Do Larger Countries Have Higher Welfare?

Existing intra-industry models with two countries and inelastic labor supply show that a larger country has a higher wage/income and higher welfare. We reexamine these outcomes by use of a model with endogenous labor supply. We show that each outcome in existing models can be reversed as well as that the larger country may have less-than-proportionate share of …rms. Especially, when consumers’love of variety is strong and trade costs are low, the larger country has lower welfare since workers in the country work too much. Key words: Country size, Endogenous labor supply, Welfare, Home market e¤ect. JEL Classi…cation: F12, F21, R12. Corresponding author. Graduate School of Management, Kagawa University, Saiwai-cho 2-1, Takamatsu, Kagawa 760-8523, Japan. E-mail:[email protected] yGraduate School of Information Sciences, Tohoku University, Aoba 6-3-09, Aramaki, Aoba-ku, Sendai, Miyagi 980-8579, Japan. E-mail:[email protected] 1 Introduction Existing two-country intra-industry models show that a larger country has a higher wage/income and higher welfare. However, these models assume inelastic labor supply and, thus, we reexamine their outcomes by use of a model with endogenous labor supply. We show that each outcome in existing models can be reversed. Especially, when consumers’love of variety is strong and trade costs are low, the larger country has lower welfare. Since Krugman (1980) and Helpman and Krugman (1985), the issue of country-size e¤ects in intra-industry models has been examined under various settings. Many researchers especially have focused on the home market e¤ect (HME) in terms of …rm share. This is de…ned as a phenomenon in which a country with a relatively larger local demand attracts a more-thanproportionate share of industry with increasing returns and transportation costs (Krugman, 1980, Section III; Helpman and Krugman, 1985, Section 10.4). For example, Head and Ries (2001), Feenstra et al. (2001), and Head et al. (2002) explore the pervasiveness of the HME in terms of …rm share and show that it can be reversed in the cases with varieties di¤erentiated by the nation of production. The HME is sometimes de…ned in another way, i.e., other things being equal, a larger country has a higher wage (Krugman, 1980, Section II; Krugman, 1991, p. 491). The HME based on this de…nition is called the HME in terms of wages. The literature shows that the HME in terms of wages is more pervasive than that in terms of …rm share. For example, Davis (1998), Yu (2005), and Takatsuka and Zeng (2012b) introduce trade costs of homogeneous goods into Helpman and Krugman (1985) and show that a larger country has a higher wage although it may not have more-than-proportionate share of …rms. Furthermore, this result is robust even when we introduce mobile capital (Takatsuka and Zeng, 2012a; Takahashi et al., 2013) and/or preferences of variable elasticity of substitution (VES) (e.g. Chen and Zeng, 2014; Bykadorov et al., 2015).1 Examining whether the HME is pervasive is important as a policy issue as well as a positive one since it suggests that smaller countries may be relatively worse o¤via lower share of …rms and lower wages by their size. In fact, the literature also supports that a larger country has higher welfare. While Yu (2005) and Takatsuka and Zeng (2012b) prove it in one-factor economies, Takahashi et al. (2013) show it by use of a two-factor model. Numerical simulations by Chen and Zeng (2014) and Bykadorov et al. (2015) suggest that it also holds under VES preferences. The above country-size e¤ects can be signi…cantly in‡uenced by endogeneity of labor supply. For example, imagine a situation with two countries and one di¤erentiated-good sector. In Wang and Gibson (2015, Proposition 2) use a model with additively separable (AS) preferences and claim that a larger country can get a higher, lower, or same wage rate. However, they do not show an example and/or conditions of the reverse HME of wages. Meanwhile, Bykadorov et al. (2015) use augmented hyperbolic absolute risk aversion (AHARA) utilities (a class of AS) and through massive simulations, they show that a wage in a bigger country is higher.