Trade Liberalization and Export Diversification

Anwesha Aditya, Rajat Acharyya

PII: S1059-0560(15)00114-8
DOI: doi: 10.1016/j.iref.2015.07.007
Reference: REVECO 1107

To appear in: International Review of Economics and Finance

Received date: 22 December 2014

Revised date: 17 July 2015
Accepted date: 20 July 2015

Please cite this article as: Aditya, A. & Acharyya, R., Trade Liberalization and
Export Diversification, International Review of Economics and Finance (2015), doi:
10.1016/j.iref.2015.07.007

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 ACCEPTED MANUSCRIPT

Trade Liberalization and Export Diversification

Anwesha Adityaa,, Rajat Acharyyab,1

a
Department of Humanities and Social Sciences, Indian Institute of Technology Kharagpur,

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India.
b

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Department of Economics, Jadavpur University, Kolkata-700 032, India.

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Abstract

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The paper examines the implications of tariff reductions for diversification of export basket
across and within industries measured in terms of larger sets of homogeneous goods and
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horizontally-differentiated varieties in two country world. In a synthesis of analytical structures
of Dornbusch, Fisher and Samuelson (1977) and Krugman (1979) we establish that unilateral
tariff reduction may make the liberalizing country’s exports diversified both across and within
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sectors whereas the trading partner may experience across-sector diversification. Under bilateral
tariff reduction exports of larger number of differentiated varieties may be realized only for the
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country in whose favour the ratio of national wages moves.

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Key Words: Export Diversification; Intra-industry Trade; Monopolistic Competition; Trade

liberalization
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JEL Classifications: D50, F12, F13


Corresponding author at: Department of Humanities and Social Sciences, Indian Institute of Technology
Kharagpur, West Bengal 721302, India.
Tel.: +91-3222-283620.
E-mail: anwesha.aditya@gmail.com, anwesha@hss.iitkgp.ernet.in.

1
Tel.: +91-33-2414-6328.
E-mail: rajat.acharyya@gmail.com.
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1. Introduction

This paper examines the relationship between trade liberalization (in the form of a reduction in
the rate of tariff on imports) and the diversification of a country’s export basket measured in

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terms of a larger set of homogeneous goods and larger set of varieties of a horizontally-

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differentiated good. The existing theoretical literature is somewhat lacking in providing definite

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directions in regard to change in diversification of exports and nature of such change (that is,
whether diversification is within or across sectors or both) after trade liberalization as we clarify

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later.

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The above research question is important for several reasons for a country liberalizing its trade
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regime. First is the growth objective. Diversified export basket may have far reaching
implications for both the level and volatility of output growth. Second is the volatility in foreign
exchange earnings. Our motivation for undertaking the above mentioned research question
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comes primarily from these two perspectives. Growth implications of a more diversified export
basket have been examined in many recent cross-country studies. For example, Agosin (2007),
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Hesse (2008) and Lederman and Maloney (2007) find that export diversification leads to faster
economic growth. However, Aditya and Acharyya (2013) and Imbs and Wacziarg (2003) have
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observed a non-monotonic relationship between export diversification and economic growth in

the sense that the developing countries benefit from greater diversification whereas the advanced
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countries perform better with specialization. On the other hand, Caselli et al. (2011) argue that
diversification through trade causes less macroeconomic volatility due to trade openness. This
result is in contrast to the view that trade increases volatility since it exposes the country to
shocks specific to the sectors in which the country specializes after trade (Newbery and Stiglitz,
1984). Giovanni and Levchenko (2009) also observed that for a sample of 61 countries covering
28 manufacturing sectors for the period 1970–1999, the sectors more open to international trade
are more volatile and more open countries exhibit greater specialization leading to increased
volatility.

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Regarding the link between diversified export basket and volatility in foreign exchange earnings,
export prices and terms of trade of a country are expected to fluctuate more the greater is the
extent of commodity concentration (Michaely, 1962; Hesse, 2008). Thus for countries with a
concentrated export basket, foreign exchange earnings become prone to fluctuations and

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uncertainty, constraining their ability to finance import bill particularly for essential imported

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inputs. This may further constrain output growth. But when larger number of goods is exported

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by a country, movements in the world prices of individual goods will offset each other and the

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country’s export price level will tend to be relatively stable. Export diversification, thus, helps in
stabilizing export earnings in the long run (Acemoglu and Zilibotti, 2007).

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Given such empirical observations regarding importance and relevance of export diversification,
one might wonder whether in a resource constrained economy that produces many goods and
product varieties, trade liberalization by releasing resources from the import competing sectors
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can make its export basket more diversified. In an extension of the comparative advantage theory
of David Ricardo to the continuum of homogeneous goods, Dornbusch et al. (1977) established
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that tariff reductions by two trading countries make export baskets of both more diversified by
expanding the set of traded goods in each country for the following reason. Trade costs like
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tariffs and transport costs make some intermediate range of goods non-traded in this type of
framework. A reduction of tariff means reduction of trade costs so that some of these non-traded
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goods can now be traded. Consequently, export baskets of both the trading nations can be made
more diversified through tariff reductions. In a sense, this is export diversification across sectors.
New trade theories, on the other hand, define export diversification in the intra-industry sense,
that is, in terms of product variety within an industry. For example, using Dixit-Stiglitz (1977)
type utility function (that displays love-for-variety) and a monopolistically competitive market
structure, Krugman (1979) established that opening up of trade leads to larger number of
varieties being exported and imported through its pro-competitive effect. Thus, an opening up of
trade causes a more diversified intra-industry trade in terms of varieties. With heterogeneous
firms Melitz and Ottaviano (2008) also find increased varieties being exported by countries after
trade opens up. On the other hand, adopting a characteristic approach (which views goods as
bundles of characteristics), with increasing returns to scale and heterogeneous consumers buying

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their ideal variety or the best approximate, Helpman (1981) had established that opening up of
trade will lead to more distinctly different varieties being produced and exported. All these
analyses essentially talk about diversification within a sector. However, these theoretical
exercises compare the autarchic and free trade states, or prohibitive and zero tariff regimes, and

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cannot tell us much about what would have happened to varieties traded when tariff is lowered

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from a non-prohibitive high level to a lower (but not zero) level because of the inherent

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indeterminacy of intra-industry trade pattern. In contrast to such favourable impact of trade,

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Arkolakis et. al. (2008), show that with trade liberalization total variety (domestic plus imported)
can increase, decrease or remain constant. Trade liberalization may lower the number of

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domestic varieties if it leads to exit by domestic firms (Tybout, 2003).

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Thus, the existing trade theories at best provide us with situations where trade liberalization
favourably affects export diversity either across industries (or sectors) or within an industry (or
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sector), but not both. But in a liberalizing economy, production adjustments and resource re-
allocation that such liberalization policies trigger need not be confined to only across varieties
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within a particular industry or across different industries but not across varieties. More
importantly, when all goods and varieties compete for the same scarce resources, a trade off may
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arise between diversification within and across industries in the sense defined above.
Conceptually, in such a case where trade liberalization makes export basket of a country contain
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more varieties but less diverse set of (distinctly different) manufacturing goods, and vice versa, it
is difficult to comprehend it as diversification of export basket. From policy perspective also it
would be difficult to evaluate the appropriateness of trade liberalization in the context of output
growth, its volatility and stability in the foreign exchange earnings, in case of asymmetric
impact, if at all, since empirical estimates regarding growth effect of export diversification (or
the export earnings argument) cited above do not separate out the effects of across and within
sectors export diversification.2

2
The theoretical literature on trade and growth also does not shed any light on this aspect. The New Growth
Theories, for example, only talk about the increased product variety or improved quality of goods in stepping up
growth rates and the role of trade in that context (Romer, 1990; Grossman and Helpman, 1991; Aghion and Howitt,
1992).

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This is where the present paper contributes to the existing theoretical literature. In this above
mentioned analytical perspective the present analysis intends to examine whether resource
constraint would be leading to contrasting or unidirectional changes in across and within sector
diversification of export basket after trade liberalization. For the purpose, we construct a two-

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country, multi-sector general equilibrium model with one sector characterized as producing

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different varieties under monopolistic competition, and there are continuum of sectors producing

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distinctly different goods under perfectly competitive conditions. The framework of analysis is

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essentially a synthesis of analytical structures of Dornbusch et al. (1977) and Krugman (1979),
which creates scope for diversification of export basket both across and within industries and

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enables us to address whether trade liberalization favourably affects both dimensions of export
diversification – larger number of different manufacturing goods as well as larger number of
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different varieties of a horizontally-differentiated manufacturing good. The other important
dimension of our analysis is that we provide an altogether different channel through which tariff
reductions may increase variety of export products, if at all. In Krugman’s (1979) analysis
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opening up of trade raises variety of the export good because of the pro-competitive effect.
Larger size of the market after opening up of trade enables the producers to reap benefits of
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economies of scale, which in turn prohibits duplication of production of a particular variety by

more than one firm. Thus firms that were producing identical varieties in the two countries
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before trade, diversify in different varieties after trade. But in the present case, the resource re-
allocation effect of tariff reduction holds the centre-stage. Tariff reductions increase variety and
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consequently within-sector diversity of the export basket only when it makes available larger
labour for production of the horizontally differentiated good. This is, however, not a foregone
conclusion because larger availability of labour for this sector depends on, as we will see later,
whether tariff reduction contracts the subset of continuum of goods produced in the other sector
or not. However, since the subset of continuum of goods produced contain goods that are
exported as well as that are not traded, so the necessity that a lower subset of continuum of goods
needs to be produced for a larger number of varieties of the horizontally differentiated good does
not mean that the set of continuum of goods exported needs to fall as well. All that we require for
not having a tradeoff between diversification of export basket within and across sectors is that
the set of continuum of goods that are not traded falls.

