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Arhan S. Ertan

Abstract In a small open economy Schumpeterian growth model where the human capital accumulation is endogenized, the short-run and long run eects of a trade liberalization policy is analyzed. Opening up to trade inuences educational decisions of individuals through its eect on the relative wages of the educated labor force relative to the uneducated due to specialization in low-tech as opposed to high-tech products. Therefore, gains from trade are likely to benet richer countries disproportionately leading to divergences in relative welfares. Countries with low initial experience in industrial production specialize in sectors with low learning potential and may thus loose from trade. The results of the analysis suggest that, in an economy which is relatively more abundant in the unskilled labor resources compared to its trading partners; in short-run, trade liberalization may have benecial eects on the per capita income growth rate whereas in long-run, it may decrease the equilibrium growth rate. An important policy implication of the model is that reforms in schooling system, which increases the returns to (or decreases the costs of) schooling, might cancel out the negative eects of trade liberalization on educational incentives.

JEL Classication: F16, O31, O40 Keywords: Trade Liberalization, Human Capital Accumulation, Economic Growth.

Dierential Eects of Trade Liberalization on Economic Growth: Role of Human Capital Accumulation
1 Introduction

Economic growth depends on the utilization of resources, the rate of population growth, the savings rate, the institutional organization of economic activity, technological know how and human capital, political environment, geographic location, climate and natural resources and some other factors. Countries vary greatly in their growth performances and in their skilled and unskilled labor levels and also in their openness to trade; which is, of course, not an outcome of a random process. The accumulation of physical capital goods is a strong factor aecting the growth of income per capita. Empirical researchers regularly nd in cross-country and panel data sets that there is statistically signicant partial correlation between the rate of growth in the capital stock and the rate of growth in per capita income. Trying to understand the causal relationship underlying this correlation, one may conclude that capital accumulation is, in fact, a response to knowledge accumulation since the technological innovations are raising the marginal productivity of capital, making the investments in physical capital goods more protable. Still, the accumulation of physical and human capital, although it matters, cannot explain much of todays cross-country income dierences 1 . Two observations have motivated many of the recent contributors to growth theory. First, output expansion has outpaced population growth since the industrial revolution. Second, dierent countries have remained on seemingly disparate growth paths for relatively long periods of time. Related to the second observation, there is another one; which is the nding of correlation of national and regional growth rates with a variety of economic, social, and political variables; many of which are aected by government policies. These observations have led the current generation of growth theorists to formulate models in which per capita income grows indenitely and long-run performance reects structural and policy parameters of the local and global economy.
1 See

Prescott (1998) and Easterly and Levine (2001).

The neoclassical model - with decreasing returns to capital, perfect competition, and exogenous technology - does not seem to fully explain the cross-country variation in per capita incomes and national growth rates. There are two seeming tensions between the models predictions and the historical evidence. First, the growth rate of the worlds technological leader has been rising over time, not falling and second, countries appear not to be converging to a common level of per capita income. But, Mankiw, Romer, Weil (1992) argue that the evidence on the international disparity in levels of per capita income and rates of growth is quite consistent with a standard Solow model, once it has been augmented to include human capital as an accumable factor and to allow for crosscountry dierences in savings rates. Perhaps the most convincing direct evidence in favor of viewing industrial innovation as the engine of growth comes from the work of economic historians. For example, Landes (1969) describes the role that new technologies played in spurring the industrial revolution, while Rosenberg (1972) provides a comprehensive survey of the relationship between technological advances and American economic growth since the early 1800s. Looking at the recent economic history, one can easily realize that there are two important trends in the world economy; i) technological innovations are becoming even more important in terms of their contribution to economic welfare, and ii) the countries are becoming increasingly open and increasingly interdependent. These two trends are, in fact, strongly related with each other. The innovations in the communication and transportation technologies make the close contacts among inventors in dierent countries possible; intensifying the motives for trade and integration into the world trading system. Consequently, this rapid transfer of the new ideas and products facilitate the process of innovation, even more. So, the countries should increase their attention into issues like productivity and technology creation to be more competitive and successful in the global economy. The productivity of domestic economic activity may be assumed to be increasing in a countrys stock of knowledge, which itself is typically proportional to the domestically known product designs. This assumption captures the evidence that growth in per capita income has been found to be correlating highly positively with a countrys stock of human capital. Since the advances in technology are mostly engineered by highly trained individuals, and even the applications of the newly invented technology in the production processes requires relatively better educated workers, we need a model that distinguishes the skilled and unskilled labor types to be able to explain the special role of education and training in the growth process. This sort of change in the demand of skilled (or better

