Integration, Fragmentation and the Geography of Welfare Author(s): Barbara Dluhosch Source: The Scandinavian Journal of Economics, Vol.

108, No. 3 (Sep., 2006), pp. 459-479 Published by: Wiley on behalf of The Scandinavian Journal of Economics Stable URL: http://www.jstor.org/stable/4121609 . Accessed: 06/07/2013 14:25
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Scand. J of Economics 108(3), 459-479, 2006

DOI: 10.1111/j.1467-9442.2006.00466.x

Integration, Fragmentation and the Geography of Welfare

Barbara Dluhosch*
HelmutSchmidtUniversity/University FAF,D-22043 Hamburg, Germany dluhosch@hsu-hh.de

Abstract
The welfareeffects of tradeintegration with endogenous technologyare examined production in a monopolisticcompetitionframework. In additionto explainingindustrylocation,trade effects on local welfare,the analysishighlightsthe endogenous patternsand accompanying in the of when economiesopen up to trade. costs change supervising production fragmented than size) as a skill-intensive (rather By regarding fragmentation activity,factorproportions albeit not affect the from trade. international of distribution Nevertheless, strongly gains for a wide rangeof parameter in values, even a skill-poorcountrycan participate generally, the gains-despite loss of industry. trade; labor markets;technology choice; Keywords:Economic integration;intra-industry welfareeconomicanalysis JEL classification: F02; F16; 033; R13

I. Introduction
The process of integrationis not always embraced,regardlessof whether such policies are broughtabout by trade or factor mobility.Rather,there is widespreadconcernamong the generalpublic that welfare is negatively The prowhole industries. affectedwhen competition fromabroadthreatens lends cess of EU enlargement is a case in point. AlthoughEU integration politicalstabilityto EasternEuropeand is generallywelcomed,competition from the new memberstates makes many apprehensive.1 Economists,however,emphasizethe gains associatedwith specialization. Theiranswerto the criticsis that even when openingup is accompanied by intereffects,as in the case of factor-proportions-driven strongdistributional industrytrade, winners are able to (over-) compensatelosers. Moreover,
* Thanks are due to Michael Burda, HartmutEgger, Peter Neary, Doug Nelson, Eric Toulemonde,two anonymousreferees as well as participantsat the EEA Congress in in and LaborMarketPerformance Stockholm,the IZA workshopon EuropeanIntegration for Bonn, and the annualconferenceof the GermanEconomic Association in Innsbruck discussionsand suggestionson a previousversionof the paper.Financialsupportfrom the GermanResearchFoundation is gratefullyacknowledged. SFora recentdiscussionof the EU services directive,see e.g. TheEconomist(2005). O The editors of the Scandinavian Journal of Economics 2006. Published by Blackwell Publishing, 9600 Garsington Road, Oxford, OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.

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460 B. Dluhosch

tradeand,in particular, It is generallypreEU tradeis largelyintra-industry. sumed that intra-industry trade may well constitutea Paretoimprovement as it suggestsad(makingeveryonebetteroff), even withoutcompensation, ditionalgains beyondthose from comparative along Heckscheradvantage Ohlin lines. By cateringto preferencesand by economies of scale, it can mitigate (negative)effects on welfare due to differencesin factor proportions. Hence, if tradeis beneficial to a countryin an overallsense, thenso goes the general argument-intra-industry trade is even more advantageous.2 the notionof tradeas beneficialin an overallsense is implicitly However, is to of empiricalstudieswhichfind thatproduction challengedby a number a largeextentfragmented across countries.3 into production stepswithinand affects the ratio of fixed to variablecosts, i.e., in orderto Fragmentation save on marginalcosts, firms incur higher fixed costs due to managing and coordinating is a fragmented process.Hence, fragmentation production closely linkedto increasingreturnsand imperfectcompetition. Yet, as pointed out by Helpman and Krugman (1985, Ch. 9) under imperfectcompetitiontrade does not necessarilyhave to be welfaredistrithat includeswithin-country maximizingfrom a nationalperspective butionalissues-particularly not if exploitingeconomies of scale reduces diversity.However,despite addressingthe trade-offbetween diversityand scale, Helpmanand Krugmanfail to providea detailedanalysisof parameters crucial for the gains and their distribution across countries.Nor do affects welfare, althoughthe latter does they explore how fragmentation affect the trade-offbetweendiversity(or variety)and productivity (or scale for that matter). In an attemptto fill this gap, we examine the trade-off,includingthe of production,i.e., when technology is endoprocess of fragmentation genized, with respect to welfare.4 It is shown that for a broad range of values, trade is beneficial-despite both the trade-offand the parameter to promoteeconomies of scale. Since fragmentendencyof fragmentation tation is considereda skill-intensiveactivity, factor proportionsremain a tradewhere,from a national key issue. Yet, in contrastto Heckscher-Ohlin
2 Anotherexception

