As history would have it, the cost of doing business internationally has declined sharply since the 18th century. While this trend seems obvious and irreversible with hindsight, it was not obviously predictable in advance, nor was it monotonic. During many periods, and sometimes for decades at a time, the trend was reversed. From 1929 to 1945, for example, international trade became increasingly difficult. Restoration of peace and the founding of GATT allowed the trend to resume, but this was not a foregone conclusion in, say, 1938.
Location and Trade Costs: A Punctuated Equilibrium
Following Krugman and Venables, this section considers the implications of lowering the cost of trade (as captured by the parameter t). To keep the analysis as sharp as possible, we take prohibitive trade costs as our initial condition.
When trade costs are high the symmetric equilibrium is stable and gradually reducing trade costs ^ф>0) produces standard, static effects – more trade, lower prices, and higher welfare (more on this below). There is, however, no impact on industrial location, so during an initial phase, the global distribution of industry appears unaffected by ф.
As trade free-ness moves beyond фса‘, however, the world enters a qualitatively distinct phase. The symmetric distribution of industry becomes unstable, and northern and southern industrial structures begin to diverge; to be concrete, assume industry agglomerates in the north. If 6K could jump, it would be on the interior-non-symmetric equilibrium (shown as the CC locus in Figure 4). Since CC is vertical at фс:|\ the impact on location would be catastrophic. That is to say, an infinitesimal change in trade costs would produce a discrete change in the steady-state global distribution of industry.
Since 0K cannot jump, crossing фса| triggers transitional dynamics in which northern industrial output and investment rise and southern industrial output and investment fall. Moreover, in a very well defined sense, the south would appear to be in the midst of a ‘vicious’ cycle driven by backward (demand) linkages and forward (cost) linkages. The demand linkages would have southern firms lowering employment and abstaining from investment, because southern wealth is falling, and southern wealth is falling since southern firms are failing to invest. The cost linkages would lead to an incease in the cost of southern investment/innovation relative to the north as 0K rises (due to localized learning externalities), and to an increase in 0K since the cost of southern investment/innovation rises relative to the north. By the same logic, the north would appear to be in the midst of a ‘virtuous’ cycle. Rising 0K would expand the north’s relative market size and reduce its relative cost of investment/innovation.