Size, Trade, Technology and the Division of Labor
We model the implications of the classical ideas that larger markets allow for a finer division of labor and this division feeds back into larger market size. Market size affects specialization due to firm-level increasing returns to scale arising from fixed costs of adopting intermediate-intensive technologies. The impacts are magnified in general equilibrium by an endogenous multiplier—due to input-output linkages in a roundabout structure—and a selection effect due to heterogeneous fundamental productivity and entry costs.
Market size expansions imply (i) larger real income gains than under fixed specialization; (ii) an increase in the aggregate variable cost share for intermediates and a decrease for labor; (iii) increased concentration; (iv) increased average productivity for survivors; and (v) an increase in the intermediate trade share. We derive similar results for intermediate productivity improvements. The effects in (ii)-(v) are absent in a similar model with exogenous specialization.
In a calibration to U.S. manufacturing in 1987-2007 we isolate trade and intermediate productivity shocks, quantify their effects. Trade cost reductions increased effective market size by 7 log points (lp) and generated (i) a real income gain 1.4 times higher than under exogenous specialization; (ii) increases in the intermediate share in production and trade of 2 lp and a reduction in the labor share of value added of similar magnitude. Two counterfactuals highlight the importance of industrial and trade policy. First, a tax that induces firms to specialize increases real income; so the initial equilibrium is inefficient. Second, an increase in trade costs of 16 lp—similar to the recent trade war—reduces market size and real income substantially: almost half way to trade autarky.
I thank Kerem Cosar, Allan Drazen, Eunhee Lee, Felipe Saffie, David Riker and participants at the 2018 Lisbon Theory Conference and 2021 WAITS and AEA Conferences. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.