costs. which has been exploredextensivelyis tradewith transportation differwith respect to the theoryand empiricsof economicgeography Althoughcontributions incomedifferences to detailsand results,some lend supportto the concernthatgeographical countriesmay even lose. or that,due to the small size of local markets, mightbe aggravated For detailssee e.g. Krugman and MidelfartKnarvik(2002), Forslid (1991), Forslid,Haaland and Wooton(2003), Baldwin,Forslid,Martin,Ottaviano and Robert-Nicoud (2003). 3 See e.g. Campaand Goldberg(1997), Feenstra(1998), Yeats (2001), Yi (2003), Jones, Kierzkowski and Lurong(2005) and, with a focus on EU integration, Baldone,Sdogatiand and Moffatt(2001). Tajoli(2001) and Lyons,Matraves 4 Ekholmand MidelfartKnarvik(2005) also examineendogeneityof technologybut focus on firm heterogeneity and labor-market effects ratherthanwelfare.
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and the geography of welfare 461 Integration, fragmentation perspective,gains are ceteris paribus larger the more diverse countries are in terms of factor proportions, countriesshould not be too diverse to realize gains from trade.5When technology is endogenous,however,the skill rangefor beneficialtradeis largerthanotherwise,despitethe fact that reducesvariety. increasesscale and simultaneously Moreover, fragmentation while the role of factorproportions turnsout to be robust,details depend on parameter values such as the fractionof income spent on variousgoods and distributional sharesof factorsin production. relevantin the welfare economics of intraBy identifyingparameters trade with the paper also provides insights into industry fragmentation, another important policy issue: the geographical distribution of the gains across countries. If trade integrationis-at least from a national issues can be regardedas perspective-mutuallybeneficial, distributional a nationalratherthan, for instance,an EU matter.It indeed turnsout that in the gains for a broad even a countrywhich loses industryparticipates values. Within this range, the demand for side payrange of parameter in the context of integration articulated (for instance, ments, as frequently the focus on geographical via regionalfunds), is not warranted. Moreover, income differences(acrosscountriesor regions),which is commonpractice in the EU, appearsto be as inappropriate a yardstickfor the gains from tradeas is the localizationof firms. For ease of comparison, the analysisdrawsto a largeextenton the standardworkhorse model of intra-industry trade.More specifically,we try to and trade on welfare highlightthe impact of (endogenous)fragmentation as developedin Burda of fragmentation, by applyingthe microfoundations trade and Dluhosch (2002), to the basic Krugman(1981) intra-industry to intemodel. The latter considerstechnology as constantand invariant while the formertreat technology gration,i.e., there is no fragmentation, as endogenous,but do not considertrade, specializationor welfare.6The is govin which fragmentation paperthus differsfrommost of the literature or by factor intensities erned either by a love-of-varietyfor intermediates allocationof on the international of components, and which focus primarily Deardorff Ethier intermediates as in 2001), (2000, (1982), production, e.g. Arndtand Kierzkowski (2001) and Feenstra (2001), Jones and Kierzkowski and Hanson(2003), or which include transportation costs, as in Venables coordination, requires (1999). Since a more fragmented process production skills. By emphasizingthe role of it increasesdemandfor (management)
in termsof gains froman individual perspec(1981) considersfactorproportions 5 Krugman tive (and withoutfragmentation) ratherthan from a nationalperspective. as factorendow6 Burdaand Dluhosch(2002) examinewhat happensto the skill premium and while explicitlyintroducing mentschangea la Rybczynski, trade,tracking specialization, analyzingthe trade-offbetweendiversityand scale with respectto (local) welfare.
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462 B. Dluhosch

these services,7 the paper shares aspects with Francois(1990) and Francois, Grier and Nelson (2005) as well as Markusen(1989) and Feenstra and Markusen (1994). However,the lattertwo are based on an Ethier-style love-of-intermediates setup, withoutexplicitlymodelingthe forces responsible for the cost effectivenessof fragmentation and the resultingtrade-off betweenscale and varietywith respectto welfare. The paper is organizedas follows. Section II sets out the basic model of endogenousproduction technologyand illustratesthe key role of labor as marketsin determiningthe relative cost of fragmentation, interpreted In Section III we the price of business services requiredin fragmentation. show general equilibriumresults for the closed and the integrated(i.e., world) economy.Sections IV and V focus on the impact of trade on the location of industriesand-by examiningthe trade-offbetween scale and Section VI concludes. variety-the welfareeffects with fragmentation.

