Economic integration

This paper considers the effect of economic integration on the industrial structure and trade patterns of two countries which differ only in size. In a general equilibrium model of intra-industry trade, each country has two imperfectly competitive industries which can differ in three respects: relative factor intensities, level of transport costs and demand elasticities. With positive transport costs and increasing returns to scale, each firm prefers to locate in the larger country due to the ''market access'' effect. But the increase in demand for factors in the large country induces a rise in relative wages to maintain factor market equilibrium. The tension between the market access effect and production cost effect determines which industry will concentrate in which country. We show that economic integration leads to some degree of specialisation, with the large country becoming a net exporter in goods which are relatively intensive in the mobile factor, capital; goods which are subject to relatively higher transport costs; and a changing pattern of net exports when demand elasticities differ.