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In the above set up, we establish the following results. First, under unilateral tariff, the desired
diversification of export basket – export basket containing larger number of goods as well as
varieties – may be realized only for the liberalizing country. In such a case, the trade-off between
export diversity across and within industries may not arise. Second, bilateral tariff reductions

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may cause export baskets of both the countries more diversified in terms of an expanded subset

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of continuum of goods being exported. In each country, a reduction of own tariff has adverse

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pro-competitive effect and favourable wage effect on the production subset whereas a reduction

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of other’s tariff has only the adverse wage effect on it. If the pro-competitive effect is stronger
than the wage-effect of own tariff reduction in each country, then bilateral tariff reductions

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expand the set of continuum of goods exported by both the countries. Third, exports of an
expanded subset of continuum of goods may be realized for a country under bilateral tariff
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reduction even for a stronger wage effect in which case the set of export good would have
contracted instead under unilateral tariff reduction. Last but not the least, under bilateral tariff
reductions, again the export diversification both across and within sectors may not be realized for
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both countries like that under unilateral liberalization. The country in whose favour the ratio of
national wages moves is more likely to experience export diversification both across and within
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sectors. For example, a fall in the Home wage relative to the Foreign wage makes the Home
country a more likely achiever of the desired export diversification. All these results together
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imply that trading nations may have different export-led growth experiences after unilateral or
bilateral trade liberalization.
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Our results can also be given a different but related interpretation and can be put in the context of
a different dimension of the export-led growth argument. It has been observed in another strand
of empirical studies on the hypothesis of export-led growth that those countries grow faster
whose export baskets contain relatively larger number of high and medium technology intensive,
sophisticated and high-value addition export goods. For example, Hausmann et al. (2007) and
Rodrik (2006), find that neither specialization nor diversification aids growth as long as exports
comprise of predominantly low value added commodities. Comparing the productivity of export
basket of China with other countries, Hausmann et al. (2007) concluded that it is not the volume
of exports or specialization according to comparative advantage in labour-intensive exports that
has led to China’s rapid growth. Rather, China’s export of highly sophisticated products, which

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is usually not expected of a poor, labour abundant country, has been the main driver of its rapid
growth. Aditya and Acharyya (2013), on the other hand, have found significant impact of the
share of high-technology intensive goods in aggregate exports on output growth during 1970-
2005 for 65 countries. Thus, in addition to diversification of export basket, the composition of a

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country’s export basket also seems to be important driver of its output growth. The new growth

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theories also locate the sources of growth in improving product quality (for example, Grossman

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3
and Helpman, 1991 and Young, 1991). In such a context, on the interpretation of Ricardian

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continuum of goods as continuum of quality-differentiated (or sophisticated) goods following
Flam and Helpman (1987), our results shed some light on whether trade liberalization makes

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export basket more diversified (in terms of larger product varieties) as well as changes the
composition of the export basket by causing relatively more sophisticated or higher quality goods
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being exported. We will elaborate on this dimension of our theoretical results later.

The rest of the paper is organized as follows. Section 2 spells out the assumptions and specifies
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the analytical framework. Section 3 determines equilibrium diversity, varieties and relative
wages under free trade. In section 4 the model is reworked with initial tariff to investigate the
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impact of tariff reduction. Section 4.1 considers unilateral tariff reduction by the Home country
and section 4.2 examines the impact of bilateral tariff reductions. In section 5 we offer an
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alternative interpretation of our results and its welfare implications. Finally, section 6 concludes
the paper.
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2. Assumptions and Specification of the Analytical Framework

Consider two countries, Home and Foreign, producing a continuum of perfectly competitive
good Z under constant returns to scale (CRS) technology and a horizontally differentiated good
X with different varieties n and n*, respectively under increasing returns to scale (IRS)
technology. It is worthwhile to note that by the IRS property, the n varieties produced in the

3
Whereas in Grossman and Helpman (1991) technology diffusion as the key to long run growth, in Young’s (1991)
model with bounded learning-by-doing, free trade growth rate is higher than in autarky.)

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Home country and the n* varieties produced by the Foreign country are distinctly different. For
this horizontally differentiated good X, the consumers in both the countries have Dixit-Stiglitz
(1977) type love-of-variety preference so that all varieties are consumed by them. That is, intra-
industry trade takes place in good X with Home country exporting the n number of varieties that

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it produces and the Foreign country exporting the n* number of varieties.

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The set of continuum of goods that the countries can potentially produce is given by the unit
interval [0, 1]. This is the feasible set of goods defined by the present state of technology. The

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number of varieties of good X and the subset of continuum of goods Z  [0, 1] produced by each
country are endogenously determined. MA
Following Dornbusch et al. (1977), let a(Z) and a*(Z) denote, respectively, the units of labour
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required to produce one unit of good Z at Home and abroad with


a ( Z )  0, a * (Z )  0  Z  [0, 1] . For any good Z  [0, 1], the per unit labour requirements in
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the two countries are not the same, a(Z)  a*(Z), which reflects their technology difference.
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However, what is relevant here for determining production specialization is how the ratio of
labour requirements change, which reflects their pattern of comparative advantage across goods
a * (Z )
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of different qualities in the closed interval [0, 1]. Thus, we define A*(Z) =  Z  [0, 1] as
a( Z )

the relative labour requirement to produce good Z, and index goods over the closed interval [0,
1] according to increasing comparative advantage of the Foreign country (or diminishing
comparative advantage of the Home country) in higher indexed good Z:


A* ( Z )  0  Z  [0, 1] (1)

W
Denoting W and W* as the wages in the Home and Foreign country, respectively, and   as
W*
the relative wage (or the double factoral terms of trade), a commodity Z will be produced in the
Home country and exported by it if,

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a(Z )W  a * (Z )W *

Let 0 < ZC <1 be such that,

a(Z C )W  a * (Z C )W *   = A* ( Z C ) (2)

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Thus, by (1), all Z  [0, ZC] will be produced and exported by the Home country and all Z  [ZC ,

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1] will be produced and exported by the Foreign country. The commodity ZC produced by both

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the countries (and the consequent range or diversity of exports) will depend on the production
technologies and the relative wages, which in turn depends on the parameters of the model – the

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labour endowments, taste parameters, and on the trade policy that we will define later. However,
the assumed pattern of comparative advantage in (1) will always mean that the Foreign country
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will export subset of continuum of higher-indexed goods than what the Home country will
export.

Given the above pattern of production and trade specialization, competitive forces drive down
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prices of domestically produced (and exported) goods to the average costs:

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P(Z) = a(Z)W  Z  [0, ZC] (3)

P*(Z) = a*(Z)W*  Z  [ZC , 1] (4)

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Each variety of the horizontally differentiated good X , on the other hand, requires α units of
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labour regardless of the level of output produced and β units of labour per unit of output. Thus,
labour is both the fixed and variable factor of production. It is immediate that in the horizontally
differentiated sector the average cost falls with the level of output so that production of each
variety is subject to economies of scale.

 
AC i     W
 xi 

This assumption, along with free entry, makes the modern sector monopolistically competitive.
Free entry in this differentiated good sector means that only zero profit can be made at
equilibrium so that price equals average cost (AC):

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 
Pxi     W (5)
 xi 

However, under IRS, each variety is produced by only one firm so that each firm exerts

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monopoly power over the variety it produces so that profit maximization means equality between

P
marginal revenue (MR) and marginal cost (MC):

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
Pxi  W (6)

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 1

where ε is the price elasticity of demand for the i-th variety faced by the individual firm.

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Similarly, for the Foreign country the two equilibrium conditions are:

 
Pxi*     W * (7)
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 xi 


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Pxi*  W * (8)
 1
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Finally, the full-employment conditions of labour in the two countries are given as follows:

ZC ZC

L  (  x)n   a( Z )Q( Z )dZ   a( Z ) M * ( Z )dZ

AC

(9)
0 0

1 1
L  (  x)n   a ( Z )Q ( Z )dZ   a * ( Z ) M ( Z )dZ
* * * *
(10)
ZC ZC

*
where, L and L are respectively exogenously given endowment of labour in the Home and the
Foreign country, Q(Z) and M*(Z) are respectively the levels of output of good Z  [0, ZC]
produced by the Home firms for the domestic market and for exports, and Q*(Z) and M(Z) are
respectively the levels of output of good Z  [ZC , 1] produced by the Foreign firms for their
domestic market and for exports.

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Finally, we have the balanced trade condition. Let the consumers spend fixed proportion of
incomes  and (1 - ) on the continuum of goods and the horizontally differentiated goods X (n
and n* number of domestically produced and imported varieties), respectively. The Home
consumers’ total expenditure on the domestically produced and imported varieties equals

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P n
* *

 PX n Lc of which they spend PX* n * Lc on imported varieties, where c denotes the

P
X

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consumption of i-th variety by a representative consumer. Thus, the share of imported varieties
PX* n *

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in total expenditure on the IRS good is , which upon substitution of values from (6)
PX* n *  PX n

n*
. Since (1 - )W L is spent on domestically produced and imported

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and (8) boils down to
n  n *
varieties taken together, so the value of Home country’s imports of the n* varieties produced by
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n*
the Foreign country equals (1 - )W L .
n  n *
ED

On the other hand, following Dornbusch et al. (1977), define b(Z) as the constant expenditure
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share of good Z. By our assumption of fixed proportion  of income spent on the continuum of
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1 ZC

goods,  b( Z )dZ   . Let, v( Z C ) =  b(Z )dZ be the fraction of income spent on all the CRS
0 0
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goods produced at Home. Hence,   v( Z C ) fraction of income is spent by the Home consumers
on the continuum of goods that are imported. The value of imports of the continuum of CRS
goods is then [   v( Z C ) ]W L . Therefore, the total import value for the Home country is,

 n* 
M =   v( Z C )  (1   )
n  n * 
WL


By similar reasoning, the total import value for the Foreign country is,

 n  * *
M* = v( Z C )  (1   )
n  n * 
W L


Hence, the trade balance condition is specified as:

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 n*  L  n 
      *
 * = v( Z C )  (1   )
n  n * 
v ( Z ) (1 ) (11)
n  n  L
C
 

Using the above demand specifications and price levels as specified in (3) and (4), output levels

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for domestic markets and for exports can be written as,

P
* *
b( Z )  L

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b( Z )W L b( Z ) L b( Z ) L b( Z ) L
Q( Z )   , M * (Z )  , Q* (Z )  * , M (Z )  *
P( Z ) a( Z ) a( Z )  a (Z ) a (Z )

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Substitution of these values simplifies the full employment conditions as:

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ZC ZC *
b( Z ) L
L  (  x)n   b( Z ) LdZ   dZ (9a)
0 0
MA 

1 1
L  (  x)n *   b( Z ) L dZ   b( Z )  LdZ
* *
(10a)
ZC ZC
ED
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3. Equilibrium Diversity, Varieties and Relative Wages

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It is easy to check that the ten (independent) equations in (2) – (11) determine the ten variables –
four sets of commodity prices, the relative wage, aggregate output levels of the IRS good
AC

produced in the two countries, the commonly produced CRS good (ZC) and the number of
varieties of the IRS goods produced in the two countries.

However, to keep the algebra for determining the range of diversity and number of varieties of
export goods at the equilibrium tractable, we assume the following specific forms of the relative
labour requirement in production of the continuum of CRS goods:

1
A*(Z) =  Z  [0, 1] (12)
Z

This specification simply assumes that the Foreign country’s comparative advantage increases,
or alternatively, the Home country’s comparative advantage decreases, proportionately as we
consider higher indexed Z goods in the range of zero to one. Of course, this proportionality is

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not required, but as we will see, this greatly simplifies the algebra. Underlying this pattern of
comparative advantage there may be different combinations of absolute advantage of Home and
Foreign countries, but what is all the more relevant for a Ricardian type production structure for
this continuum-goods sector is comparative advantage of nations.

