From Costas Arkolakis, Natalia Ramondo, Andrés Rodríguez-Clare, and Stephen Yeaple:
The process of globalization features increasing international specialization in innovation or production. To assess the welfare implications of this process, we develop a quantitative, multi-country general equilibrium model where firms can serve a market by exporting from their home country, by producing in the foreign market, or by exporting from a third loca- tion. In making their location decisions, firms face a tradeoff: trade costs may induce firms to open many plants to be near local customers but this is at the expense of producing in the country with the lowest production cost. In the aggregate, countries that have a high productivity in innovation relative to production tend to specialize in innovation but home market effects lead production to concentrate in countries with large “market potential” and draw innovation towards countries with large “production potential.”
Our quantification of this framework reveals that asymmetric bilateral trade and MP costs play a critical role in determining the structure of global innovation and production. We also demonstrate that falling MP costs generate efficiency gains but can make some countries worse off, particularly when innovation is induced to leave a country, thereby exposing it to a deterioration in its terms of trade. Within countries, workers with specific types of skills can lose even as national welfare rises. Finally, we use our model to study the impact of the integration of China into the global economy. We find that despite having a large impact on the structure of global specialization, with production largely migrating to China and innovation migrating to the developed world, workers in the developed world largely gain.