Paper No. 19-2005
We consider a model of international trade with increasing returns in a non-traded input into industry, infrastructure, and show that the nature of equilibrium depends crucially on whether the infrastructure provider acts in a nave manner akin to a Level 1 agent in a cognitive hierarchy (C-H) model or in a more sophisticated manner. Infrastructure requires a fixed investment and is produced under decreasing marginal costs, and we model two possible market forms, monopoly and Cournot oligopoly with free entry both capable of generating pecuniary externalities in the manufacturing sector . Unlike most other work exploring the theme of increasing returns, we derive a unique closed economy equilibrium. In a small open economy, we show that with nave infrastructure provider(s), multiple equilibria obtain. In this event whether or not a small open economy becomes an industrial exporter depends crucially on the presence of unexhausted economies of scale, and it is possible to have equilibria where manufactures are exported in spite of the world price of manufactures being lower than the autarky price. With a more sophisticated infrastructure provider, however, even an open economy has a unique equilibrium, which for a wide range of parameter values also involves a greater degree of industrialization than any of the nave equilibria. For some parameter values, however, neither infrastructure nor manufacturing can develop and the economy remains totally agrarian.