TP
Before we proceed further, a few properties of the above framework deserve attention. First,

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constant demand elasticity () means that price of each variety produced in each country is
proportional to the national wage rates:

SC
PˆX  Wˆ , PˆX*  Wˆ * (13)

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dP
where, “hat” over a variable denotes proportional change (e.g., PˆX  X ). Thus, the only
PX
MA
difference in prices that may arise is due to difference in money wage.
ED

Second, the output of each variety is invariant with respect to change in its price. Totally
PT

differentiating expressions in (5) and (14) and then using (13) we obtain:

 
PˆX  Wˆ  x , PˆX*  Wˆ *   * x *
CE

 
 x  0 , x*  0 (14)
AC

 
where,   , *  .
PX x PX* x *

Third, it follows from the full employment conditions (9a) and (10a) that, starting from a free
trade equilibrium, there is a trade-off between the number of varieties of the horizontally
differentiated export good X and the set of continuum of export goods (as indicated by the value
of ZC)4:

nˆ  
 D
LZ 
  ELZ ˆ
ZC 
 ELZ
ˆ (15)
 LX  LX

4
The algebra underlying these relationships are given in the appendix.

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nˆ *

 D*
LZ  ELZ*  BZˆ ELZ*
 * ˆ (16)
*LX  LX
C

where,  DLZ and  ELZ are respectively shares of Home country employment in production of the

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set of (lower-indexed) Z-goods produced for domestic sales and for exports (or imports by the

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Foreign country),  DLZ* and  ELZ* are respectively shares of Foreign country employment in

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production of the set of (higher-indexed) Z-goods produced for domestic sales and for exports

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ZC
(or imports by the Home country), B = ,  LX is the share of Home country employment in
1  ZC

NU
production of all varieties of good X taken together and *LX is the share of Foreign country
employment in production of all varieties of good X taken together.
MA
The above relationships bring out the implication of resource allocation effect on the goods and
ED

varieties exported. Competition for scarce resources means that in each country the number of
varieties of the horizontally differentiated good is constrained by the availability of labour for
PT

this sector, which in turn depends on the diversity as well as quantity of the continuum goods
produced and exported. A contraction of the subset of goods Z in the Home country ( Zˆ C  0 ),
CE

for example, reduces the demand for labour in this sector not only for domestic sales but also for
exports since the Foreign country now correspondingly produces a larger set of goods
AC

domestically and thus imports only a smaller set of goods from the Home country. This creates
scope for larger availability of labour for production of the horizontally differentiated good and
consequently a larger number of its varieties produced in the Home country. This is indicated by
the negative sign of the coefficient of Ẑ C in (15) above. However, even then the number of
varieties of the differentiated good may not rise because larger availability of labour for its
production may not be realized if larger quantities of the Z-goods produced are demanded. A fall
in the Home relative wage ( ˆ  0 ), for example, makes Home goods cheaper so that foreigners
demand larger amounts of each good Z  [0, ZC] that they import. This in turn raises the demand
for labour in the Z-sector and consequently has an adverse effect on the number of varieties
produced in the X-sector. That is, whereas a smaller set of goods being domestically produced

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 ACCEPTED MANUSCRIPT

and exported tends to raise the number of varieties of the X-good, a lower relative wage tends to
lower the number of varieties. Thus, the trade-off arises between the number of export varieties
of good X and both the number and the output levels of the continuum of export goods Z.

P T
Similarly, for the Foreign country, Zˆ C  0 means the set of Z goods produced and exported by it

RI
rises. This withdraws some labour from the CRS-sector there which in turn lowers the number of

SC
varieties of the horizontally differentiated good X produced by the Foreign country. Hence the
relationship between changes in n* and ZC is positive as indicated in (16). But again the volume

NU
of production is also relevant, though a fall in Home relative wage has a favourable effect on
number of varieties produced in the Foreign country.
MA
Given the above relationships in (13)-(16), we illustrate the equilibrium pair of relative wage and
ED

set of Z goods produced in each country with the help of the following two equations of change
derived from the cost efficiency condition (2) and the trade balance condition (11), as shown in
PT

the appendix:
CE

ˆ  Ẑ C (17)

ˆ  Ẑ C
AC

(18)

 E E* 
 , M ( Z )    v( Z C ) * = per capita
~ ~ ~ L
where,   M ( Z )  M * ( X )  M ( X ) 1  LZ  *LZ
  LX  LX  L
~ n* L
value of imports of Z-goods by the Home country, M ( X )  (1   )  * = per capita
n  n L
*

value of imports of differentiated varieties of good X by the Home country, ,

~ n
M * ( X )  (1   ) = per capita value of imports of differentiated varieties of good X by
n  n *
n ~ n* ~
the Foreign country, and M ( X )  M ( X *)  M * ( X ) is the weighted average of
n  n * n  n *

~ ~  L   D  ELZ DLZ*  ELZ* 

M * ( X ) and M ( X ) , and   Z C v( Z C ) *  1  M ( X )  LZ  .
 L    LX *
LX 

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 ACCEPTED MANUSCRIPT

Equation (17) indicates that a decline in the relative Home wage establishes comparative
advantage for the Home country in a proportionately larger set of Z-goods and consequently

T
raises the set of Z-goods being produced and exported by it proportionately. This one-to-one or

P
proportionality rule follows from our assumed specification of the relative labour requirement in

RI
(12). In Figure 1, this inverse relationship is represented by the curve AA. This gives us all
combinations of relative wage and the commonly produced good ZC that maintains the relative

SC
cost efficiency or comparative advantage condition (2). On the other hand, equation (18) gives us
the relationship between relative wage and the commonly produced good ZC that maintains the

NU
trade balance condition (11). This relationship is captured by the BB curve. The equilibrium
relative wage and the commonly produced continuum of goods are determined at the intersection
MA
of these two curves, that is, these values satisfy both the relative cost efficiency condition (2) and
the balanced trade condition (11).
ED

Figure 1. Equilibrium Relative Wage and Trade Pattern


PT

A B
CE
AC

e

B A
ZC
O Z e
C 1

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 ACCEPTED MANUSCRIPT

Note that the BB curve is drawn positively sloped under the assumption that both  and  are
positive in signs.5 A sufficient condition for  to be positive in sign is that the per capita value of
Home imports of higher-indexed Z goods be larger than the weighted average of the per capita
value of Home and Foreign imports of horizontally differentiated varieties of X goods, M (X ) ,

P T
times the employment shares in the two countries:

RI
~  E E* 
M ( Z )  M ( X ) 1  LZ  *LZ 
  LX  LX 

SC
~
Since M ( Z ) is increasing and M (X ) is decreasing in the share of expenditure on Z goods ( ), so

NU
this condition is satisfied for a sufficiently high value of , ceteris paribus. The high value of 
also ensures that  is positive.6 In rest of our analysis we will confine ourselves with high value
MA
of expenditure share for good Z. The implication of low expenditure share shall be discussed
later.
ED

Before moving to the analysis of tariff, it is worthwhile to discuss the implication of the
proportionality rule in (17) for the tradeoff between within and across sector diversification of
PT

export baskets of countries. This is summarized in the following Lemma:

CE

Lemma 1. Given (12) and for any given endowment of labour, if the subset of continuum of
goods exported by the Home country expands, the number of varieties produced by it
AC

falls and the number of varieties produced by the Foreign country increases.

Proof: As specified in (17) above, by (12) a fall in the relative Home wage establishes
comparative advantage of the Home country in proportionately larger number of goods.
DLZ ˆ
Substitution of this proportional relationship in (15) and (16) yields nˆ   Z C and
 LX

DLZ* B  1  B ELZ* ˆ
nˆ *  Z C . Hence, if Zˆ C  0 , which means that the Home country has a
 LX
*

5
This also ensures stability of the equilibrium pair of relative wage and the commonly produced good ZC.
As   1, M (X ) approaches to zero. At the limit, Z v( Z )  L  1  0  M ( X )  LZ  LZ  LZ  LZ  . Thus, either
D E D* E*
6
C  *   
 LX *LX 
C
L 
   [0, 1] or for  > * , the sign of  is positive.

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 ACCEPTED MANUSCRIPT

more diverse set of export good Z and the Foreign country has a less diverse set, then
nˆ  0 and nˆ *  0 . 

Thus, under the proportionality specification, we obtain a one-to-one inverse relationship

T
between the number of varieties of good X and the set of continuum of export good Z, for any

P
given endowment of labour in the two countries. This is the trade-off between within and across

RI
sector diversification of export basket we were mentioning about. However, as we show later,
under tariff, only a subset of continuum of goods produced is exported so that though the trade

SC
off still exists between the set of continuum of goods and varieties produced, such a trade off
may not exist between the set of goods and varieties exported.

NU
MA
4. Impact of Trade Liberalization

To examine the effects of trade liberalization, we rework the model with initial tariffs being
ED

imposed by the two countries on their import of the continuum of good Z. In this context, tariff
on imports is modeled as in Dornbusch et al. (1977). Let t and t* be the rates of uniform ad-
PT

valorem tariff on imports of Z  [0, 1] imposed by the Home and the Foreign country,
respectively. Then a good Z  [0, 1] is produced by the Home country if,
CE

a(Z)W ≤ (1 + t) a*(Z)W* (19)

AC

Let ZC be such that,

a(ZC)W = (1 + t) a*(ZC)W*

1   
 ZC = A *   (20)
1 t 

Similarly, a good Z  [0, 1] is produced by the Foreign country if,

a*(Z)W* ≤ (1 + t*) a(Z)W (21)

Let Z C* be such that,

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 ACCEPTED MANUSCRIPT

1

Z C* = A* (1  t * )   (22)


Thus, for any given relative wage, since by assumption A*  0 , so ZC > Z C* . That is, all goods Z

 [0, ZC] will be produced by the Home country and all goods Z  [ Z C* , 1] will be produced by

P T
the Foreign country. Amongst these set of goods produced in the two countries, the commonly

RI
produced set of goods [ Z C* , ZC] are not traded by either country whereas all goods Z  [0, Z C* ]

SC
will be exported by the Home country and all goods Z  [ZC, 1] will be exported by the Foreign
country.

NU
The equilibrium range of traded and non-traded goods must, however, be determined
MA
simultaneously with the relative wage as spelled out in section 3. The trade balance condition
(11) should now account for the tariff proceeds. Following Dornbusch et al. (1977), the tariff
ED

proceeds are assumed to be redistributed to the domestic citizens in lump sum manner. Let R and
R* denote the total income of the country which is the sum of wage income and tariff proceeds.
PT

Let  ( Z C ) and  ( Z C* ) be the fractions of income spent on all goods (exported and non-traded)

produced in the Home and the Foreign country, respectively. By our earlier assumption of 
CE

fraction of total income being spent in each country on the continuum of goods taken together, it
is immediate that [ -  ( Z C ) ] fraction of total income R will be spent on imported good at the
AC

tariff inclusive prices:

[ -  ( Z C ) ]R = (1 + t)Mt(Z) (23)

1
where, M t ( Z )  P
*
( Z )m( Z ) is the total value of imports of the continuum of goods at the
ZC

international price P*(Z), m(Z)  Z  Z C , 1 is the volume of import of good Z.

