Trade liberalization by less developed countries with a large market size: Meager welfare gains?

Abstract

In this paper we present a one-sector Dixit-Stiglitz-Krugman model of North-South trade, in order to evaluate the welfare and convergence implications of a gradual, bilateral trade liberalization. Using the same formal setting that generated the “new trade theory” wave, we show that a technologically disadvantaged South may diverge in welfare terms with the North, provided that its population and market size were large enough. Both countries are shown to benefit from trade in absolute terms. The causality mechanism deals with a home-market effect, which reinforces the potential exports of the largest economy, and a simultaneous terms-of-trade effect, which preserves trade balance by reducing the relative prices and wage rate of the largest and poorest country.