II. The Model

Supposean economy is populatedby high (H) and low (L) skilled labor, labor supply is inelastic and labor marketsare segmentedby skill level. Productionin this model economy consists of two sectors, consumerserare vices and manufacturing. Consumer services,which serve as numrraire, consists of sector producedby low-skilled labor only. The manufacturing both severalsubsectors.First,there is a manpower types industryin which of labor are combinedinto an intermediate labor service. This service is sold to the second subsector,direct production,where it is either used or the production manufacture process wholly to producea differentiated is fragmented into a numberof production steps. Ceterisparibus, more fragmentedproductionwith a largernumberof steps lowers unit costs. However,it also requiresmore management(or business serindirectproduction) which is suppliedby the thirdsubsector, vices, in order to coordinatethe various productionsteps. This tends to increaseproductioncosts. There is thus an optimalnumberof production which is drivenby the tradeof manufactures steps in the directproduction off between these two cost components.8Figure 1 displaysproductionin the model economy,startingwith low- and high-skilledlabor (LHS) and ending with the two sets of output,consumerservices and (differentiated) manufactures (RHS).
(1990) who did not, however,set 7 This idea can be tracedback to Jones and Kierzkowski up a formalmodel. 8 By focusingon fragmentation, we abstract from IO and strategicconsiderations which may also be important in fragmentation relatedto FDI; see e.g. McLaren(2000) and Grossman and Helpman(2002).
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Integration, fragmentation and the geography of welfare 463

Inputs Consumer Services
Lowskilled

Outputs (FinalGoods)

0
'

employedin consumer
services

labor

E.
0

u,

Low skilled

laboremployed o manuf acturing Highskilled

0 labor employed in .

Manufacturing (perfectly competitive) directproduction,

manpower
industry

more orless

cc M

0
E 0o

produces a labor composite (of highandlowskiled labor)

-"

fragmented

manufacturing "2 X P_ I Highskilled labor employedin business services indirect production (business services, forsupervisingand coordinating production)

Fig. 1. Inputs,productionand outputin the model economy

The business services requiredto managea fragmented proproduction cess use high-skilledlabor,so thatlabordemandin this subsectorcompetes with employwith the demandfor high-skilledlabor in direct production, ment in business services and direct productiondenoted by Hs and Hp, respectively.Low-skilled labor, by contrast,is employed in either direct conditionsare production, Lp, or consumerservices, Ls. Full-employment therefore
H = Hp + Hs L = Lp + Ls. (1) (2)

Product Markets conThe two types of final goods marketed in the economy,(homogeneous) i= sumer services, xo, and (differentiated) manufactures, 1,..., xi (with consumer according to a n), enter into the utility of a representative Cobb-Douglasfunctionalong the lines of Dixit and Stiglitz (1977), with
expenditure shares (1 - p) and p, respectively:

U = x

"

i= 1

i '7

(3)

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464 B. Dluhosch so that for n large, the elasticity of demandfor manufactures is approxiBoth tradable of to be are assumed mately q7. internationally types goods on behavior etc. in the case of consumer (call centers, services). Optimal the consumerside yields the followingfamiliaraggregatedemandfunctions for given income Y and relativepricepi,j of manufacture i, j:
xi p=" =

p Yp7

(4)
(5)

xo = (1 - ,A)Y,

with
Y = wLL + WHH (6)

as aggregateincome and WL, H as wages of low- and high-skilledlabor, respectively. (Partial) Equilibrium in the Marketfor Consumer Services Firmsin this sector supplyconsumerservices using low-skilledlaboronly, function: accordingto the following linearproduction
xo = Ls.

(7)

The marketfor consumerservices is thus clearedif, for given Y, supplyof consumerservices (7) equals demand(5):
Ls = xo = (1 /p)Y. (8)

(Partial) Equilibrium in the Marketfor Differentiated Manufactures Production LaborServices.Givenfactorprices,the producof Intermediate tion of differentiated manufactures startswith inputsLp andHp suppliedby as a coma perfectlycompetitivemanpower industryto direct production posite of the two types of laborunderminimumcost conditions.This labor service is assumedto be producedaccordingto a Cobb-Douglasfunction f(Hp, Lp) = Hp L -. Output of the manpower industry has the value
pcHpL,1-

supply (by the manpowerindustry)and demand(by direct productionin manufacturing). Direct Production.The bundles of labor services enter direct production where they can be combinedwholly, i.e., unfragmented production,or in
C
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= pc(H - Hs)o(L - Ls)'-?, with price pc determined by

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Integration, fragmentation and the geography of welfare 465

denoted with the extentof fragmentation steps, i.e., fragmented production, z. index In either an amount of the labor-services by case, compositerein the costs F. direct fixed rise to of firm each quired production gives Variable if not, is on whether costs, instead,depend production fragmented: variablecosts are the the the more Otherwise, fragmented production, Txg. lowerthe variable function with the iso-elastic cost costs, savingsabidingby whereparameter denotesthe effectivenessof fragmentation v(z) = 7 fz,', in cost reduction.9 variablecosts are Vz Hence, with fragmentation, Due to the symmetryof the model, each firm which producesa differen,xi. tiatedmanufacture operateson the same scale and index of fragmentation. We can thus drop subscriptsi, j and focus on a representative firm. Equilibriumthen requiresthe value of the directcost input(with both fixed and variableparts) of n firms (where n denotes both productvariety and the numberof firms) in manufacturing to equalthe costs of hiringthe required amountof high- and low-skilledlabor from the manpowerindustry(LHS and RHS of (9), respectively).
(F + Vz-lx)n = pc(H - Hs)?(L - Ls)1-0. (9)

