PRODUCT DIFFERENTIATION, SKILL DISTRIBUTION, AND SYSTEMS OF CITIES IN A NORTH-SOUTH TRADE MODEL

Abstract

The objective of this paper is to investigate the impact of free trade on the structure of urban systems, skill distribution, income disparities, and welfare. The paper proposes a model that integrates international trade theory and the theory of urban systems. This is done in a two/three sector, spatial, general equilibrium model of a North‐South trade. Each country is populated with a continuum of unskilled workers with heterogeneous potential ability. Workers can acquire skill by investing in training. Thus, skill distribution in both countries is determined endogenously in the model through self‐selection. The economy produces a final good with the use of differentiated intermediate inputs and unskilled workers. The differentiated inputs are produced by skilled workers. Cities are formed in this model as a result of investment in public infrastructures and knowledge spillover among diverse skilled workers. I characterize two different types of spatial equilibria: a closed‐economy equilibrium, in which each country consists of a system of cities without trade, and a free‐trade equilibrium, in which we allow for trade between cities and countries. One of the main findings of the model is that free trade induces further productivity due to the agglomeration of diverse skilled workers. Thus, the model demonstrates a channel through which international trade interacts with the agglomeration economy through urban labor markets. Furthermore, free trade affects the structure of cities within the system.