educated) labor, resulting from technological changes is referred to as ability-biased technological change. In eect, skilled and unskilled workers generally perform very dierent tasks both in the industrial research laboratories and in the manufacturing enterprise, thus these two types of labor should be considered as distinct and imperfectly substitutable inputs in the production process. As a consequence of this fact, it is very natural to observe increasing wage inequalities among dierent industries and countries, depending on the degree of technological advancements2 . Because of this high wage inequality, the motives for the individuals to have a better education (so as to have a higher skill level and to have the chance to be employed as a skilled laborer) are much higher in a rapidly improving technological environment3 . Therefore, the human factor supply in an economy also becomes endogenous and aected by the rate of technological change. As a result of all these factors, we can talk about a feedback loop, such that;

(i) technological change increases the demand for skilled individuals, (ii) therefore, the relative reward to ability (or skilled labor) also increases, (iii) then, the economy should observe a supply response from the individuals in medium/long run by investing more in human capital, (iv) which, in turn, will result in an increase in the rate of the technological progress.

Another observation of the technological progress experience of the dierent economies is that various manufacturing activities dier both in the intensity with which they employ dierent factors inputs and also in their potential for contributing to innovation and productivity growth. This means the opportunities for technological progress are not uniform across sectors of the economy and dierent sectors employ the factors of production in dierent combinations.
2 See Galor and Moav (2000), Caselli (1999), Bartel and Sicherman (1998), Galor and Tsiddon (1997), Acemoglu (1990). 3 See Doms et.al. (1997).

The Model

The theoretical framework that this paper builds on, is the one provided by recent work on trade and endogenous technical change4 . In these models, R&D spending creates new technology in the form of product design for new and improved intermediate products. Many rms, both domestic and foreign, can benet from a new design by purchasing the intermediate good produced by that design. In that sense, the design is non-rival, which captures the notion of technology spillovers in this framework. Industries in dierent countries gain access to these new-design products to the extent that they purchase intermediate goods from the other, more advanced sources. The model will follow, basically, the set-up in Grossman and Helpman (1991, ch.6) with the economic environment of a small open economy; which does not aect the larger economic environment in which it operates. The implications of this will be that: a) the country will face a perfectly elastic demand for its products, b) on the trade in world capital markets, a small country will take the rate of interest as exogenous, and c) the eect of the R&D activities of the small country on the accumulation of the worlds knowledge capital will be negligible. Moreover, two important assumptions are made which will be eective on the analysis: i) there exists no international technology or knowledge spillovers and, ii) there is no international ow of intermediate goods5 . The main dierence of the model presented here and the model of Grossman and Helpman is that, supplies of skilled and unskilled labor is endogenized in the current model.



To analyze the innovation process, it is assumed that the innovative products often displace earlier vintage goods from the marketplace6 . Firms that manufacture the product with the latest technology earn positive prots in imperfectly competitive markets. So, potential investors compare these prot opportunities with the cost of research. Entrepreneurs will target their research eorts to improve upon the new state of the art and to develop superior versions of these goods. This implies that, in contrast to the Aghion-Howitt model of creative destruction, the technological spillovers
and Howitt (1992), Grossman and Helpman (1991), Romer (1990). assumptions eliminate any direct eect that trade might have on the protability of R&D. 6 The technological innovation process will be based on the notion of quality ladder, as in Aghion and Howitt (1992)
5 These 4 Aghion

will take place in the industry level rather than at an economy wide level.

