it follows tat > 0 K K T T. By proposition 1, te Sout expans its comparative avantage in intermeiate qualities of te ifferentiate prouct, wic were ominate by te Nort before. Te result lies in te fact tat te market price of te ifferentiate prouct is etermine by labor efficiency an te relative wage in te Nort. As long as te fall in te labor input in proucing te ifferentiate prouct ominates te fall in te relative wage in te Nort, te quality spectrum exporte by te Sout will expan upwar. Te conition is likely to ol because wage ajustment in te Nort is sluggis an incomplete. Tus, 24

34 we ave establise a positive causal link between FDI an prouct quality upgraing in te Sout. We next examine te resulting effects on trae volumes an sares. Lemma 1. Total trae volume coul increase or ecrease wit imitation activity in te Sout. Proof: Rewrite equation (24a) as VT 1 = 2( w L + rk ) f ( ) (1 α( z )) f ( ) + = 0 = It is alreay sown above tat rises wit T. Wen tere is a rise in imitation activity in te Sout, te first item in te bracket increases unambiguously. Given tat te expeniture sare on te omogenous prouct 1 α( z) ecreases in z an z rises wit T, te secon item in te bracket ecreases unambiguously. However, by property of probability istribution, we know tat 1 α( z) is less tan 1, it follows tat = 0 f( ) = K T 1 = f ( ). Given tat K 1 f ( ) (1 α( z )) ( ) f = 0 = ols K T > T K T always. However, because te relative wage an te capital stock in te Nort fall, te cange in total income in te Nort is negative. Te net effect is tus ambiguous. 25

35 Te reasoning for Lemma1 is given as follows. Wen tere is a rise in imitation activity, te iviing income class in te Nort rises. A larger portion of te income istribution in te Nort as been allocate to nortern consumers wo purcase te ifferentiate prouct from te Sout. Before, tis part of income was istribute between nortern-prouce ifferentiate prouct an te omogenous prouct from te Sout. Now, tis part of income is istribute between soutern-prouce ifferentiate prouct an te omogenous prouct from te Sout. As te result, te cange in te importe ifferentiate prouct from te Sout is positive. However, te cange in te importe omogenous prouct is uncertain because te total income in te Nort falls. Witout any prior information, te volume of total trae coul fall or rise. However, one ting we are certain is tat te sare of nortern expeniture on importe goos rises unambiguously, an tere is less portion of income spent on omestic consumption. Lemma 2. Te volume of intra-inustry trae rises wit imitation activity in te Sout. Proof: Recall tat in our moel, eac consumer emans one unit of te ifferentiate prouct. As a irect implication, te volume of IIT is etermine by te lowest quality an igest quality exporte by te Sout, wic is z, min z. From proposition 1, we z alreay know tat > 0. Recall tat K T f (0)( w L + r K ) zmin = z, w, an Nn(0) z min rises wit w. As we ave sown tat te real relative wage in te Nort falls, te lower en 26

36 of quality of te ifferentiate prouct importe from te Sout falls also. It follows tat te quality range of te ifferentiate prouct expans towars bot ens. In te case tat eac consumer consumes one unit of te ifferentiate prouct, te volume of intrainustry trae increases necessarily. Te result in Lemma 2 stems from te fact tat te quality range exporte by te Sout expans. As te total income in Nort falls, nortern consumers in te lowest income bracket switc to eman te ifferentiate prouct wit lower quality, suc tat te quality spectrum importe by te Nort move ownwars. On te oter an, prouct quality upgraing in te Sout attracts nortern consumers in intermeiate income class to consume soutern prouce intermeiate quality ifferentiate prouct. Recall tat a basic feature of our moel is tat eac consumer is restricte to consume one unit of te ifferentiate prouct, te expansion of te quality exporte by te Sout irectly implies tat te volume of Nort-Sout IIT rises necessarily. Tat is, combining wit proposition 2, we ave establise a positive causal link between FDI, prouct quality upgraing an te volume of Nort-Sout IIT. We ave sown tat bot te volume of total trae an IIT rises unambiguously wen FDI flow to imitation activities in te Sout. At te same time, we are also intereste in te cange of te sare of Nort-Sout IIT because it inicates te cange in trae pattern. Te sare of IIT in total trae is etermine by te magnitues of canges in total trae an IIT. 27