The tariff proceeds (TR) for the Home country is

t   v( Z C )R
TR  tM t ( Z ) 
(1  t )
By definition,

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 ACCEPTED MANUSCRIPT

t   v( Z C )R
R  WL  TR  WL 
(1  t )

which boils down to

(1  t )W L

T
R
1  1     ( Z C t

P
(24)

RI
Similarly, given the tariff proceeds (TR*) for the Foreign country,

SC
* * t * v( Z C* ) R *
*
TR = t M ( Z ) = (25)
(1  t * )
t

NU
the total income of the Foreign country equals,

*
(1  t * )W * L
*
MA
R =

1  1   ( Z C* t *  (26)

Using (24) and (26), the total value of imports of the continuum of goods by the two countries
ED

boils down to:

PT

  v(Z C )R =   (Z C )W L

*
v( Z C* )W * L
 
*
Mt(Z) = , M (Z ) =
(1  t ) 1  1     ( Z C t 1  1   ( Z C* t *
t
CE

(27)

Therefore, the trade balance condition (11) changes to:

AC

   v(Z C ) n*  L  v( Z C* ) n 
     (1   )

1  1     ( Z C )t
(1 ) *
n  n  L *
= 
1  1   ( Z C ) t
*
*
 
n  n * 
(28)

The rest of the analysis and simultaneous determination of equilibrium relative wage, range of
traded goods (along with the range of non-traded goods) and the number of varieties of the
horizontally differentiated goods will be similar to that spelled out in the earlier sections. Let e,
*
ZCe, Z Ce , ne and ne* be the equilibrium values, which depend on the tariff rates t and t*.

Given these system of equations for initial tariff rates t and t*, it is easy to check that the cost
efficiency (or comparative advantage) conditions (20) and (22) provide us the relationships

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between changes in tariff rate and changes in the pattern of comparative advantage and
production specialization in the two countries as:

Zˆ C   ˆ  tˆ (29)

T
Zˆ C*   ˆ   *tˆ *

P
(30)

RI
Before proceeding further, it is again relevant to check the relationship between the set of

SC
continuum of export goods Z and variety of good X under tariff. Given that the value of
consumption of good Z is constant fraction b(Z) of total income R in the Home country and b(Z)

NU
of total income R* in the Foreign country, from the full employment conditions adjusted
accordingly we obtain (see appendix): MA
 tZ C v ( Z C )   DLZ ˆ  t * Z C* v ( Z C* )   ELZ ˆ *
nˆ   1   Z  1  *
ZC
 1  {1    v( Z C )}t   LX  1  {1  v( Z C )}t   LX
C *

(31)
E D E
 LZ ˆ    A(t ) LZ tˆ  A* (t * ) LZ tˆ *
ED

 LX  LX  LX
PT

 tZ C v ( Z C )   ELZ* ˆ  * t * Z C* v ( Z C* )   DLZ* ˆ *
nˆ *   B   Z   B   ZC
1  {1    v( Z C )}t  *LX 1  {1  v( Z C* )}t *  *LX
C
  (32)
CE

ELZ*  ELZ* ˆ  DLZ* ˆ *

 *   A(t ) * t    A (t ) * t
ˆ * * *

 LX  LX  LX
AC

{1    v( Z C )} {1  v( Z C* )}
where, A(t )  and A* (t * )  .
1  {1    v( Z C )}t 1  {1  v( Z C* )}t *

The first term on the right hand side in (31) captures the change in labour demand when a larger
set of Z goods is produced in the Home country. Production of a larger set of goods requires
additional labour by the amount DLZ Ẑ C . At the same time, a smaller set of goods is now
imported so that a smaller tariff revenue is generated for any given tariff rate. Consequent
smaller total income lowers quantity demanded of each domestically produced good Z, and
tZ C v ( Z C )
correspondingly the labour demand. This is measured by DLZ Zˆ C . If the direct
1  {1    v( Z C )}t
effect is larger in magnitude than the induced income effect, then an increase in the set of

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 ACCEPTED MANUSCRIPT

domestically produced Z goods in the Home country lowers the number of varieties of the X-
good being produced. However, this does not necessarily mean that there will be a trade-off
between set of Z-goods exported and number of varieties of X-good produced and exported since
only a sub-set of Z goods produced is now exported.

P T
RI
The second term reveals that a larger set of goods produced by the Foreign country ( Zˆ C*  0 )

SC
increases the number of varieties of X-good produced and exported by the Home country. Not
only now a smaller set of goods are being imported from the Home country, consequent lower

NU
tariff revenue reduces the quantity demanded of each import good. The demand for labour in the
Home country to produce Z goods demanded by the Foreign country thus unambiguously falls,
MA
which in turn makes it possible to increase the number of varieties being produced in the Home
country. The third term is the real wage effect on the number varieties being produced as
explained earlier. The fourth term in (31) captures the revenue or income effect of a reduction in
ED

Home tariff ( tˆ  0 ) on labour demand in Z sector and correspondingly on the number of

varieties of the X good. A smaller tariff lowers revenue by the magnitude  tˆ , and raises the
PT

revenue by the magnitude A(t) tˆ because of higher volume of import demand as a result of lower
tariff-inclusive price of Foreign goods. As shown in the appendix,  > A(t) so that, overall, tariff
CE

revenue and correspondingly total Home income (R) decline when trade is liberalized. This in
AC

turn reduces demand for domestically produced Z-goods and consequently tends to raise the
number of varieties of the X-good being produced. But, a reduction of Foreign tariff has an
adverse effect on the number of Home varieties being exported because lower tariff on imports
of Home goods encourages Foreign consumers to demand larger quantities of Home Z-goods,
which in turn raises revenue and total Foreign income by the magnitude A*(t*) tˆ * .7 Volume of
production of Z-goods imported by the Foreign consumers thus rises. This necessitates
withdrawal of labour from the X-sector and consequently fall in the number of varieties
produced there.

7
Note that since foreign consumers pay tariff-inclusive price (1+t*)P(Z) for each Z-good imported from the Home
country, the relevant income for import demand is not R* but income evaluated at international prices
*
R* W*L . Lower foreign tariff unambiguously raises this income.

 
1  t * 1  1   ( Z C* t *

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 ACCEPTED MANUSCRIPT

In the Foreign country, as evident from (32), similar trade off exists between the set of Z-goods
produced and number of varieties of X-good produced and exported under the assumption that

T
the direct effect is stronger than the induced income effect of a larger set of Z goods ( Zˆ C*  0 ).

P
On the other hand, effects of reductions in Home and Foreign tariff are exactly opposite for

RI
analogous reasons as spelled out above.

SC
Given the trade-offs in (31) and (32), the trade balance condition (28) provides us the third
relevant equation of change as (see appendix):

NU
  t Zˆ C  ˆ   t* Zˆ C*  tˆ   *tˆ * (33)
MA
where,

v ( Z C ) ~ 

D
tv ( Z C )   ELZ*  DLZ   E* 

 t  1  tmt ( Z ) M t ( Z )  M t ( X ) LZ   *    B *LZ 
  v( Z C )   LX 1  1    v( Z C )t   LX  LX
   LX 
ED


Z C* v ( Z C* ) ~ * 
  LZ  ELZ DLZ*
 E* 
 t*  1  t * mt* ( Z )   B * *LZ 
E
t * v( Z C* )
     * 
 
M ( Z ) M ( X )
  LX 1  1  v( Z C ) t
   LX  LX  LX 
t t
v( Z C* ) * *

PT

 ELZ ELZ*   D ELZ* 

 ,   A(t ) M t ( Z )  M t ( X )  A(t )  LZ
~ ~
  M (t )  M t ( X )1   *  A(t ) *  , and
  LX  LX    LX  LX 
CE

 DLZ* * *  LZ 
 *  A* (t * ) M t* ( Z )  M t ( X ) *  A* (t * ) 
E
~
 A (t ) 
AC

 *LX  LX 

The three equations of change (29), (30) and (33) determine changes in the set of Z goods
produced by each country (and consequently the set of non-traded goods), the Home relative
wage, and the number of varieties of X and X* goods due to tariff reductions by the two
countries. We begin with unilateral tariff reduction by the Home country in the following sub-
section, and subsequently consider bilateral tariff reductions.

4.1. Unilateral Tariff Reduction by the Home Country

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Consider a ceteris paribus reduction in the tariff rate by the Home country: tˆ  0  tˆ * . Referring
back to (30), it is immediate that for no change in the Foreign tariff, the change in set of goods
produced by the Foreign country will be inversely proportional to the change in the Home
relative wage:

P T
Zˆ C*   ̂ (30a)

RI
On the other hand, at the initial equilibrium relative Home wage, a tariff reduction by the Home

SC
country lowers ZC, since Foreign products now become more competitive. The Foreign country
thus exports a larger set of goods. But the final outcome, that is, whether at the new equilibrium

NU
a smaller set of continuum of goods will be produced in the Home country (and accordingly a
larger set of goods being exported by the Foreign country) or not, depends on how tariff
MA
reduction changes the relative wage.
ED

There are many contrasting effects of tariff reduction on the relative wage. First of all, the initial
contraction of the production set in the Home country causes a fall in the demand for labour
PT

there, which tends to pull down the relative wage. Then there are the revenue and income effects
of a reduction in the tariff rate. As argued above, tariff revenue and consequently total Home
CE

income (R) declines, which in turn reduces the quantity demanded of each domestically
produced Z-goods and consequently lowers production levels and labour demand thereof. This
AC

further pulls down the relative wage. In the Foreign country, an expansion in its set of Z-goods
exported raises the demand for labour and consequently the Foreign wage so that decline in the
Home relative wage gets reinforced. But there are forces as well that tend to raise the relative
wage. First of all, there is the resource allocation effect in the Home country of a reduction in the
tariff rate. Labour released from the Z-sector due to the initial contraction of the set of Z-goods
being produced and fall in demand for and production of each Z-good, moves to the X-sector and
causes an expansion of the number of varieties. But if additional varieties being produced require
more labour than released from the Z sector, then there will emerge an excess demand for labour,
which will push up the Home relative wage. Similarly, in the Foreign country if labour released
from the Y-sector for each variety being shut down to sustain additional production of Z goods
for exports is larger than what is required in the Z sector, then the consequent excess supply of

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labour depresses down the Foreign wage and consequently raises the Home relative wage. That
is, the resource allocation effects in each country may put upward pressure on the Home relative
wage. Finally there are the induced effects of these contrasting changes in wage, some of which
reinforces and others dampen initial changes. The final change in the Home relative wage is thus

T
ambiguous and so are the changes in the set of goods produced by the two countries. This is also

P
evident from the algebraic expressions for changes in the Home relative wage () and ZC, as

RI
worked out in the appendix and given below:

SC
t   ˆ
ˆ  t (34)
   t*   t

NU
ˆ (   t* )  
ZC  tˆ (35)
(   t* )   t
MA
As shown in the appendix, for sufficiently large value of the share of expenditure on Z-goods
(),  ,  t ,  t* and  are positive in values. Thus, given the assumption of a high value of , a
ED

reduction in tariff by the Home country, ceteris paribus, lowers the relative Home wage.
PT

Essentially, recalling the different effects of a tariff reduction on the relative Home wage, high
value of  and corresponding positive signs of  ,  t and  t* means that the reallocation and other
CE

induced effects which together work to put an upward pressure on the relative Home wage is
weaker than the pro-competitive and revenue effects of the tariff reduction which tend to lower
AC

the relative Home wage.

The fall in the equilibrium relative wage under the above assumption means that we have
contrasting pro-competitive and wage effects of a tariff reduction on the equilibrium set of Z-
goods being domestically produced in the Home country. Whereas tariff reduction by the Home
country lowers the set of goods domestically produced through the pro-competitive effect, it
establishes comparative advantage in a larger set (and in relatively higher qualities) of Z-goods

by lowering the relative Home wage. If this wage effect is weaker, i.e.,   , then a tariff
   t*
reduction implies a smaller set of the continuum of good will be produced in the Home country

25
 ACCEPTED MANUSCRIPT

at the new equilibrium (i.e., Ẑ C ). This is more likely to be the case if initially the Home tariff

was very high, because  is larger in value.

T
Finally, given that tˆ *  0 , since change in Z C* is inversely proportional to the change in , so

P
RI
under the assumption of high value of , a reduction in the Home tariff causes a smaller set of

goods being produced in the Foreign country at the new equilibrium ( Zˆ C* > 0).

SC
NU
These results are summarized in the following Proposition:
MA
Proposition 1. For sufficiently large value of the share of expenditure on Z-goods () such that
 ,  t ,  t* ,  > 0, a ceteris paribus reduction in tariff on imports of the continuum of
ED

Z-goods by the Home country will lower the relative wage ( ˆ  0 ) and contract

the set of goods produced by the Foreign country ( Zˆ C* > 0). The tariff reduction
PT

contracts the set of goods produced by the Home country ( Zˆ C  0 ) if the pro-


CE

competitive effect is larger than the wage effect (   ). This is more likely
   t*
for high initial tariff rate in the Home country. Otherwise, the set of Z-goods
AC

produced in the Home country expands.

Proof: Follows from the above discussion and algebraic details worked out in the appendix. 

However, though whether the set of goods produced in the Home country expands or contracts
depends, among others, on the initial tariff level, contraction in the set of non-traded goods and
consequently more goods being traded now is unambiguous. This is evident from the following
Lemma:

Lemma 2. For tˆ  0  tˆ * , Zˆ C  Zˆ C*  0 .

26
 ACCEPTED MANUSCRIPT

Proof: From (34) and (35) it follows that,

Zˆ C  Zˆ C*  Zˆ C  ˆ  tˆ <0 (36)

Hence proved. 

P T
Proposition 1 and Lemma 2 have the following implications. First, for a ceteris paribus reduction

RI
in the (uniform) tariff on imports of continuum goods by the Home country, the Home exports
become more diversified since Zˆ C* > 0. Second, under the assumption of stronger pro-

SC
competitive effect of tariff reduction by the Home country, exports of Z-goods by the Foreign

NU
country become more diversified because Zˆ C  0 . Thus, despite the set of goods produced in
each country contracting, the export baskets are now more diversified. But in case of stronger
MA
wage effect in the Home country, Zˆ C  0 so that exports of the continuum of goods by the
Foreign country becomes less diverse since its set of exports contracts. Figure 2 illustrates this
ED

reduced set of non-traded goods for a stronger pro-competitive effect of tariff reduction by the
Home country.
PT
CE
AC

Figure 2. Unilateral Tariff Reduction by Home country and Pattern of Trade

Pre tariff reduction

Exports by H Non-traded Exports by F
pattern of trade
goods
0 Z
*
Z Ce Z Ce 1
Exports Post tariff reduction
Non-
Exports by F
by H traded pattern of trade
goods

27
 ACCEPTED MANUSCRIPT

Now substitution of (30a) in (31) yields the change in the number of varieties of the X-good
produced and exported by the Home country after tariff reduction as,

 tZ C v ( Z C )   DLZ ˆ  t * Z C* v ( Z C* )   ELZ
nˆ   1   Z   2  *
ˆ
 1  {1    v( Z C )}t   LX  1  {1  v( Z C )}t   LX

T
C *

(31a)

P
 DLZ ˆ * *  LZ ˆ *
E
   A(t ) t  A (t ) t
 LX  LX

RI
SC
By Proposition 1, on account of the revenue (or income) effect and stronger pro-competitive
effect of tariff, the number of varieties of good X produced and exported rises. This is because

NU
some workers are released from the Z-sector towards the X-sector due to the fall in the
consequent volume of production and set of production of Z-goods respectively. But as the
MA
reduction of Home tariff lowers the relative Home wage and consequently makes its exports to
the Foreign country more competitive and proportionately larger in terms of number of varieties
(as evident from the contraction in the subset of goods produced in the Foreign country,
ED

Zˆ C*   ̂ > 0), this requires additional labour. This has a contractionary effect on the labour
availability for X-sector and expansion of varieties. Thus, the adverse effect on the number of
PT

varieties of X-good does come from the more diversified set of exports of Z-goods. That is, the
trade-off between export diversity of Z goods and export variety of good X exists. Yet, the final
CE

(or combined) outcome may be an increase in the number of varieties produced and exported at
the equilibrium if the two favourable effects are stronger than this diversified-export effect, in
AC

which case the trade-off is no longer apparent.

Similarly ambiguous is the change in the number of varieties of good X produced and exported
by the Foreign country as is evident from (32) using Zˆ C*   ̂ and tˆ * = 0:

 tZ C v ( Z C )   ELZ* ˆ  * t * Z C* v ( Z C* )   DLZ*  ELZ* 

nˆ *   B   Z   B     ˆ
1  {1    v( Z C )}t   LY 1  {1  v( Z C* )}t *   LY  LY 
C
 
(32a)
 E*
 A(t ) LZ tˆ
 LY

But now the adverse effect on the number of varieties of good X produced by the Foreign
country comes not only from its more diversified export of good Z (because Zˆ C  0 ) but also

28
 ACCEPTED MANUSCRIPT

from the (Home) revenue effect of the reduction in the Home tariff on the volume of Z-goods
exported by the Foreign country. Thus, an expansion in the number of export varieties produced
by the Foreign country is less likely than an expansion in the number of export varieties
produced by the Home country.

T
P
Proposition 2. A ceteris paribus reduction in tariff on imports of the continuum of goods by the

RI
Home country may expand the set of continuum of goods exported by both the
countries but may increase the number of varieties of the other export good only

SC
for the country that is liberalizing its trade.

NU
Proof: The first part of the proof (that is, more diversified export of Z-goods) follows from
Proposition 1 and Lemma 2. The second part of the proof (that is, change in the number
of export varieties) follows from (31a), (32a) and the discussion above. 
MA
ED

Thus, unilateral trade liberalization by the Home country may have different effects on across
and within sector diversification of export baskets of the two countries. For the Home country,
PT

achieving export diversification across sectors through trade liberalization necessitates that such
a policy lowers its wage relative to the Foreign wage to make its goods more competitive and
CE

thereby make some of the non-traded goods exportable. The corresponding larger volume of
production of these Z goods (to meet the demand from Foreign consumers in addition to
AC

domestic demand) raises the demand for labour in these sectors and correspondingly constrains
an expansion of the number of varieties of good X. But whereas the pro-competitive effect of
tariff lowers the subset of Z-goods being produced at Home, the revenue (or income) effect of
the tariff reduction lowers domestic demand and hence level of output of all goods produced. On
both accounts, the demand for labour falls in Z sectors. Thus, despite the fall in Home wage and
corresponding expansion of the subset of Z goods being exported, labour can be released from all
Z-sectors taken together if the pro-competitive and revenue effects are stronger than the wage
effect. In such case, the number of varieties of good X exported increases as well so that
unilateral tariff reduction by the Home country enables it to achieve export diversification both
across and within sectors. But, whereas reduction of trade costs for the Foreign country due to
reduction of tariff on its export goods may enable it to export a larger subset of continuum goods

29
 ACCEPTED MANUSCRIPT

and achieve across-sector diversification of its export basket, within-sector export diversification
is most likely to fall.

T
This not-so-desirable effect on its export basket for the Foreign country, which may retard its

P
faster growth prospects or destabilize its export earnings in the long run, may prompt the Foreign

RI
country to lower its own tariff. To see whether such an action by the Foreign country helps it

SC
achieve diversification both across and within sectors, we examine the effects of bilateral tariff
reduction in following sub-section.

NU
4.2. Bilateral Tariff Reduction
MA
Consider now reduction in tariffs on imports of the Z-goods by both the countries, that is,
tˆ  0, tˆ *  0 . As shown in the appendix (see equations (A.14) – (A.16)),
ED

 t    ˆ  t* *   * ˆ *
ˆ  t t (37)
PT

   t   t*    t   t*

(   t* )    * *   * ˆ *
CE

Zˆ C  ˆ t
t t (38)
   t   t*    t   t*
AC

    ˆ  *  (   t ) * ˆ *
Zˆ C*   t t t (39)
   t   t*    t   t*

Thus, reductions in Home and Foreign tariff rates have contrasting effects on the relative Home
wage. Whereas the Home tariff reduction lowers the relative Home wage, the Foreign tariff
reduction unambiguously raises it. Accordingly, a significantly large reduction of Foreign tariff
relative to the reduction of the Home tariff may raise the equilibrium Home relative wage.
Regarding expansion or contraction of production sets in the two counties as a result of bilateral
tariff reductions, it is immediate from the cost efficiency conditions (29) and (30) that in each
country, a reduction of own tariff has adverse pro-competitive effect and favourable wage effect
on the production set whereas a reduction of other’s tariff has only the adverse wage effect on it.

30
 ACCEPTED MANUSCRIPT

If the pro-competitive effect is stronger than the wage-effect of own tariff reduction in each
country, then bilateral tariff reductions unambiguously lowers the production set (and

consequently makes export baskets of both more diversified): Zˆ C  0 and Zˆ C* > 0. Thus, the

T
results stated in Propositions 1 and 2 extend to the case of bilateral tariff reductions. In fact, the

P
contraction of set of Z-goods produced in both countries and expansion of set of Z-goods

RI
exported by both countries get reinforced or magnified under bilateral tariff reductions.