Ignoringthe integer problem,the equality holds for a sequence of production modes, each for given outputand extent of fragmentation. More fragmented productionimplies that economies of scale on the firm level are exploitedto a greaterextent, i.e., outputx is largerwhile the number of firms n in manufacturing is smaller,and less of the labor compositeis needed to produceone unit of x. However,all three variablesz, x and n are determined endogenously. BusinessServices.If the production firms incurmanprocessis fragmented, those for direct to for in business addition services, agement costs, i.e., If the direct produceach in firm z features production. productionsteps is given tion of manufactures, services for business demand economy-wide nz= Z. These business at services are supplied price pz by competiby firms which use skilled laborHs accordingto the tive, profit-maximizing constant-returns productiontechnology Z=AHs with productivityparameter A. The marketprice for business services pz equates demandfor business services z from n manufacturing firms with total supply
nz = AHs. (10) The Calculus of the Firm with Respect to Direct Production. If, due to

realizes each firm in the directproduction of manufactures fragmentation,

bounds thatmarginal we alsoimpose costsatz = 0 areinfinite. Below, explicit 9Thisimplies on y so thatfragmentation is not"tooeffective" in costreduction.
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466 B. Dluhosch
production steps in directproduction .-.............................................................................................................................

v
fragmentation

z ..

finalgoods
"varieties"

reduces variablecosts

pzz
... and increases managementcosts

Fig. 2. Cost effectiveness of fragmentation

cost savings with respect to variable costs according to v-z-', while also incurringadditionalcosts pzz for business services (as illustratedin firm can be writtenas Figure2), profits 7r of the representative
r = px - (F + ?z-7-x + pzz). (11)

The trade-off between the two cost componentsis a matter of relative prices which, in turn, are determinedby labor markets.However,with free entry in direct production,profits are drivento zero by endogenous variationof n. Optimalbehaviorof firms in symmetricproductmarket then yields the scale (12), the price (13), the extent of fragequilibrium mentation(14) and,via the zero-profitcondition,the numberof firms (15) in manufacturing:

x - 7( 1 -rj S- 1

F(X 1) F(r- (-1)

--

1) 7Y(j

pz
-

/V

(12 (12)

(1

1))pz

q7qF

(13)

7(rj - 1)F -= (1 - 'y(r - 1))p z n

=I

(14)

(1 - t)

77F

Ls.

(15)

We limit our attentionto economicallymeaningfulequilibria by assuming that -y < 1/(q - 1) throughout. Accordingto (12)-(14), the relative price
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Integration,fragmentation and the geography of welfare 467

of business servicespz is crucial in the calculus of the firm. Since pz is endogenous,it will be influencedby conditionsprevailingin labormarkets, as which thus affect the scale, the price and the extent of fragmentation well as, via its impacton sectoralemployment, the numberof firms. Hence, in orderto close the model, we have to considerlabormarkets. Closing the Model.- Labor Markets We assume that high- and low-skilled labor is supplied inelasticallyby householdsin proportion n = L/H to perfectlycompetitivelabormarkets. between sectors is costless, so that the demandcurve for each Mobility of in labor each sector is the "supplyprice"to the other.The relevant type labor-market are thus the equalityof wage and value conditions equilibrium in direct and consumer(business)services for marginalproduct production both types of labor,low (16) and high (17) skilled:10
=

WL =

PC(1

0)

(L

Hs)-

Apz = WH= PC

- Ls

(H

LsLs )

(16)

(17)

III. General Equilibrium Pre- and Post-integration

The model thus consists of a system of 10 equations,(4), (5), (7), (9), (12)-(17) in 10 unknownsxo, x, p, z, n, pz, Pc, Y, Ls and Hs. Solving the model, we obtainthe equilibrium quantityof consumerservices and of each of the differentiated as well as the equilibrium manufactures, prices, the equilibrium numberof firms, etc. in the economypriorto integration. We now introduce a second country and denote foreign variables by an asterisk (e.g. foreign factor proportions:n* = L*/H*). In order we use to distinguishvalues of variablesex ante and ex post integration, the superscript ie when referringto the integrated(world) economy.Factor proportions of the integratedeconomy are thus Kie = (KH + K*H*)/ (H + H*). Solving the model, we obtain the price of business services
Since consumerservices serve as numeraire, labor demandoriginatingfrom this sector o0 is infinitely elastic at 1 (LHS of (16)), the value marginalproductof unskilled labor in these services, while the marginalproductof low-skilled labor in the manpowerindustry is pc(1 - O)((H - Hs)/(L - Ls))' (RHS of (16)). As for high-skilledlabor,demandfor labor in the businessservices sector is infinitelyelastic at Apz (LHS of (17)), which in a competitivelabormarketequalsthe marginal productof high-skilledlaborin the manpower industry(RHS of (17)).
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468 B. Dluhosch

pZ in the integrated economy:" 0 + (1 - 0)7

77
ie

(18)

(1 o 1The lower the ratio of low- to high-skilledlabor,the lower is the relative price of business services. Note that since the relative price of business services and the index of fragmentation are inverselyrelated (see (14)), the extent of fragmentation is independentof the size of the economy, is thus larger, Productionfragmentation though not of factor proportions. the more abundantis high-skilledlabor,12while via fragmentation, scale of production in manufacturing are is largerand differentiated relagoods labor if skilled a hosts force, tively cheaper.Hence, Foreign relativelylarge business services in Home will become cheaper;fragmentation and scale increasewhile prices of manufactured goods decline. This differs substanfrom models of trade in which both the scale tially many intra-industry and the price do not depend on factor endowmentsor marketsize, but remainunchangeddespite integration. In such models, factor supplies and the extent of the market are only relevant for the number of firms in equilibrium.