37 Proposition 2. As FDI flows into imitation activities in te Sout, te cange in te sare of Nort-Sout IIT is ambiguous. A sufficient conition for te sare of IIT to increase is tat, for nortern consumers, te expeniture sare on soutern prouce ifferentiate prouct is greater tan te expeniture sare on te omogenous prouct. Proof: Recall tat SIIT β ( ) ( ) = α( ) ( ) = IIT z f = = VT z f Ten te cange in te sare of Nort-Sout IIT is te following: 1 ( ) ( 1 α( z ) ( ) f = ) ( z ) f ( ) 1 ( z ) f ( ) ( z ) f ( ) ( z ) f ( ) SIIT = 1 ( z ) f ( ) + + β 0 α β α = = = = β ( z ) ( ) 0 f α = = Te sign of te cange in Nort-Sout IIT sare epens on + + β α = = 1 ( z ) ( ) β 0 f α = = ( z ) f ( ) ( z ) f ( ) 1 ( z ) f ( ) wic is te comparison of proportional cange in te volume of IIT an total trae. Te first term is positive an secon term is negative. Witout prior assumption about te magnitues of te canges, te sign of te cange in IIT is ineterminate. It can be sown tat if β 0 > β = = 0 ( z ) f ( ) (1 ( z )) f ( ), ten ( z ) f ( ) ( z ) f ( ) >0 always ( z ) f ( ) + + β α = = 1 β ( z ) ( ) 0 f α = = 13 See Appenix A 1.4 for etaile proof. 28

38 It follows tat te cange in te sare of Nort-Sout IIT is unambiguously positive uner te assumption. Inee, it is reasonable to assume tat β 0 > β = = 0 ( z ) f ( ) (1 ( z )) f ( ). Te fall in te expeniture sare on nortern ifferentiate prouct is sare by te rise in te expeniture sare on soutern prouce prouct an te expeniture sare on te omogenous prouct. Given tat β ( z) is increasing in z, an 1 β ( z) is ecreasing in z, it is tus reasonable to assume tat te expeniture sare on soutern prouce ifferentiate prouct rises more tan proportionately tan te expeniture sare on te omogenous prouct. Proposition 2 says tat wen tere is quality upgraing taking place in te Sout, soutern prouce intermeiate quality ifferentiate prouct becomes ceaper, an Nortern consumers turn to purcase tem from te Sout. Altoug te total income in te Nort affects te volumes of trae, only te expeniture sares on soutern prouce ifferentiate prouct an te omogenous prouct matter wen it comes to te sare of Nort-Sout IIT. As long as te expeniture sare on omogenous prouct rises less proportionately tan tat on soutern prouce intermeiate quality ifferentiate prouct, te sare of Nort-Sout IIT rises always. Our results suggest tat FDI flow to imitation activities in te Sout canges te iviing income classes, iviing income level, an real relative wage in te new equilibrium. Diviing income classes an iviing income level sifts cange consumption pattern of te ifferentiate prouct, resulting in canges in trae 29

