9 - The Wealth of Nations

Summary

How do innovative entrepreneurs affect international trade and economic prosperity? Realizing gains from trade requires countries to adjust their consumption and production profiles. Some of these adjustments may be achieved through restructuring the activities of existing firms. However, the adjustments needed to realize gains from trade generally will require new firms and often entirely new industries. Innovative entrepreneurs are thus essential to developing the wealth of nations.

The growth of international trade has indeed sparked entrepreneurship in many countries. To better understand this phenomenon, I extend the general equilibrium model of entrepreneurship (Kihlstrom and Laffont, 1979; Lucas, 1978) to examine international trade with heterogeneous technologies (Melitz, 2003; Chaney, 2008). I find that opening economies to international trade does not change extensive margins in comparison with closed economies and does not equalize factor prices, so that efficiency differences and wage differences persist in equilibrium. I then show that entrepreneurs engage in FDI to transfer technology from the country with the lower labor-technology ratio to the country with the higher labor-technology ratio. The main result is that the combination of FDI and international trade equalizes both wages and extensive margins and generates benefits from trade.

The model predicts the direction and volume of international trade and FDI; countries with relatively greater endowments of labor as compared to technology attract FDI and have international trade surpluses and deficits in FDI earnings. Based on differences in relative endowments of labor and technology, the model helps explain why the United States or the European Union (EU) have trade deficits while obtaining net earnings surpluses on foreign investment (Bureau of Economic Analysis, 2010). In contrast, countries such as China, with relatively larger labor-technology ratios, tend to have trade surpluses with these trading partners.