Intermediate and Final Goods Production In line with the argument that the dierent sectors employ the factors of production in dierent combinations, I will consider an economy in which the production of good Y represents the hightechnology sector which employs skilled labor - HY and the intermediate goods - D, whereas the production of good Z represents the traditional sector that employs unskilled labor, LZ and the intermediate goods - D. Each nal good is manufactured by a Cobb-Douglas technology with constant returns to scale:

1 Y = AY .DY .HY


Z = AZ .DZ .L1 Z


In the above equations D represents the index of the intermediate goods used in that sector and Ai s are arbitrary constants. The index of the intermediate goods is formulated as:

Log (Di ) =

log m(j ) .xi (j ) dj


where xi (j ) is the input of intermediate j of quality m in production of nal good i and is the size of the quality dierential (which is taken to be exogenous, with the quality of the lowest product being equal to 1). Each variety of intermediate goods are produced with similar constant returns to scale technologies, which uses both skilled and unskilled labor types as inputs. I will denote the average (and marginal) cost of producing an intermediate by cx (wL , wH ). By symmetry among the intermediates, all intermediates are employed in equal quantities. If we denote the probability of achieving a quality improvement with (which will be endogenously determined), then the above index of intermediate inputs can be expressed as:

Di = AD .Xi


where Xi = n.xi and n = 1 and where AD (t) = .t represents the average quality of intermediates.

The R&D Sector In this model, technological progress stems from costly investments undertaken by prot-seeking agents. Entrepreneurs will target their research eorts at particular goods at the market and attempt to develop superior versions of these goods. Growth will be sustained if commercial R&D remains as economically viable so that the average quality of industrial products continues to rise. The public good characteristics of technical knowledge (non-rivalness) and the fact that it may be dicult for the originators of the ideas to prevent others from using them without monetary compensation (non-excludability) are relevant in this context. Every product can potentially be improved an unlimited number of times. Firms that manufacture state-of-the-art products earn positive prots in imperfectly competitive markets. Potential investors foresee these prot opportunities and compare them to the cost of research. The R&D technology is constant returns to scale and requires only skilled labor - H . The unit input requirement in the R&D sector is a = a(S ), which is assumed to depend negatively on the duration of education - S 7 . Since we denote the probability of achieving a quality improvement with (which will be endogenously determined), the cost of that rate of improvement becomes; wH .a. . Denoting the stock market value of an innovative rm with v , the expected stock market value becomes v. . With the free-entry assumption, the equilibrium condition for the value of a rm becomes:

v wH .a

(with equality when > 0)


I assume that the innovative rms engage in price competition, then the industry leader can charge:
7 This means that, productivity of skilled workers increases only in the reserach labs with the duration of education that they get.

Px = .cx (wL , wH ) And the price of the intermediates will be:


PD = Px / AD Then the prots of the leader rm become:


= (1

1 )..E


where E = pY Y + pZ Z represents the total value of the nal output in the economy.

No-Arbitrage Condition To determine the stock market valuation of prot making enterprises, the relation between the expected equity returns and the interest rate on a riskless bond should be considered. The expected return on any stock, including the ow of dividends (prots) and expected capital gains and capital loss should be equal to the return on an equal size investment in a riskless bond. This relationship gives us the following no-arbitrage condition:

r.v = + v .v


Together with the free-entry condition above, the no-arbitrage condition implies that (using also the equation for prots):

1 w H v = + r [.(1 ).E = = . log . = r v wH Therefore:



1 ).Q = ( + ).a.w H 7


= where Q


and w H =


are the productivity-adjusted values of Q and AD .