39 composition. Specifically, Te Nort imports more ifferentiate prouct from te Sout an consume less omestically prouce ifferentiate prouct. Te Sout consumes more omestically prouce ifferentiate prouct. A necessary result is tat te relative importance of te IIT is strengtene. Terms of trae move in favor of te Sout. Soutern consumers are unambiguously better off, because tey enjoy a iger income an a wier prouct quality variety. Nortern consumers can be better off or worse off. On one an, tey pay less for te intermeiate quality ifferentiate prouct; on te oter an, teir total income falls. As te result, teir consumption of te omogenous prouct may rise or fall. Te above results are obtaine by moifying te existing Flam an Helpman (1987) quality base prouct cycle moel. Te inclusion of capital as a factor an imitation activity enables one to link FDI wit quality upgraing as well as te volume an sare of Nort-Sout IIT. Most importantly, imitation process in te Sout serves as a cannel for FDI to affect quality upgraing an Nort-Sout IIT. FDI promotes quality upgraing in te Sout because one eterminant of prouct quality--labor efficiency--is positively correlate wit FDI-riven imitation activity in te Sout. Tere is a positive link between FDI an te volume of intra-inustry trae, because quality upgraing taking place in te Sout leas to more soutern prouce ifferentiate prouct being exporte to te Nort. Te positive link between FDI an te sare of Nort-Sout IIT is establise uner some reasonable assumption. As long as te total expeniture sare on soutern prouce ifferentiate prouct is greater tan te total expeniture sare on te omogenous prouct, FDI inflow to imitation activities in te Sout contributes to a iger sare of Nort-Sout IIT. 30

40 V. Wiening Gap of Factor Enowment Difference In tis section, we examine te scenario tat te ifference between factor enowments for te two countries becomes more significant. Specifically, we consier te case tat tere is no cange in Sout s capital stock as well as capital allocation, an te Nort becomes more capital abunant because of a new iscovery of capital stock. In tis case, te factor enowment gap becomes more evient. Tat is K > 0. Suc a cange as consequences on variables in equilibrium. From comparative statics, we are able to etermine te signs of te canges of te iviing income level, te real relative wage, an te iviing income classes as follows: 14 I w > 0, > 0, > 0, > or < 0 K K K K K Te explanation is tat te iscovery of new capital raises te return to labor suc tat te real wage of nortern workers rises. Consequently, te Nort loses comparative avantage in proucing intermeiate quality ifferentiate prouct to te Sout, an Soutern consumers in te intermeiate income bracket turn to purcase soutern prouce ifferentiate prouct. It follows tat te iviing income class an iviing income level in te Sout must rise. In te Nort, tere are two opposite effects on te iviing income class in te Nort. On one an, te increase in real income in te Nort allows intermeiate consumers turn to purcase iger quality ifferentiate prouct from te Nort, tus ecreases te iviing income class. On te oter an, te rise in te real relative wage causes te Nort to lose its comparative avantage in proucing te intermeiate qualities of te ifferentiate prouct, wic tens to raise te iviing 14 See Appenix A 1.2 for etaile erivations. 31

41 income class. In tis stuy, we only consier te case tat te secon effect ominates, tat is K > Before we look into te resulting canges in trae volumes, we nee to examine its effect on comparative avantage pattern. Proposition 3. A wiening gap of factor enowment between te Nort an te Sout expans te Sout s comparative avantage into intermeiate quality ifferentiate prouct, wic was ominate by te Nort before. Proof: Recall tat te market price for te ifferentiate prouct is etermine by p % ( z) = min a( z, T ) + rb( z), w a ( z) + rb ( z) an tere exists a break-even point z suc tat azt (, ) = wa( z). As te relative real wage in te Nort rises, te break-even point sifts upwar, an te Sout gains comparative avantage into intermeiate quality ifferentiate prouct. Te intuition for proposition 4 is tat te market prices of te ifferentiate prouct for various qualities are etermine by real relative wage of te Nort an prouction efficiencies between countries. All else constant, a rise in te real relative wage in te 15 Matematically, tis means tat we impose te conition tat ( ) ε. See Appenix A A r for etaile erivations. f r R z f α ε ( ) Nn ominates 32