IV. Industrial Location in Trading Equilibrium

As mentionedin the introduction, based on trade the generalpresumption is that with theory openingup is associated gains for both tradingpartners. The results are less clear, however,if variety as well as quantityin the consumptionof each good matterfor welfare. Yet, throughits impacton incomes and technology,trade affects the trade-offbetween variety and as well as welfare.Let us examine quantityand thus specialization patterns these issues in detail.
" Solve (16) for pc and insert the result into (17) to obtainthe relativeprice of business servicesPz as a functionof services employment pz in (10) and, Ls, Hs. Then, substitute nz to obtain an equationin high- and low-skilledservices employmentonly. subsequently, condition(9) and substitutefor x and z by using (12) and Next, take the market-clearing (14), and, finally,pc, n to obtaina second equationin Ls, Hs. Solving the reducedsystem of two equationsin Ls and Hs gives the equilibrium price of business servicespz in the closed economyas a functionof parameters A, 0, q,, y, p and factorproportions n. In order to obtainp", substitute in the integrated for K by the factorproportions economy prevailing
Kie

12 in business services Note that fragmentation also increaseswith exogenousimprovements in information A, for instancewith advancements productivity technology(whilepz declines).
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and the geography Integration, of welfare 469 fragmentation We begin by assumingthat the integrated economycan be replicatedso that factor-price = w~j equalizationholds, i.e., H = w ; w =LT w = w, with superscriptT denoting values in wtrading equilibrium.This rules out equilibria with full specialization. In addition, we assume that trade only takes place with respect to final goods, i.e., horizontally. Note, however, that in this frameworkvertical trade, i.e., outsourcing, would affect the geographicalallocation of industries while welfare conclusions-the main focus of this paper-are likely to remain valid. 3 The location of industriesand thus the patternof specializationare obtainedby consideringtradeflows. FollowingDixit and Stiglitz, consumers betweenHome- and Foreign-made goods. split their income proportionally Tradeis balancedif the value of Home's importsequals its exports, and trade-balance equilibrium yields the numberof firms located in Home as
ieHF - 1)Y 7( F P) 1) + (1 O)(r 7(r (1 Given , (r*), the number of local firms nT is an increasing func-

1-

tion of K* (r,)-the countryin whicheverbusiness services are relatively cheaperbefore integrationwill succeed in attractingindustries.They remain the same as pre-integration though, unless relative factor supplies differ:
n
_

T0(1 0)((1- 7(q-

1)) + (1

1)

(e

A)r
--

)H

(20)

With r,*, H* insteadof ,, H, (20) yields the impacton industrieslocated

abroad nT* - n*.

V. Welfare in Trading Equilibrium

Neither wages nor the location of industriesor trade volumes necessarily allow for any conclusionson the welfare effects of trade integration. Therefore,we now tracethe consequencesof tradeon regionalwelfarefor various parameters of the model. Recalling that welfare depends on the of and x as well as diversityn (see (3)), we observethat: xo consumption
13Instead one couldsolve for the of tradein the numbraire andin differentiated manufactures, in manufactures) fractionof intermediates equilibrium (i.e., the fractionof directproduction tradedin additionto final goods. Economieswouldthen specializein eitherbusinessservices that It shouldbe kept in mind,however, thatthey aretradable) or directproduction. (provided about the natureof trade if trade is associatedwith factor-price assumptions equalization, results. or vertical)are unlikelyto be crucialfor welfare-economic (horizontal
Journalof Economics 2006. O The editorsof the Scandinavian

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470 B. Dluhosch (i) The supplyof consumerservices(xo) increaseswith the effectiveness of fragmentation in cost reduction.14 Whenrestructuring production, firms reduce their demand for unskilled labor. Therefore,employment in consumerservices Ls is larger than otherwise, and so is the equilibrium quantityof consumerservices supplied,to the benefit of consumers.At any rate,the welfare-economic impactof trade on and whether factorproportions of Home depends Foreigndiffer. The number of refers to the manufactured (ii) goods post-integration total number of goods produced in the integratedtrading area (Nie =nT+ n*T), whereas consumerswere previously restrictedto buyinghome-madegoods. The increasein varietyhas a positive impact on welfare--ceterisparibus. (iii) If productionis fragmented,factor proportionsare importantfor In there is a trade-offbetweenthe numquantities x1,...,N. particular, ber of varietiesand economies of scale: the higherthe ratio of lowto high-skilledlabor,the largerthe numberof differentiated goods. However,when focusing on the scale of operationin manufacturing, which is relatedto the productivity and leasteffect of fragmentation cost technologyin particular, we observethat if high-skilledlaboris more abundant the econabroad,welfare increaseswith integration: omy benefits from integration by being able to exploit economiesof scale to a greaterextent. In orderto assess the welfareeconomicsof openingup to trade,all of these effects must be takeninto account.Comparing equilibriain the closed and in the tradingeconomy,we obtain the following expressionsfor the net impactof tradeon welfare AU in Home: log AU = (1 - A)logxo + log n + p logx

