Markups, International Specialization, and the Gains from Trade

This paper develops a new theory of international specialization that tractably combines all aspects of North-North and North-South trade into one model. The new theory also provides an alternative explana- tion for many other well-established facts, most notably the âWashington applesâ effect. The theory builds upon, and retains the central elements of Krugman [1980]. In the new framework, North-North trade is governed by national product differentiation. North-South trade is governed by a new channel of across product specialization that has been overlooked in the literature. Specifically, there are many products and each product comes in different varieties. Products differ in how (horizontally) differentiated they are. Monopolistically competitive firms charge a higher markup for varieties of highly differentiated products. In equilibrium, rich countries specialize in highly differentiatedâhigh markup products, while poor coun- tries specialize in less differentiatedâlow markup products. To quantify the gains from trade, I estimate the structural parameters of the model using disaggregated data. Incorporating the new channel of across- product specialization into the Krugman model magnifies the gains from opening to trade by around 200%. Despite trading less, low-income countries experience the largest gains from trade liberalization.