Figure 5 shows how the ratio of steady-state real income levels (north’s divided by south’s) varies with trade costs. As discussed above, we are unable to analytically characterise the transitional dynamics, so the figure approximates the actual predicted path by assuming that the system is always at the stable steady state
that corresponds to each level of trade free-ness. There are clearly three phases in the figure. In the first phase, trade cost reductions have no impact on this ratio. Per capita income levels are identical since 0E=0K= 1/2 and, by symmetry, northern and southern price indices are identical. In the second phase, where ф>фС!”, industry begins to agglomerate in the north.
This is greater than that of the first stage even with A=1 since all investment/innovation occurs in the north (or which ever nation acquires the core).
Finally, notice that while further reduction of ф raises both nations’ real income trajectories (via one-off drops in the perfect price index), liberalization has no affect on the common slope of their growth paths. Routing Protocol
This has two effects, both promoting income divergence. First, as 0K rises, northern steady-state wealth rises while southern steady-state wealth falls. Second, due the ‘home market’ effect (Venables 1987), the shift in industry location has a favourable impact on the northern price index and a dilatory impact on the south’s price index. That is, as long as trade is not costless, southern consumers face higher consumer prices since all trade costs are passed on to consumers. In the final phase, some of the divergence is reversed. The reason is that although the north’s wealth is higher than the south’s, lowering trade costs reduces the difference in north and south price indices up to the point ф=1, where the twro price indices are identical.