+ log1

-1
K'ie

(K*

)H*p 0 + (1 -

(r0)7

1)\\ +(21 (21)

each economyconsumesa fractionof Note thatworldsupplyis x'. In trading equilibrium, in each country to its income share yr/yie. Since x'0e =(1-p)Y'e, consumption xo according which increasesin 7. is a functionof nationalincome in tradingequilibrium
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14

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Integration,fragmentationand the geography of welfare 471 Replacing variables xo, x, n and parameters H, r, (r* - K) with those of Foreign, (x*, x*, n* and H*, K*, (, - r*), respectively, yields the corre-

spondingresults log A U* for Foreign. We now turn to a calibrationexercise on the effects of integrationon welfareand the robustnessof the resultswith respectto variousparameter shares, values, i.e., factor endowments,expenditureshares, distributional the effectivenessof fragmentation in cost reductionand the elasticity of substitution in demand.In orderto illustrate the effects in two dimensions,
we consider the benchmark case H = H*, and let w -= */.
15

Factor Proportions and Welfarewith Endogenous Fragmentation Figure3 shows the consequencesof tradefor welfarein Home (solid line) values used in and in Foreign(dotted line), with the following parameter the calibration exercise:"16
Parameter Value

p
0.5

9 0
0.5 4

y 0.3

F 1

H 4.5

A 1

AU, DU*

Home

.*

Foreign
2 3 ,*(0

??o
10

3 ??o
goo

economicimpactof tradefor Home(solid) and Foreign (dotted)as a Fig. 3. Welfare of relative factor w function proportions

15w > 1 thusimplies withskilled thatHome(Foreign) is relatively wellendowed (unskilled) areidentical. countries whileforw < 1 theopposite Inthecasewhere holds. w= 1,both labor; to p, 9, the sameapplies for F, T, A, H aremaintained the analysis; Values 16 throughout unless otherwise indicated. K, 7, ?
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472 B. Dluhosch Home fares better than Foreignif it is relativelyskill abundant and vice versa.17If countriesare identicalin terms of endowment,both enjoy the same increase in welfare when opening up to trade. However,suppose that Home is low-skill abundant, i.e., w < 1, or equivalently,, > i*. When takes It is nevertheless Home loses integration possible for place, industry. Home to benefit from integration.Hence, trade is welfare improvingif countriesare not too diverse in terms of factor proportions."Otherwise, Home suffers from welfare losses. The same applies to Foreign at high values of w (which meansthatForeignis very poorlyendowedwith skilled labor). The lower and upper bounds on w for which trade is beneficial (the in Figure 3) are due to the fact gray shaded range of factor proportions that imperfectcompetitionand the love of variety involve a trade-offbethe more tween the numberof varietiesand the quantityof each consumed: varieties,the lowerthe quantity, i.e., economies of scale are exploitedless extensively.The trade-offalso obtains when opening up because there is more diversity.For given income, however,less of each variety is consumed. Thus, income effects of trademay or may not be outweighedby the increasein varietiesdue to trade.The exact shape of the trade-offas well as its evaluationdependson the actualparameter values of the utility functionand the technologyside of the model since both affect incomesas well as diversity,with and withoutfragmentation. Note that even for y = 0, trademay involvea welfareloss for one of the countriesfor w low or high enough(see also Figure5 below). Fragmentation effect to trade makes a differencein the sense that it adds a productivity which, for w < 1 (w > 1), Home (Foreign)is able to enjoy when opening in Foreign(Home) than in Home up. Skilled labor is then more abundant so thatthe priceof businessservicesfor production fragmentation (Foreign), declines and economies of scale are exploitedmore extensivelyin Home is considereda skill-intensiveactivity,factor (Foreign).As fragmentation of the gains thansize) provedecisive for the distribution proportions (rather from trade. Yet, for a wide rangeof parameter values, both countriesattaina higher level of welfare,even if they lose industry. This resulthas important policy transfers in within such a range,the demandfor international implications: 19 orderto achieve consent on integration cannotbe based on tradetheory. Figure 3 displays the welfare-economicimpact of trade for a particular set of parameter values only. Below, we show that the results are robust
businessservices increasesin the skill-abundant country. criticalw (i.e., a break-even point) for Home to do betterin as compared to autarky. In Figure3 we obtainw > 0.327 (w < 3.06) for tradingequilibrium welfarein Home (Foreign)to improve. 19 transfers on incentives. Note thatthis is quiteapartfromthe negativeimpactof international
18 In any event, there exists a
17 Note, however, that the price of

