Increasing Returns and All That: A View From Trade

Do scale economies contribute to our understanding of international trade? Do international trade flows encode information about the extent of scale economies? To answer these questions we examine the large class of general equilibrium theories that imply Helpman-Krugman variants of the Vanek factor content prediction. Using an ambitious database on output, trade flows, and factor endowments, we find that scale economies significantly increase our understanding of the sources of comparative advantage. Further, the Helpman-Krugman framework provides a remarkable lens for viewing the general equilibrium scale elasticities encoded in trade flows. In particular, we find that a third of all goods-producing industries are characterized by scale. (The modal range of scale elasticities for this group is 1.10-1.20 and the economywide scale elasticity is 1.05.) Implications are drawn for the trade-and-wages debate (skill-biased scale effects) and endogenous growth. (JEL F11, F12, D2) Over the last 20 years, general equilibrium models of international trade featuring increasing returns to scale have revitalized the international trade research agenda. Yet general equilibrium econometric work remains underdeveloped: it has been scarce, only occasionally well-informed by theory, and almost always devoid of economically-meaningful alternative hypotheses. There are exceptions of course. These include Helpman (1987), Hummels and Levinsohn (1993, 1995), Brainard (1993, 1997), Harrigan (1993, 1996), and Davis and Weinstein (1996). However, this list is as short as the work is hard. The complexity of general equilibrium, increasing returns to scale predictions has deflected empirical research of the kind that is closely aligned with theory. Surprisingly, one empirically tractable prediction remains overlooked, despite the fact that it is central to the approach of Helpman and Krugman (1985). We are referring to a variant of Vanek’s (1968) factor content of trade prediction. In its Helpman-Krugman form the factor content of trade depends critically on the extent of scale returns in each industry. Scale matters because it determines both the pattern of trade and the amount of factors needed to produce observed trade flows. As Helpman and Krugman showed, their variant of the Vanek prediction comes out of a very large set of increasing returns models and so provides a robust way of evaluating these models. Yet remarkably, this increasing returns to scale factor content prediction has not been explored empirically. We know that the Heckscher-Ohlin-Vanek factor content prediction performs poorly e.g., Trefler (1995). Yet there has not been one iota of evidence that the Helpman-Krugman class of models performs better. Exploring this uncharted region is our first goal. The second and more important goal of this paper is to quantify the extent of increasing returns to scale in the context of a general equilibrium model of international trade. This forces us to part