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A Ricardian Model with Endogenous Comparative Advantage and Endogenous Trade Policy Regimes

  • Wen Li Cheng
  • Meng-chun Liu
  • Xiaokai Yang

This paper develops a general equilibrium model with transaction costs and endogenous and exogenous comparative advantages. In the model, the governments are allowed to choose between tariff war, tariff negotiation, and laissez faire regimes. The model shows that the level of division of labor and the volume of trade increase as transaction conditions improve. In the process of moving to a high level of division of labour, a country may receive more gains from trade even if its terms of trade deteriorate. This is because an expansion of the network size of division of labour can generate productivity gains that outweigh the adverse effect of the terms of trade deterioration. When a high level of division of labor occurs in general equilibrium, if both countries play a Nash tariff game, a tariff war may break out, which can dissipate all the gains from trade. Facing this risk, all governments would prefer trade negotiations to a trade war. A Nash tariff negotiation would result in zero tariff rates. If a medium level of division of labor occurs in general equilibrium, then unilateral tariff protection and unilateral laissez faire policies would coexist. The result provides a plausible story about the evolution of trade policy regimes, and highlights the importance of trade negotiations in achieving trade liberalization.

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Paper provided by Center for International Development at Harvard University in its series CID Working Papers with number 12.

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Date of creation: Apr 1999
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Handle: RePEc:wop:cidhav:12
Contact details of provider: Postal: Center for International Development at Harvard University (CID). 79 John F. Kennedy Street, Cambridge, MA 02138.
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  1. Grossman, G.M. & Helpman, E., 1993. "Trade Wars and Trade Talks," Papers 1-93, Tel Aviv.
  2. Dixit, Avinash K & Kyle, Albert S, 1985. "The Use of Protection and Subsidies for Entry Promotion and Deterrence," American Economic Review, American Economic Association, vol. 75(1), pages 139-52, March.
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