GLOBAL FACTOR TRADE: Theory
A successful account should provide a parsimonious and plausible set of departures from the standard model. In order to understand the role played by each of the assumptions, it is important, both in the theory and empirics, to begin with the standard model, relaxing the assumptions one at a time. The theoretical departures are developed in this section and implemented empirically in the following section electronic-loan.com.
The Standard HOV Model
We begin by developing the standard HOV model from first principles. Assume that all countries have identical, constant returns to scale production functions. Markets for goods and factors are perfectly competitive. There are no barriers to trade and transport costs are zero. The number of tradable goods is at least as large as the number of primary factors. We assume that the distribution of these factors across countries is consistent with the world replicating the integrated equilibrium (cf. Helpman and Krugman 1985).
Then factor prices will be equalized, so all producers will choose the same techniques of production. Let the matrix of total factor inputs for country c be given by Bc. The foregoing implies that for all countries c:
The first equality is effectively a factor market clearing condition, while the second embodies the assumption of FPE.
The standard demand assumption is based on identical and homothetic preferences across countries. With free and costless trade equalizing goods prices and FPE equalizing non-traded goods prices, the demand in a country will be proportional to world net output:
A Common Technology Matrix Measured With Error
The foregoing assumes that both the true and measured technology matrices are identical across countries. A glance at the measured technology matrices reveals this is not the case. Before we pursue more elaborate hypotheses on the nature of actual technological differences, it is worth investigating the case in which the technology matrices are measured with error. Assume, then, that the measured technology matrix for country c is given as: