Endogenous Comparative Advantage∗

A stylized model of trade between identical countries is developed, where the only departure from standard neoclassical theory is that worker skills are imperfectly observable. This creates an informational externality since firms take aggregate investments into consideration when making inference about individual workers. The interaction between the informational externality and price effects generates a force in favor of specialization. Equilibria where comparative advantages in different industries arise endogenously exist even when the autarky model has a unique equilibrium. ∗This paper was previously circulated under the title “Endogenous Inequality in a Trade Model with Private Information”. We thank Hal Cole, Lutz Hendricks, Pat Kehoe, Tim Kehoe, Narayana Kocherlakota, John Knowles, Rody Manuelli, Andrew Postlewaite, Paul Segerstrom, Ananth Seshadri, Robert Staiger, Kjetil Storesletten, Scott Taylor and Fabrizio Zilibotti for helpful comments, suggestions and discussions. We have also benefited from feedback from seminar participants at several conferences and institutions. Support from NSF Grants #SES-0003520 and #SES-0001717 is gratefully acknowledged. The research for this paper was done partly when Peter Norman was visiting IIES Stockholm and he is grateful for their hospitality. The usual disclaimer applies. §Department of Economics, University of Minnesota. Email: [email protected] ¶Department of Economics, University of Wisconsin-Madison. Email: [email protected]