Endogenous Comparative Advantage*

• Published date: 01 July 2019
• DOI: http://doi.org/10.1111/sjoe.12291
• Date: 01 July 2019

Scand. J. of Economics 121(3), 1088–1124, 2019

DOI: 10.1111/sjoe.12291

Endogenous Comparative Advantage*

Andrea Moro

VanderbiltUniversity, Nashville TN 37235, USA

andrea@andreamoro.net

Peter Norman

University of North Carolina at Chapel Hill, Chapel Hill NC 27599, USA

normanp@email.unc.edu

Abstract

We develop a model of trade between identical countries. Workers endogenously acquire skills

that are imperfectly observed by firms; therefore, firms use aggregate country investment as the

prior when evaluatingworkers. This creates an informational externality interacting with general

equilibrium effects on each country’s skill premium.Asymmetric equilibria with comparative

advantages exist even when there is a unique equilibrium under autarky. Symmetric, no-trade

equilibria can be unstable under free trade. Welfareeffects are ambiguous: trade can be Pareto-

improving even if it leads to an equilibrium between rich and poor countries, with no special

advantage regarding country size.

Keywords: Human capital; reputation; specialization; trade

JEL classification:D62; D82; F11; O12

I. Introduction

In this paper, we develop a stylized model of international trade in which

a country can establish a reputation for having a high-quality labor force.

This provides new insights into the understanding of the causes of trade,

specialization, and inequality across countries.

A reputation for the high or low quality of a labor force can arise

when employers do not perfectly observe workers’ competencies and skills.

Workers acquire human capital not only through education and work

experience, but also through personal effort and investments that are not as

easily observable. We focus on this informational asymmetry, showing that

it can generate self-fulfilling differences in reputation across countries.

Research has shown that informational asymmetries of this kind are

empirically relevant. Farber and Gibbons (1996) and Altonji and Pierret

*It is nearly impossible tot hank everybodythat contributed comments and suggestions. We thank

them all, especially the anonymous associate editor and two referees. Support from NSF Grants

SES-0003520 and SES-0001717 is gratefully acknowledged.

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The editors of The Scandinavian Journal of Economics 2018.

A. Moro and P. Norman 1089

(2001) first showed that employers’ learning is significant, supporting the

assumption that employers initially observe workers’ skills with noise.1

Recent literature confirms these results.2This suggests that there is

significant scope for the mechanism proposed in this paper to play a role

in determining workers’ wage distribution and their incentives to acquire

skills, and in sorting across industries.

Based on this evidence, we cannot dismiss the possibility that labor

market informational asymmetries might play a role in explaining, at least in

part, trade and specialization across countries. In this paper, we demonstrate

that they are sufficient to generate self-fulfilling cross-country differences

in reputation that imply human capital differences, trade, and specialization

between otherwise identical countries. There is arguably an incomplete

understanding of the patterns of trade and specialization observed in the

real world, which suggests that exploring alternative models could provide

new insights.3

In our model, technology has constant returns to scale, a country is

defined as a labor market, and international trade is frictionless. Countries

are symmetric in every respect, so the model always admits symmetric

equilibria that replicate autarky, without gainful trade. The only aspect of

the model that is non-standard is workers’ skill acquisition. We investigate

the conditions that generate equilibria with asymmetric country reputations

for skill investments, and we show the properties of such equilibria.

Workers can acquire skills at a cost that varies across workers. There are

two sectors demanding labor (i.e., a high-tech sector and a low-tech sector),

and skills increase productivity only in the high-tech sector. Incentives to

acquire skills are affected by an informational asymmetry: workers’ skills

are only observed by employers with noise, through a signal of productivity

that can be thought of as aggregating information provided by the worker’s

1In most of the literature, the identification of the main effect exploits panel data where workers

are observed over time. If employers imperfectly observe workers’ skills, but learn over time

through the observation of productivity signals, then as tenure increases, wages should become

more correlated with measures of productivity available to the researcher (typically, workers’

scores in aptitude tests).

2Inpar ticular,Lange (2007) measured the “speed” of employer learning, and found that, according

to the best estimates, it takes three years for an employer to reduce their expectation error to

50 percent of its initial value, and 26 years to reduce it to less than 10 percent of its initial

value. Note that median employee tenure is currently just above four years (January 2016;

see the US Bureau of Labor Statistics Economic News Release, Employee Tenure Summary,

https://www.bls.gov/news.release/tenure.toc.htm). See also Sch ¨onberg (2007), Pinkston (2009),

and Kahn and Lange (2014) who use US data, and Lesner (2018) whouses Danish data. Cor nwell

et al. (2017) use Brazilian data to show that variation in how employers perceive workers’race

significantly affects wages.

3A full empirical investigation of the model implications, which would require accounting for

(and separately identifying) other relevant factors, is outside the scope of this paper.

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The editors of The Scandinavian Journal of Economics 2018.

1090 Endogenous comparative advantage

curriculum vitae, interviews, and observation in the workplace. A worker

without skills (hereafter referred to as an unqualified worker) can send a

good signal, but this is less likely than a qualified worker (i.e., a worker

with skills) sending a good signal.

Before observing the noisy signal, the prior probability of investment

is determined in each country by aggregate investment rates summarized

by the proportion of qualified workers. The probability of investment of

each worker is then computed using their signal, but it is also affected

by the prior. Hence, the actual proportion of qualified workers, together

with endogenous relative prices, determines incentives to invest. There is

no point in investing in skills if there are very few qualified workers in the

country, because firms interpret a good signal as most likely being noise

and the good signal raises the wage very little. Symmetrically, if almost all

workers invest, firms ignore bad signals as “bad luck”, and again there is

no point in investing as all workers receive high wages regardless of the

signal. Incentives to invest are at their highest at some intermediate level

of aggregate investment because this is when firms pay most attention to

the noisy signals.

Hence, starting from a relatively low level of investments, the value

to acquire human capital increases if the proportion of skilled workers

in the economy increases as the signal-to-noise ratio decreases. Working

against this, there are relative price effects that make the high-tech good

less valuable when its supply increases, but these effects are smaller

when countries trade than in autarky. Additionally, when skills increase

in one country, the incentives to acquire skills in the other country are

unambiguously reduced because of the price effects. Hence, an asymmetric

allocation of human capital and goods production can arise even if

countries are fundamentally identical. As far as we know, this is an

explanation of trade and specialization that is novel in the international

trade literature. What is crucial for this result is that the reputation for

having a qualified labor force is like a public good – operating within a

country regardless of its size.

While our mechanism is novel, there are some similarities with models

of agglomeration. Scale economies and network effects can also create

asymmetries between countries. However, these models usually assume

some exogenous differences that are being accentuated in equilibrium.

Moreover, in these models it is typically an advantage to have a large

domestic market, whereas in our model there is no systematic effect that

favors large countries. It is not the number, but the proportion of qualified

workers that is critical in generating the reputational externality. This is

because employers, when assessing workers, use the proportion of qualified

workers as their prior for human capital investment. A worker is more likely

to be qualified the higher their country’s proportion of qualified workers.

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The editors of The Scandinavian Journal of Economics 2018.