SC
Interesting and contrasting implications bilateral tariff reductions arise, however, in cases where
the wage effect is stronger in one or both countries. Suppose, for example, the pro-competitive

NU
*
effect of Foreign tariff reduction is weaker than the wage effect of it (  
*
), so that for
MA   t

unilateral reduction in Foreign tariff the production set there expands ( Zˆ C* < 0). But the
production set in the Foreign country contracts (and consequently the Home export basket
ED

becomes more diversified) under bilateral tariff reduction if the degree of reduction in Home
tariff and its induced effects are large enough relative to the reduction of the Foreign tariff to
PT

lower the relative Home wage. This is because, if the relative Home wage falls (or the relative
Foreign wage rises) as a consequence of bilateral tariff reduction, the set of Z-goods produced in
CE

the Foreign country actually becomes relatively dearer causing some lower indexed goods
previously produced by it unprofitable. Thus, the initial pro-competitive effect of tariff reduction
AC

in the Foreign country is reinforced. This result is in sharp contrast with unilateral tariff
reduction and is formally stated in the following Lemma:

Lemma 3: For tˆ  0 and tˆ*  0 , ̂ < 0  Zˆ C*  0 .

Proof: From (37), the relative Home wage falls if,

 t    tˆ   t* *   * tˆ*  tˆtˆ

*
  t      t* *   * [since tˆ  0, tˆ *  0 ]

Given that  t  0 , this means.

*

tˆ *
 t     *
(40)
tˆ

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 ACCEPTED MANUSCRIPT

Finally, rewrite (39) as,

 tˆtˆ
*
  t       *  (   t ) *
Zˆ C*  tˆ
   t   t* (39a)

P T
ˆ*
From (39a) and (40) it is now immediate that Z C  0 for tˆ  0, tˆ  0 . 
*

RI
 ˆ
Similarly, even in case of   so that Z C  0 under unilateral tariff reduction by the

SC
   t*
Home country (see Proposition 1), if under bilateral tariff reduction the relative Home wage rises

NU
( ˆ  0 ), the set of Z-goods produced in the Home country falls. That is,
MA
Lemma 4: For tˆ  0 and tˆ*  0 , ̂ > 0  Zˆ C  0 .

Proof : Proceeding as in case of Lemma 3, from (37), the relative Home wage rises if,
ED

 t      t* *   * 
tˆ *
 tˆtˆ
*
    t* *   * since  t  0 . Then rewriting (38) as
tˆ
PT

 tˆtˆ
*
(   t* )     t* *   *
CE

Zˆ C  tˆ
   t   t*
AC

ˆ
it is immediate that Z C  0 for tˆ  0, tˆ  0 . 
*

These two Lemmas clearly bring out the contrasting implications of bilateral tariff reductions.
The above results are summarized in Proposition 3 below:

Proposition 3: Bilateral tariff reductions ( tˆ  0, tˆ *  0 ) expand the set of continuum of goods

exported by both the countries ( Zˆ  0 , Zˆ *  0 ) in any one of the following
C C
situations:
(a) if the wage effect is weaker than the pro-competitive effect of own tariff
reduction in each country, regardless of the change in the equilibrium Home
wage;
(b) if the wage effect is weaker than the pro-competitive effect of own tariff
reduction in the Home (Foreign) country and the equilibrium Home relative
wage falls (rises).

32
 ACCEPTED MANUSCRIPT

Proof: (a) Weaker wage effect than the pro-competitive effect of own tariff reduction in each
 *
country means   and  *
 . From (38) and (39) it is then immediate that
   t*   t

Zˆ C  0 , Zˆ C*  0 .

P T
(b) By (39), a weaker wage effect than the pro-competitive effect of own tariff reduction


RI
in the Home country (   ) means Zˆ C  0 . On the other hand, by Lemma 3,
   t*

SC
̂ < 0  Zˆ C*  0 . The other case can be similarly proved. 

NU
The above proposition means that the likelihood of export baskets of both countries becoming
MA
more diverse across sectors is greater under bilateral tariff reductions than under unilateral tariff
reduction.
ED

However, again, bilateral tariff reductions unambiguously lower the set of non-traded goods. But
as the following Lemma suggests, more Z-goods now become traded relative to unilateral tariff
PT

reduction by the Home country:

Lemma 5. For tˆ  0 and tˆ*  0 , Zˆ C  Zˆ C*  0

CE

Proof. Subtracting (39) from (38) we obtain,

AC

Zˆ C  Zˆ C*  tˆ   *tˆ * < 0. 

That under bilateral tariff reduction the contraction in the set of non-traded goods is larger seems
obvious because both the countries now provide greater market access to each other by lowering
tariffs.

Finally, we examine the implications of bilateral tariff reductions on the number of varieties of X
good. Substitutions of (29) and (30) in the expressions in (31) and (32) yields,

33
 ACCEPTED MANUSCRIPT

 tZ C v ( Z C )   DLZ ˆ  t * Z C* v ( Z C* ) 
nˆ   1   Z   2  *
ˆ
 1  {1    v( Z C )}t   LX  1  {1  v( Z C )}t 
C *

(31b)
D  t * Z C* v ( Z C* ) 
   A(t ) LZ tˆ  1   A* (t * )tˆ *
 LX  1  {1  v( Z C )}t
* *


P T
 tZ C v ( Z C )   ELZ*  * t * Z C* v ( Z C* )   DLZ* ˆ *
nˆ *   1  B   
ˆ   B   ZC

RI
 1  {1    v( Z C )}t  *LX  1  {1  v( Z C* )}t *  *LX
(32b)
 tZ C v ( Z C )   ELZ*  DLZ* ˆ *
 

SC
  A(t )  B   t    A (t ) * t
ˆ * * *

 1  {1    v( Z C )}t  *LX  LX

NU
It is evident that bilateral tariff reductions lead to similar trade-off between set of Z-goods
produced and the number of varieties of the differentiated product similarly as does a unilateral
MA
tariff reduction. It is interesting to note, however, that since now the equilibrium relative Home
wage may rise, and yet the set of Z-goods produced in the Home country can rise under a weak
wage effect there (see Proposition 3), the number of varieties of good X produced and exported
ED

by the Home country is most likely to rise ( nˆ  0 ) unless the adverse effect coming from the
reduction of the Foreign tariff (the last term in the right hand side of (31b)) is significantly large.
PT

But in this case of a rise in the equilibrium relative Home wage, the number of horizontally
differentiated varieties produced and exported by the Foreign country falls, which reinforces the
CE

adverse effect of Home tariff reduction (the third term in (32b)). So though the contraction in the
set of Z-goods produced by the Foreign country ( Zˆ *  0 ) and own tariff reduction (the last term)
AC

have favourable effects, the number of varieties produced by the Foreign country may fall
( nˆ *  0 ). On the other hand, if the relative Home wage falls, given the conditions under which
Zˆ C*  0 , increase in the number of varieties exported by the Foreign country is more likely. But
at the same time this means that increase in the number of varieties exported by the Home
country is less likely than in case of an increase in the relative Home wage.

Thus, like the unilateral tariff reduction case, larger varieties of exports of the differentiated good
may not be realized for both countries under bilateral tariff reduction.

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 ACCEPTED MANUSCRIPT

What appears from the above argument is that for the Foreign country, own tariff reduction have
both favourable and adverse effects on the number of varieties produced by it. Hence, lowering
its own tariff in reaction to tariff reduction by the Home country may not help it achieve export
diversification both across and within sectors.

P T
RI
5. Discussion

SC
5.1. Alternative Interpretation of Results

NU
The Ricardian continuum of goods that we consider here differs from each other in terms of their
labour requirement per unit of output as specified in Section 2. These reflect labour productivity
MA
differences across the continuum structure. Higher indexed Z goods require larger units of labour
per unit of output, which means that labour is less productive in production of higher-indexed
goods. This lower productivity may be actually because of variations in sophistication or quality
ED

across such a continuum of goods. That is, higher indexed Z goods may be more sophisticated or
of higher quality so that they require more complicated tasks or stages of production to be
PT

performed (relative to lower indexed Z goods), and accordingly, being produced solely by
labour, requires larger number of workers to produce one unit of output. The existing literature
CE

on trade in vertically (or quality) differentiated goods relates quality variations with factor
intensity or relatively larger use of a particular factor per unit of output. For example, Falvey
AC

(1981) and Falvey and Kierzkowski (1987) considers quality as an increasing function of capital
intensity, whereas Acharyya and Jones (2001) consider quality as an increasing function of
8
capital per unit of output. Our reinterpretation of the continuum of goods as quality
differentiated goods, however, is motivated by Flam and Helpman (1987). In their North-South
trade model, labour being the only factor of production, quality differences between varieties
from the North and the South originate from differences in technology and therefore in relative
labour requirements per unit of output in exactly the same way we perceive here. 9 From such a

8
In a Gruen-Corden type model with skilled labour, and physical capital producing a quality-differentiated export
good, Acharyya and Jones (2001) assumed that a higher quality export good requires larger units of capital but fixed
unit of skilled labour per unit of output. But this essentially means that higher-quality goods are relatively capital
intensive like Falvey (1981) and Falvey and Kierzkowski (1987).
9
To use the parlance of Rodrik (2006) and Hausmann et al. (2007), we can also call the continuum of Z goods as a
continuum of sophisticated goods.

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 ACCEPTED MANUSCRIPT

perspective, first of all, the Ricardian continuum goods and the pattern of production defined in
(2) means coexistence of different quality goods at equilibrium (like in Flam and Helpman,
1987). The assumption of relative labour requirement in (1) now means increasing comparative
advantage of the Foreign country (or diminishing comparative advantage of the Home country)

T
in higher quality Z goods. Accordingly, the equilibrium condition (2) indicates that the Home

P
country specializes in relatively lower quality Z goods and the Foreign country in relatively

RI
higher quality Z goods. Second, our results shed some light on whether trade liberalization

SC
makes export basket more diversified (in terms of larger product varieties), on the one hand, and
changes the composition of the export basket by causing relatively more sophisticated or higher

NU
quality goods being exported, on the other hand. Accordingly, the results can be put in a different
but related context. MA
The importance of exporting relatively larger number of high and medium technology intensive,
sophisticated and high-value addition export goods in fostering growth of countries has been
ED

discussed in theory as well as found to be significant in recent empirical estimates. For example,
the New Growth Theories locate the sources of growth both in increasing product varieties
PT

(Romer, 1990; Grossman and Helpman, 1991) and in rising product quality (Aghion and Howitt,
1992; Grossman and Helpman, 1991). Thus, countries exporting larger varieties and better
CE

quality goods would do better in augmenting their growth rates through productivity gains,
spillover effects, and learning-by-doing than other countries (Grossman and Helpman, 1991;
AC

Young, 1991). This suggests a change in the composition of exports of a country from primary
commodities and low value addition manufacturing goods to skill-intensive, high-quality goods
for achieving a faster rate of growth through exports.

Recent empirical estimates also find support for such an argument. For example, Hausmann et al.
(2007) and Rodrik (2006), find that neither specialization nor diversification aids growth as long
as exports comprise of predominantly low value added commodities. Comparing the productivity
of export basket of China with other countries, Hausmann et al. (2007) concluded that China’s
export of highly sophisticated products has been the main driver of its rapid growth. Aditya and
Acharyya (2013), on the other hand, have found significant impact of the share of high-
technology exports in total exports on output growth in their panel data estimates during 1970-

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2005 for 65 countries. Thus, in addition to diversification of export basket, the composition of a
country’s export basket also seems to be important for achieving higher output growth, which is
in support of results of the New Growth Theory.