Preferences of the Individuals The inter-temporal preferences of the individuals take the following form:

Ut =

e.( t) . log [u (CY ( ), CZ ( )] d


where the terms Ci ( ) represents the consumption of nal good i at time and u(.) is assumed to be homogenous of degree one. Utility maximization implies that the optimum growth path of the expenditures should satisfy: E =r E (13)

Human capital (skilled worker) accumulation results from the individuals decision about devoting time to schooling or not. So the factor supplies will be endogenous together with the rate of technological change. It is assumed that the population is constant and agents are identical in their capacity of learning. Each individual has a lifetime interval of nite length T for work. The lifetime income of an individual who is at the beginning of his working age at time t and chooses to become an unskilled worker is equal to:

VL =

e.( t) .wL .d =

1 e.t .wL


It is assumed that the education is costless except the time allocated for it. Then, the lifetime income of an individual who is at the beginning of his working age at time t and chooses to invest in education to become a skilled worker is equal to:

VH =

e.( t) .wH .d =

1 e.t .wH


where S is the optimally chosen duration of education taking into account the discount rate (),

lifetime interval for work (T ) and reward to human capital8 . At the equilibrium, the values of these two income streams should be equal to each other, namely VH = VL , which implies that: = (1 e.T ) wH = .S = > 1 wL (e e.T ) (16)

Therefore at the equilibrium, relative rewards of the skilled and unskilled labor depends on duration of schooling as long as the factor supplies are constant.

Factor Market Equilibrium The last equilibrium condition for this economy reects the clearing of factor markets. Unskilled labor is used in the production of intermediates and good Z , whereas skilled labor is used in the production of intermediate goods and good Y but also employed in the research labs. Therefore, the market clearing conditions for labor can be written as: H = (aHY + aHx .axY ).Y + (aHx .axZ ).Z + (a. ) (17)

L = (aLZ + aLx .axZ ).Z + (aLx .axY ).Y where aij are the cost minimizing unit input coecients:


PY aHY = (1 ). w H PZ aLZ = (1 ). w L

PY axY = . P X PZ axZ = . P X


aHx =

cx (wL, wH ) wH

aLx =

cx (wL, wH ) wL

Since the relative prices are constant at the equilibrium trajectory, the above unit input coecients are also appears to be constant. Multiplying equation 17 by wH and equation 18 by wL and summing up the resulting equations using the productivity adjusted parameters and the relation
8 This type of approach to individuals decision making for investing in education builds on the framework of Findlay and Kierzkowski (1983).

between the prots and output, one can obtain the following aggregate resource constraint: (1 (1 1 )) w H .(H a ) + w L .L = Q. (20)

which equates total value of primary resources to total value of the resources employed in R&D and in manufacturing9 .

Equilibrium Growth Rate Equation 20 (aggregate resource constraint) and equation 9 (no-arbitrage condition) describe the economys allocation of resources to the manufacturing and research activities. These equations implicitly involve the productivity adjusted factor prices, which are constant relative to each other at equilibrium, as long as is small enough (less than a critical value, say c )10 . Solving aggregate resource constraint and no-arbitrage condition together, we nd the following equation for the equilibrium innovation rate: = (1 1 h 1 ) (1 (1 )) a (21)

wL where h = H + L w measures the market value of the resource endowment in units of human H

capital. = PY . Y + PZ .Z and since total Now, the TFP growth rate can be calculated as follows: Since Q expenditure is equal to total output, namely: E = A D .Q and using the equation for : D E A = . = . log . E AD (22)

Thus, we conclude that the long-run growth rate of total output increases with the countrys resource base - h. The equilibrium allocation can be depicted in Figure 1.
9 Note 10 When 1 that (1 ) is the prot rate in the intermediate sector. > c , the above conditions are not linear, since the country stops producing Y, due to high R&D




Opening Up to Trade

Now, with the small open economy assumption, the prices of the nal goods will be determined by the worlds prices. Also, in this small economy, the agents can borrow and lend at an exogenous and constant international interest rate r (assuming perfect capital mobility). Since the relative prices of the output will be constant and determined by the world prices, we can use the analysis in
PY the previous section. The only dierence will be that the unit input coecients aHY = (1 ). w H PZ and aLZ = (1 ). w will be determined by the world prices. But the other input coecients L

will remain to be same and also constant at the equilibrium because the relative wage (at the equilibrium) is determined by the education decision of the individuals.

