The curse and blessing of fixed specific factors in small-open economies
This paper investigates how a country's specific-factors endowment affects its long-run economic performance. We build an open-economy version of the two-sector neoclassical growth model in which we introduce fixed industry-specific inputs in both activities. The model predicts the type of international factor-price equalization found by Trefler (1993). We show that, under factor price equalization, differences in input shares between sectors that only use mobile factors and industries that employ fixed specific inputs can explain why nations that seem to have similar factor endowments can show very different income levels. In particular, larger amounts of factors specific to the industry with a lower (larger) labor share lead the economy to enjoy larger (smaller) long-run income levels. The model can also account for overtaking episodes between countries along their development paths.
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