P T
In this context, our result in Proposition 1 suggests that both a diversified export basket (in terms

RI
of larger varieties) and the desired change in the composition of the export basket (in terms of
higher quality goods approximated by higher-indexed Z goods) may be achieved through trade

SC
liberalization. Few comments are warranted at this point. First, the continuum goods framework
of DFS enables us to endogenize the pattern of trade in these goods and consequently the

NU
composition of export baskets of trading partners. Second, with Z goods being interpreted as
continuum of quality-differentiated goods, trade costs like tariff makes some of the intermediate
MA
range of quality goods as non-traded qualities. This leaves scope for the country specializing in
the lower subset of quality-differentiated Z goods (in our case, the Home country) to export some
of these intermediate quality-differentiated goods, which are of higher qualities than the highest
ED

quality of the goods that were earlier exported. The export basket of the trade liberalizing Home
country thus now contains relatively higher quality goods and it is in this sense composition of
PT

its export basket changes in the direction desirable for growth. In similar spirit, however, for the
Foreign country specializing in the higher subset of quality-differentiated goods, what
CE

Proposition 1 states is that its export basket may now contain fewer lower-quality goods (relative
to what it was exporting before the Home country reduced its tariff). On the other hand, if the
AC

subset of quality-differentiated goods exported contracts for the Foreign country, then it means
that the Foreign country specializes in higher quality goods. Given the findings of Imbs and
Wacziarg (2003) and Aditya and Acharyya (2013) that developing countries benefit from greater
diversification whereas the advanced countries perform better with specialization, this may be
good for growth of our Foreign country.

5.2 Welfare Implications

Though the focus of the paper is not welfare issues, yet one may wonder what the welfare
implications of our results are. First of all, note that acroos-sector diversification of export basket

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 ACCEPTED MANUSCRIPT

requires that the Home wage relative to Foreign wage must fall. This is a source of welfare loss.
On the other hand, there are two sources of welfare gains, if at all. First is the increase in the
variety of the horizontally differentiated good, which is gain at the extensive margin as in
Krugman (1979) and Melitz and Ottaviano (2008). Second is the gain from exports of good Z

T
that were previously not traded. This may be interpreted as gains at the intensive margin. Thus,

P
our result in Proposition 1 suggests that trade liberalization though may augment growth by

RI
making export basket more diverse (both across and within sectors), it may be welfare reducing

SC
when the welfare loss on account of the fall in relative wage outweighs the welfare gains from
increased variety and larger subset of Z goods being exported.

NU
Such a possibility of welfare of the Home country going down is similar in spirit of Melitz and
MA
Ottaviano (2008), who show that unilateral trade liberalization leads to a loss in welfare for the
liberalizing country in the long-run. 10 At the same time, this welfare loss, if at all, brings out the
conflict between growth and welfare in an open economy. The standard competitive general
ED

equilibrium models not only show that trade promotion (such as export subsidy) reduces welfare
through TOT deterioration, but also that growth may be immiserizing when it is export-biased
PT

(Bhagwati, 1958). In similar spirit, our result indicates that though trade liberalization may
promote growth through across and within sector diversification of exports, it may lower
CE

welfare.
6. Conclusion
AC

The present paper examines whether tariff reductions leads to diversification of exports both
across and within sectors defined respectively as larger subset of distinctly different goods and
larger varieties of a horizontally differentiated good. Such an analysis is worthwhile from the
perspective of recent empirical findings suggesting that diversification of export basket of
countries fosters their growth rates as well as stabilizes export earnings in the long run.

10
Note, however, that in Melitz and Ottaviano (2008) there is a gain (or loss) if more (or less) firms export since
exporters in their analysis are endogenously determined. In our model, it is the number of goods exported (and
imported) that are endogenously determined. There is thus a difference in the source of welfare gains in addition to
gains at the extensive margin arising due to increased variety.

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 ACCEPTED MANUSCRIPT

In the model that synthesizes Ricardian continuum of traded goods model with Krugman’s
(1979) intra-industry trade model, we have shown that it is possible to achieve export
diversification both across and within sectors. While a trade off between across-sector and
within-sector diversification may arise, since all sectors compete for the same factor of

T
production, labour, and only a subset of goods produced is exported under tariff, so tariff

P
reductions may still lead to diversification on both these dimensions. This is more likely under

RI
bilateral rather than unilateral tariff reduction, however. On an interpretation of Ricardian

SC
continuum of goods as continuum of quality-differentiated goods, our results also shed some
light on whether trade liberalization makes export basket more diversified (in terms of larger

NU
product varieties), on the one hand, and changes the composition of the export basket by causing
relatively more sophisticated or higher quality goods being exported, on the other hand.
MA
The present analysis can be extended to several directions, which constitute our future research
ED

agenda. First, as robustness check, it may be worthwhile to consider non-uniform tariffs such

that t ( Z )  0, t * ( Z )  0 . Second, though we have interpreted higher-indexed goods requiring
PT

larger per unit labour as higher quality from the production side, the same has not been reflected
on demand for good-Z. One obvious way of capturing the demand dimension of higher quality is
CE

that a larger fraction of expenditure is being spent on a good-Z of higher quality, that
is, b(Z )  0 . Third, the existing empirical literature does not identify the relative importance of
AC

across and within sector export diversification for augmenting growth rates of countries.
Therefore, it is relevant to explore whether any such trade off exists or not. If it does not, then
targeted trade policies to achieve export diversification (and hence indirectly promote growth)
may not be necessary. But, if such a trade off exists, then the next relevant research question
(both theoretical and empirical) may be does it make any difference whether export basket is
more diversified in one way but less in the other way. If so, then depending on which type of
diversification may be more relevant, trade policy must be designed in way to further such a
specific type of export diversification.

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 ACCEPTED MANUSCRIPT

Appendices

A.1. Equilibrium Diversity, Varieties and Relative Wages under Free Trade

Total differentiation of the Home country’s full employment condition (9a), given the assumption of
constant expenditure share b(Z)  Z  [0, 1], yields,

P T
 b L 
* *
bL Z C
d L    X dn  ndX  b L 
 dZ  d
  C

RI

   2

SC
  X n
*
bL
Defining  LX  ,  D
 bZ C and  E
 as employment shares respectively in X-
L
LZ LZ
L

NU
sector, in production of local sales and of exports of Z goods produced by the Home country, we obtain:

Lˆ  LX nˆ  DLZ  ELZ Zˆ C  ELZ ˆ MA (A.1)

Similarly,

Lˆ*  *LX nˆ *  DLZ*  ELZ* Zˆ C  ELZ* ˆ (A.2)

ED

From these we obtain the trade-offs specified in (15) and (16) in the text for Lˆ  Lˆ*  0 .

Now consider the cost efficiency condition specified in (2). Using (12), total differentiation yields,
PT

1
d   dZ C
Z C2
CE

 ˆ  Ẑ C
AC

which is the relationship specified in (17) in the text.

Next consider the trade balance condition (11) in the text reproduced below:

 n*  L  n 
      *
 * = v( Z C )  (1   )
n  n * 
v ( Z ) (1 )
n  n  L
C
 

 n*   L
Defining M    v( Z C )  (1   )
~
n  n *  L *
, total differentiation yields:


40
 ACCEPTED MANUSCRIPT

L  n* 
 * 
      ˆ
n  n * 
v ( Z C ) (1 )
L 

  v ( Z C )dZ C  1   
 
n  n * dn *  n * ( dn  nd  dn *  L
 *
 n  n * 
2
  L

T
 v ( Z C )dZ C  1   
 
n  n * dn  nd   dn( dn  nd  dn * )

P
n  n *
2
 

RI
~  L 
 Mˆ  Z C v ( Z C ) *  1 Zˆ C 
1   nn *  nˆ  nˆ *  ˆ  L  nˆ  nˆ *  ˆ 
   

SC
2  
L  
n  n *   L
*


NU
 ~  n ~   L  ˆ  n ~ 
 M   M ( X ) 
n* ~*
M ( X )  
ˆ  Z v ( Z )
C   1
 Z   M ( X ) 
n* ~
M * ( X ) nˆ  nˆ *  
 n  n n  n  n  n n  n
* * C * C * *
  MA L  

n ~ n* ~
Substitution of values from (A.1) and (A.2), using M ( X )  M ( X )  M * ( X ) , yields,
n  n *
n  n *
ED

~
   L 
  ˆ
   DLZ   ELZ  DLZ*   ELZ* 
 M  M ( X ) ˆ  Z C v (Z C ) *  1Z C  M ( X )   ˆ   ELZ  ELZ*  
Z C    * ˆ 
L     LX *LX    LX  LX  
PT

~ ~   ELZ  ELZ* 
  M ( Z )  M ( X )  M ( X )1   *  ˆ
   LX  LX 
CE

  L    DLZ   ELZ  DLZ*   ELZ*  ˆ

  
  Z C v ( Z C ) *  1  M ( X )   Z C  0
 L    LX *LX 
AC

This is the relationship specified in (18):

ˆ  Ẑ C

~ ~  ELZ DLZ* 
where   M ( Z )  M ( X )  M ( X ) 1    and
  LX *LX 

 L   DLZ  ELZ DLZ*  ELZ* 

  Z C v( Z C )  1
  M ( X )   
L
*
   LX *LX 

41
 ACCEPTED MANUSCRIPT

A.2. Impact of Tariff Reduction by Home Country

1 1
Rewrite (20) and (22) in the text using (17) as, (1  t )   and  (1  t * )  (A.3)
ZC ZC
and total differentiation we obtain the following relationships :

T
ˆ  Zˆ C  tˆ (A.4)

P
ˆ  Zˆ C*   *tˆ *

RI
(A.5)

SC
t t*
where,   and  
*
.
1 t 1 t*

NU
Now consider the full employment conditions as:

ZC Z C*

L    x n   a( Z )Q( Z )dZ   a( Z ) M * ( Z )dZ

MA
0 0

1 1
L    x n   a ( Z )Q ( Z )dZ   a * ( Z ) M ( Z )dZ
* * * *
ED

Z C* ZC
PT

Given that constant b(Z) fractions of total Home and Foreign incomes, defined in (24) and (26) as
*
(1  t )W L (1  t * )W * L
R *

1  1     ( Z C t
and R =
1  1   ( Z C* t * 
, being spent on each good Z by Home and Foreign
CE

consumers respectively, and the consumers in Home and Foreign country pay respectively the tariff-
inclusive prices equal to (1  t )a * ( Z )W * and (1  t * )a( Z )W for their imports, the full employment
AC

conditions under tariff can be rewritten as,

*
(1  t )b LZ C b L Z C*
L    x n  
1  1     ( Z C t  1  1   ( Z C* t *    (A.6)