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Integration,fragmentationand the geography of welfare 473

with respect to differentparameter aspects values--though distributional can differ in detail.20

Robustnessof the Results

Figures4-6 applythe conceptof iso-welfarefunctionsto display(the distribution of) the gains from tradeas a functionof variousparameters, where welfareis increasingwith subscripts.21 The rangeof the factor-proportions w has been confinedto 0 < w < 1 (thatis, with Foreignrelatively parameter skill abundant). For w > 1, the results are symmetrical.In any case, Forfor all welfare increasesby more than Home's(Foreign's) eign's (Home's)
values of w < 1 (w > 1). Expenditure and Distributional Shares. The panels of Figure 4 display the

welfare-economicimpact of trade as a function of parametervalues /A held constantas in Figure 3. (LHS) and 0 (RHS) with other parameters Accordingto the LHS panel, the criticalp for which tradedoes not affect welfare in Home increasesin w. For lower values of p, the relativeabundance of skilled labor in Foreign depresses incomes of skilled labor in Home, i.e., less consumptionof xo, x, where the losses are not compensated by the largernumberof varietiesavailablethroughtrade. However, if countriesare sufficientlysimilar,the lattereffect dominatesand, given w, a largerfractionof income spent on manufactures implies that a higher

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Valuesclose to w = 0 are meaningless,since Foreignwould then have unrealistically large amountsof skilled labor(relativeto unskilledlabor). 21 Or, more precisely,each curve summarizes the loci in parameter space for which welfare gains are the same.
20

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474 B. Dluhosch iso-welfarefunctioncan be reachedin tradingequilibrium (as the market sustainsa largernumberof varietieswith increasing For given A, Home y). catches up in terms of welfare gains while Foreign benefits less as w increases. The RHS panel of Figure4 shows that the lower bound on w in order for Home to benefit from tradealso increaseswith the distributional share 0 of skilled labor in direct production.For w < 1, (negative)income effects for skilled laborare largerwith increasing0. Hence, tradeis welfare improvingonly if countriesare sufficientlysimilar,so that income effects are compensated by the (positive)impactof tradeon diversity.Foreign,in benefits for all values w < 1, as does Home for 0 small enough. contrast, the latter result only obtains for 7 sufficientlylarge, as Home However, then benefits from the productivity effect of a lowerprice for businessservices when opening up-which makes a difference.Since incomes of the high skilled are depressed(boosted)by trade,Home (Foreign)again benefits less (more)than Foreign(Home) for all values w < 1 for which trade is mutuallybeneficial. For w > 1 (not shown) the opposite holds. For values of w close to unity,thereis a parameter rangewithin which gains first decreaseand, then, at higher values of 0, increase,i.e., where iso-welfare in 0-w space. Welfareeffects nevertheless gains of Home bend backwards from left to right, i.e., the more similar convergeas we move horizontally countriesbecome. modifies in Cost Reduction.Fragmentation Effectiveness of Fragmentation the trade-offbetweenscale and diversity:it implies less varietythanotherAt the same time it featuresadditional wise, i.e., without fragmentation. income effects. These are due to a productivity effect in that economiesof scale are exploitedmore extensively,which ceterisparibus raises wages of the high-skilledin particular. effect Figure5 shows thatwith respectto the criticalw, the productivity lowers the dominates,i.e., a higher cost effectivenessof fragmentation 7 lowerboundon w for which tradeis welfareimproving for Home.22 While for Home welfaregains increasein 7, for Foreign,as thoughpositive,they first (at lower values of y) decrease and then increase (at higher values of 7). Hence, for given w, the same iso-welfarecurve may be attained in Foreignwith differentparameter values 7. However,as previously,the distributional effects of trade are smaller and losses less likely, the more similarcountriesare.

22In the skill-abundant country, the relative price of business services increases and economies of scale are exploited to a lesser extent so that any welfare gains from trade are smallerwith, as compared to without,fragmentation.
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Integration, fragmentation and the geography of welfare 475

/
0.3 0.25 0.2 0

AU1

AU2

0.15

1 0.05
0.05

0 0.35 0.4 0.45 0.5 0.55 0.6 o

Fig. 5. Welfareeconomic impactof tradein Home (solid) andForeign(dotted)as a function of factorproportions w and the effectiveness of fragmentation in cost reductiony