42 Nort necessarily raises its supply price of te ifferentiate prouce over various qualities, an it loses comparative avantage in intermeiate quality ifferentiate prouct as te result. Te effect on te volume of total trae is straigtforwar. In te worl of balance trae, te total trae can be efine as te volume of ifferentiate prouct importe from te Nort. As te iviing income class in te Sout rises, te Sout imports less ifferentiate prouct from te Nort, an te volume of total trae falls necessarily. Lemma3. Te volume of total trae falls as te capital enowment gap enlarges. 1 Proof: Recall tat VT = = α ( z ) f ( ) ( L rk ) + Sout rises, it is necessary tat te volume of total trae woul fall., as te iviing income class in te Te unerlying reason for Lemma3 is tat te Sout extens its comparative avantage into te intermeiate qualities of te ifferentiate prouct ue to te rise of te real relative wage in te Nort. Given tat tere is no cange in te Sout s total income an income istribution, soutern consumers in te intermeiate income bracket woul turn to purcase te ifferentiate prouct omestically. Furtermore, tere is no cange in te igest quality emane by soutern consumers. Te sortening of te quality spectrum exporte by te Nort irectly causes te volume of total trae to fall. 33

43 Lemma 4. Te effect of a wiening enowment gap on te volume of Nort-Sout IIT is positive if te iviing income class in te Nort rises as te result of a wiening enowment gap. Proof: From β = 0 IIT = 2( w L + rk ) ( z ) f ( ), we know tat, new IIT = 2 ( L w rk ) β( z ) ( ) ( ) ( ) ( ), ol 0 f w L rk β z f + + = = It follows te sign of cange in te volume of IIT is etermine by + = = 0 β ( z) f ( ) L w + β z f wl ( ) ( ) + rk + rk. Since te iviing income class in te Nort rises by assumption, te sign of te first term is positive. Furtermore, ue to te fact tat w > 0, K > 0, te sign of te secon term is positive. Togeter, te sign of te cange in IIT is unambiguously positive. Tat is, te volume of IIT rises. Te implication of Lemma 4 is of particular interest to our purpose. We fin tat te wiening of enowment gap reuces te volume of total trae, but is likely to raise te volume of intra-inustry trae. Te implication is tat te volume of inter-inustry trae must fall more proportionately tan te volume of total trae oes. Previous stuy like Falvey an Hierzkowski (1987) as suggeste tat a wier capital enowment ifference can possibly lea to increase volumes of total trae an 34

44 inter-inustry trae, but a reuce volume of intra-inustry trae in a Nort-Sout vertical ifferentiation moel. Teir results are istinctively ifferent from ours. Tis is so because teir moel aopte ifferent assumptions from our moel. Falvey an Hierzkowski assume tat quality ranges prouce by te two countries are constant, tus no quality upgraing taking place in te Sout. A wier capital enowment ifference reuces te overlapping quality range, wic in turn reuces te volume of intra-inustry trae. Also because a wier capital enowment ifference results in a iger capital return in te Sout, te Sout emans more ig quality ifferentiate prouct from te Nort ue to te rise in teir real income. Our moel ignore te income effect associate wit capital return because we impose te assumption tat te rate of capital return is equal for bot countries. Most importantly, quality ranges prouce by te two countries are not constant in our moel. As quality upgraing takes place in te Sout, te overlapping quality range between soutern proucers an nortern consumers woul not necessarily fall. Uner some conitions, we can expect a rise in te volume of intra-inustry trae. At te same time, quality upgraing in te Sout also allows soutern consumers to eman a wier quality range of omestically prouce ifferentiate prouct, wic reuces te epenency on te Nort, an consequently te volume of total trae. Let s consier a reverse situation, in wic te enowment gap narrows ue to FDI flow from te Nort to te Sout s prouction instea of imitation activities. Te fall in te real relative wage in te Nort woul reuce te quality range importe from te Sout, tus reuce te volume of intra-inustry trae. Te volume of total trae rises because te Sout now emans a wier quality range of te ifferentiate prouct from 35