*
(1  t * )(1  Z C* )b L b L (1  Z C )
L    x n 
*

  
*
(A.7)
1  1  (Z C t * *
1  1     ( Z C t

Total differentiation of both sides in (A.6) yields (using Xˆ  0 ),

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 ACCEPTED MANUSCRIPT

b LZ C dt  (1  t )dZ C  b LZ C (1  t )tv ( Z C dZ C  1    v( Z C )dt 

d L  0    x dn  
1  1    v( Z C )t 1  1    v(Z C )t 2
 2
b LZ C* d

b L dZ C*

* *

b L dZ C*  t * v ( Z C* )dZ C*  1  v( Z C* ) dt *   
    
 1  1  v( Z C* ) t *  1  1  v( Z C* ) 
 1  1  v( Z C* ) t *
2
  

T

b LZ C (1  t ) tˆ  Zˆ C  
b LZ C (1  t ) tZ C v ( Z C ) Zˆ C  t1    v( Z C )tˆ 

P
 0  n  x nˆ  
1  1    v( Z C )t 1  1    v(Z C )t 2

RI

b LZ C* ˆ

*

b L Z C* Zˆ C*

  
b L dZ C*  t * Z C* v ( Z C* ) Zˆ C*  t 1  v( Z C* ) tˆ *
*
 
     

SC
 1  1  v( Z C* ) t *  1  1  v( Z C* )  1  1  v( Z C* ) t *   2

~
 
 0   LX nˆ   LZ tˆ  Zˆ C   DLZ
tZ C v ( Z C )
Zˆ C   DLZ A(t )tˆ   LZ ˆ

NU
1  1    v(Z C )t 
 t * Z C* v ( Z C* )  ˆ*
  ELZ 1   Z C   LZ A (t )tˆ
E * * *


 1  1  v( Z C ) 
MA *


where

bZ C (1  t ) 1    v(Z C )t , E *
1  v(Z C* )t *
ED

b L Z C*
 D
  LZ  , A* (t * ) 
  
, A(t) = (A.8)
1  1    v( Z C )t 1  1    v(Z C )t  1  1  v( Z C* )t *
LZ
 L 1  1  v( Z C* ) t *
PT

Solving for n̂ yields the expression in (31) in the text:

 tZ C v ( Z C )   DLZ ˆ  t * Z C* v ( Z C* )   ELZ ˆ *
nˆ   1   Z  1  *
ZC
CE

 1  {1    v( Z C )}t   LX  1  {1  v( Z C )}t   LX
C *

(A.9)
 ELZ  DLZ ˆ * *  LZ ˆ *
E
     A(t )
ˆ t  A (t ) t
AC

 LX  LX  LX

Similarly, totally differentiating both sides in (A.7) and solving for n̂ * we obtain the expression in (32) in
the text:

 tZ C v ( Z C )   ELZ* ˆ  * t * Z C* v ( Z C* )   ELZ* ˆ *
nˆ *   B   * Z C  B   ZC
 1  {1    v( Z C )}t   LX  1  {1  v( Z C* )}t *  *LX
(A.10)
 E*  E*  D*
 *LZ ˆ  A(t ) *LZ tˆ   *  A* (t * ) *LZ tˆ
 LX  LX  LX

where,

b(1  Z C* )(1  t * ) b L (1  Z C )
DLZ*  and  ELZ* 

1  1  v( Z C ) t
*

*
1  1     (Z C t L
*
. (A.11)

Now consider the trade balance condition (28) reproduced below:

43
 ACCEPTED MANUSCRIPT

   v(Z C ) n*  L   ( Z C* )
 (1   )
n 
    
  
 (1 ) *
=
1  1     ( Z C )t n  n  L 1  1   ( Z C ) t n  n * 
* * *

Totally differentiating and proceeding as in case of free trade regime we obtain:

T
 Z C v ( Z C ) tZ v ( Z C )  v( Z C ) L ˆ   v( Z C )1    v( Z C )t L ˆ

P
~
 M (t)ˆ    C 2 
 * ZC   *t
 1  1    v( Z C )t  1  1    v( Z C )t   L 1  1    v( Z C )t 2

RI
L
nn *
 1   
L
 * (nˆ *  nˆ  ˆ )
n  n  L

SC
*

 Z C* v ( Z C* ) t * Z C* v ( Z C* )v( Z C* )  ˆ * v( Z C* )1  v( Z C* )t * *

  ZC  tˆ

     
1  1  v( Z C )t   
1  1  v( Z C )t 

NU
* * * 2 * 2
 1 1 v ( Z ) t * *
C

nn *
 1    (nˆ  nˆ *  ˆ )
n  n 
*
MA
~   v ( Z C )1  1    v( Z C )t dZ C    v( Z C ) 1    v( Z C )dt  tv( Z C )dZ C   L
M (t)ˆ   
 1  1    v( Z C )t 2  L
*

 1   
n  n dn
* *
 n * ( dn  nd  dn * )

L
ED

n  n * 2
L
*


    
v ( Z C* ) 1  1  v( Z C* ) t * dZ C*  v( Z C* )  t * v ( Z C* )dZ C*  1  v( Z C* ) dt * 
1  1  v(Z )t 
PT

* * 2
C

 1   
n  n dn  nd   n( dn  nd  dn )
* *

n  n 
CE

* 2

Z v ( Z C ) ~ n
 M (t)ˆ  1  tm t ( Z ) C
~ ~ ~
M t ( Z ) Zˆ C  A(t ) M t ( Z )tˆ  M t ( X )(nˆ *  nˆ  ˆ )
  v(Z C ) n  n *
 
AC

  Z vv(Z(Z) ) M~
* *
~ n* ~
 1  t * mt* ( Z ) C C *
( Z ) Zˆ C*  A* (t * ) M t* ( Z )tˆ *  M t* ( X )(nˆ  nˆ *  ˆ )
*
C
t

n  n *

Substitution of values from (A.9) and (A.10) yields,

 tZ C v ( Z C )   DLZ  ELZ*  ˆ  t * Z C* v ( Z C* )   ELZ  ELZ*  ˆ *

ˆn  nˆ *   1  B      Z C  1  B 
*
   Z C
 1  {1    v( Z C )}t   LX *LX   1  {1  v( Z C* )}t *   LX *LX 
 E  E*    D  E *    E  D*  
  LZ  *LZ  ˆ    A(t ) LZ  *LZ tˆ   *  A* (t * ) LZ  *LZ tˆ *
  LX  LX     LX  LX     LX  LX 

Substitution of this value yields the equation of change (33) in the text reproduced below:

  t Zˆ C  ˆ   t* Zˆ C*  tˆ   *tˆ * (A.12)

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Finally, substitution of Zˆ C*   ˆ   *tˆ * as in (30), the above expression in (A.17) boils down to,

  t Zˆ C  (   t* ) ˆ  tˆ   * t*   * tˆ* (A.13)

where,  t ,  ,  ,  and  are as defined in the text.
t
* *

T
The change in relative Home wage and change in Z C are then solved from the system of equations

P
comprising (A.13) and (29) in the text as:

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 t    ˆ  t* *   * ˆ *
ˆ  t t (A.14)
   t   t*    t   t*

SC
ˆ (   t* )    t* *   * ˆ *
ZC  ˆ
t t (A.15)

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   t   t*    t   t*

    ˆ  *  (   t ) * ˆ *
Zˆ C*   t t t (A.16)
MA
   t   t*    t   t*

Putting tˆ *  0 in (A.14) and (A.15) we obtain the equilibrium changes as in (34) and (35) in the text.
ED

A.3. Sign of Parameters

PT

Now recall the expressions for the relevant parameters from the text reproduced below along with
employment shares defined in (A.8) and (A.11):
CE

v ( Z C ) ~  D
 tv ( Z C )   ELZ*  DLZ   E* 

 t  1  tm t ( Z )
~
M t ( Z )  M t ( X ) LZ   *    B *LZ 
 
  v( Z C )   LX 1  1    v( Z C )t   LX  LX
   LX 

AC

Z C* v ( Z C* ) ~ *  ELZ  ELZ DLZ*  D* 

 t*  1  t * mt* ( Z )
~  t * v( Z C* )
   B * *LZ 
    * 
 
M ( Z ) M ( X )
  LX 1  1  v( Z C ) t
   LX  LX  LX 
t t
v( Z C* ) * *

~ ~  ELZ ELZ* 
  M (t )  M t ( X )1   * 
  LX  LX 

 DLZ ELZ* 
  A(t ) M t ( Z )  M t ( X )  A(t ) 
~ ~
 A(t ) * 
  LX  LX 

First, it is easy to check that the first term in  t is rising in the share of expenditure on Z-goods (). For
the second term, M t (X ) is decreasing in  whereas the other components in the parenthesis collectively
are rising in it. However, as   1, M t (X ) approaches to zero. At the limit, the first term is strictly
larger than the second term. On the other hand, for  = 0, the first term is zero whereas the second term is

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positive. This, if the values are continuous in , then for sufficiently high values of , the sign of  t is
positive. That is,  t > 0   >  * > 0.

Second, in case of  t* , the first term is invariant with respect to  whereas the second term is
unambiguously decreasing in it. Thus, either    [0, 1] or for  >  ** , the sign of  t* is positive. Third,

T
~ ~ ~
given that by definition M (t ) = M t ( Z )  M t ( X ) , the first term in the expression for  is increasing in

P
~
 whereas the other two terms are strictly decreasing in it. So again,  > 0   >  > 0.

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For the sign of  , first of all note that   A(t ) > 0:

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t 1    v(Z C )t t  1    v( Z C )t 2  (1  t )1    v( Z C )t
  A(t )   
(1  t ) 1  1    v( Z C )t  (1  t )1  1    v( Z C )t 

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t  1    v( Z C )t t 1  1    v( Z C )t 
   0
(1  t )1  1    v( Z C )t  (1  t ) 1  1    v( Z C )t 
MA
So the second term in  is positive and decreasing in    < 1. Then by analogous logic as above it can
be checked that  > 0   >  > 0.
ED

 ~

Therefore, if we assume that  > max  * ,  ** ,  ,  , then  ,  t ,  t* and  are positive in values.

Note that by analogous logic  * > 0 for high values of . Since by definition,
PT

 * DLZ* * *  LZ 
 
E
~*
  A (t ) M t ( Z )  M t ( X )   A (t ) *  A (t )
* * * * *

  LX  LX 
CE

~
where the first term remains invariant with respect to ,   A(t ) > 0 and M t ( X ) is decreasing in  .
AC

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Acknowledgements

We thank an anonymous referee for valued comments and suggestions that have led to
substantial improvement in the quality of the paper. The usual disclaimer applies, however.

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Trade Liberalization and Export Diversification

Highlights

 We examine the implications of tariff reductions for export basket diversification.

T
 Export diversification is defined across and within industries.

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 Unilateral tariff reduction may diversify liberalizing country’s exports more.

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 The trading partner may experience across-sector diversification.
 Bilateral tariff reduction may not diversify export of both countries.

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