in Demand.Forgiven y, welfaretendsto decrease Elasticityof Substitution in the elasticity of demand for manufactures r. The lower bound on w in order for Home to enjoy a welfare improvement is thus lower ceteris the smaller is is r. The smallerir, the larger n, i.e., the number paribus, of varieties, and the more diverse countries may be in terms of factor while still realizinggains from tradewithin the rangeof paraproportions meter values for which factor-price equalizationobtains.Correspondingly, the upperbound on w in orderfor Foreignto do betterwith than without tradeis higher,the lower is r (see LHS of Figure6).
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tion of factor proportionsw and the elasticity of substitutionin demandr7;RHS: Home's indifferencecurves in r and -y (at w = 0.8)
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476 B. Dluhosch Twoobservations are noteworthy: (i) as usual,the welfaregain for Home is smaller than for Foreignif w < 1, while the opposite holds for w > 1, with the differencebecoming smaller the more similar countriesare as measuredby w; (ii) dependingon w, there is a trade-offbetweenr and y curves (see RHS panel of Figure6).23The actualshapeof the indifference = in on increases welfare however. For w for instance, 1, depends w, 7 (for any given r) while it decreasesin r7(for any given -y). Discussion With respect to gains from trade, the calibrationexercise sheds light on additionalforces at work in the process of trade integrationsuch as the endogeneityof technology due to fragmentation. Although intra-industry trade is generallyconsideredless disruptivethan factor-proportions-driven continueto trade,the analysis shows that factor proportions inter-industry a in an role with to even intra-industry play significant respect welfare, framework. Factorendowmentsare decisive, despite the fact that production fragmentation also promotesscale economies. Hence, as Lovely and Nelson (2002) have pointedout in a differentcontext,the usual presumption that intra-industry trade is not associatedwith majordisruptionsand structural change (unless it is combinedwith exogenoustradecosts) may be premature, as intra-industry trade may involve a considerableamount of indirectinter-industry trade. Moreover,by affectingvariety as well as quantity,trade integrationmay-in contrastto classic factor-proportions Heckscher-Ohlin trade-be associatedwith welfare losses for one of the in particular if countriesdiffertoo much in termsof factor tradingpartners, as the analysisshows,for a broadrangeof parameter However, proportions. which is less conduciveto the exploitation values,even a skill-poorcountry, of economiesof scale, benefits from openingup. for given endowment with low-skilledlabor,scale increases Nevertheless, in high-skilledlabor,24 so that the model has some constant-returns propincrease erties. For given parameter values 0, P9,r~,7 an equiproportional in factorendowments merely leads to an increasein the numberof firms. Tradereplicatesthis result,However,there are two avenuesthroughwhich increasingreturnson the supplyside enterthe processof tradeintegration. of the manufacturing scale withineach industry First,via factorproportions, the facsectoris affectedand thus local welfare.FromHome'sperspective, tor ( /i'e)IIY in (21) increaseswith skill abundance in Foreign;Home can thus benefit from the productivity effect in manufacturing, despite loss of
23Recall that 7 < 1/(rl- 1) in orderto ensureeconomically meaningfulresults. 24Note that via pz, outputof each varietyvaries inverselywith the ratio of low- to high-

skilled labor.
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and the geography Integration, of welfare 477 fragmentation industry.Second,scale, tradepatternsand local (as well as global) welfare vary with the cost effectivenessin fragmentation -y. As long as Foreignis more skill abundant thanHome, the scale of production in Home increases in y, whereasthe oppositeholds when Home is more skill abundant than Foreign. This paper concentrateson the trade and welfare implicationsfrom a nationalperspective,with special focus on the robustnessof the results with respect to differentparameter values. A detailed discussion of the of as many implications fragmentation transmitted by the effectivenessin cost reduction is beyondthe scope of this analysis,and is thus left to further research.

VI. Concluding Remarks

trade is welfareDespite the general presumptionthat intra-industry enhancing,Helpman and Krugman(1985) have shown that since intraindustrytradeis associatedwith imperfectcompetition,this need not hold true.They have thus lent support to concernsamongthe generalpublicthat welfare. competitionfrom abroadthreatens This paper explores the welfare effects of trade integrationin a model In this with monopolisticcompetitionincludingendogenousfragmentation. framework, technologychoice, i.e., the optimalextent of productionfragmentation,is drivenby a trade-offbetween two cost components:on the one handfragmentation lowersvariable costs; on the otherhand,it increases coordination costs which are invariant with respect to output.Since these two componentsare affecteddifferently, affects firm size tradeintegration as well as the numberof firms that producedifferentgoods. In a calibration exercise, it is shown that via its impact on productivity(economies of scale) and diversity,the optimizing behaviorof firms has important implicationsnot only for the localizationof industries,but also for local welfare.Althoughfragmentation is associatedwith economiesof scale, factor proportions role. The skill range for continueto play an important mutuallybeneficial tradeincreasesin the cost effectivenessof fragmentation while it decreasesin (i) the fractionof income spent on differentiated goods, (ii) the elasticity of demand for these goods and (iii) the distributional share of skilled labor. However,for a wide range of parameter in the gains, despite loss of values, even a skill-poorcountryparticipates As skilled laborbecomes relativelyless expensive,firms become industry. moreproductive more intensively. Hence,within by fragmenting production this range, since the countryas a whole gains from trade, compensation of losers can be regardedas a nationalratherthan, for instance,an EU matter.
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478

B. Dluhosch

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Firstversionsubmitted 2004; January final versionreceivedOctober2005.

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