Figure 1: Equilibrium Innovation Rate

By the Stolper-Samuleson eect, exposing the economy to international prices leads to a decrease of the relative skilled wage if the country is less skill abundant (and an increase of the relative skilled wage if the country is more skill abundant) than the rest of the world. Hence, open markets


increase entry into the skilled labor force in skill abundant countries and decrease them elsewhere. If the country is abundant in unskilled labor, after opening up to trade, the price of the good Y (human capital intensive good) will decrease and the price of the good Z (unskilled labor intensive good) will increase (by the standard Stolper-Samuelson theorem). Then, the rms will adjust their optimum input decisions and either try to decrease the wage of the skilled individuals or decrease their demand for skilled labor if the relative wage remains constant (see the functional form of cost minimizing unit input coecient for H above). In any case, this will create a pressure on the individual decision making such that either fewer individuals among new generations will choose to invest in education and become skilled workers or individuals will allocate less time for education (optimal level of S will be lower). It means that either the the resource base will be lower or a (unit input requirement in the R&D sector) will be higher and hence the long run growth rate will be lower (see equation 21 and recall that
wL wH

< 1). Of course, these results will be reversed if we

consider a human capital abundant country. To summarize the results of the analysis, in an unskilled labor abundant country: In Short-Run: Supplies of skilled and unskilled labor will be xed but relative price of the human capital intensive good decreases (PY / PZ ). But then the relative wages of the skilled
H workers have to decrease ( w wL ) increasing the resource base h (since employing skilled workers in

R&D sector will be cheaper) and therefore both the innovation rate and the growth rate of output will increase. In Long Run: Relative price of the human capital intensive good will remain at its lower level (PY / PZ ). But supplies of skilled and unskilled labor will not stay xed and respond to
wL ), resulting in a relatively lower supply of skilled workers the change in relative factor prices ( w H compared to before ( H L ), either until the relative wage becomes equal to again or the time

allocated for education decreases which also decreases the productivity of skilled workers in research labs. Therefore, innovation rate and the rate of output growth will be slower in long-run.



Since various manufacturing activities dier both in the intensity with which they employ dierent factors inputs and also in their potential for contributing to innovation and productivity growth, the opportunities for technological progress are not uniform across sectors of the economy. Dierent sectors employ the factors of production in dierent combinations; which points out the necessity of a sector-by-sector and country-by-country analysis to better understand the possible results of a trade policy. With a simple open economy Schumpeterian growth model where the human capital accumulation is treated as endogenous, the above analysis shows that trade liberalization may be harmful (in terms of the long-run income growth level) for an economy which is relatively more abundant in the unskilled labor resources. The above framework is a preliminary attempt to identify the eects of international trade on per capita income growth. The analysis of this model totally neglects the possible positive eects of technology transfers via dierent channels (such as foreign direct investments (FDI) and the multinational companies (MNCs) or disembodied technology in traded intermediates). In the above model, innovations are conned to a sector producing non-tradable goods, and two nal output sectors are equally intensive in their use of the innovative products. These assumptions eliminate any direct eect that trade might have on the protability of R&D. The model also, does not say directly anything about the welfare eects of opening up to trade. So, the results cannot say much about the socially desirable trade policies. But, what the model suggests is that, it does not sound plausible to suggest that trade openness must have similar eects across countries, regardless of country specic circumstances, which should be analyzed in a more detailed way. In practice, the long-run eects of the policy of trade liberalization for a country specializing in low-technology sectors (or natural resources) may be less benecial (or even be harmful) than for a country specializing in high-technology sectors. In order to come up with solid conclusions, consistent with these dierential long-run eects of trade openness on dierent countries, empirical work may enlighten our ideas. Overall, much of the empirical work supports the idea that openness is growth promoting, but it is controversial and subject to a wide variety of criticisms.


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