Trade, Foreign Investment, and Industrial Policy for Developing Countries 4045

In Section 2.4 we turn to IP aimed at “diversification.” This is something that is

often stated as a goal by many countries. We present a simple model where diversifica-
tion is linked to productivity and argue that if there is a market failure reducing the
level of diversification below the optimal one (as in Hausmann & Rodrik, 2003), then
a policy of encouraging discovery and diversification would indeed be welfare
enhancing.
2.1 Multiple equilibria and latent comparative advantage
We first present a static model with exogenous prices, and then discuss the implications
of the model when prices are determined by production costs in the rest of the world.
2.1.1 Exogenous international prices
There is a small economy, which we call “South,” two goods and one factor of pro-
duction, labor, in fixed supply, L.3 Good 1 is produced with CRS and no aggregate
externalities: a unit of labor produces l1 units of good 1. Good 2 is produced with
CRS at the firm level, but there are aggregate externalities, so that labor productivity is:

! ; L 2 Þ%
l2 ½1 þ aMinðL

with a > 0. The term 1 þ aMinðL ! ; L 2 Þ captures Marshallian externalities that are
increasing with industry-wide employment, L2, but that are exhausted once the labor
force in a sector reaches the level L ! . The term y & 1 þ aL ! > 1 can be seen as the max-
4
imum benefits of clustering in sector 2. We assume that the total labor supply in South
is higher than L! , so that if there is complete specialization in good 2 then productivity
is yl2.
Let p'i be the international price of good i and let p' & p'2 =p'1 . Let us derive a con-
dition under which there are multiple equilibria, with one equilibrium characterized by
complete specialization in good 1 and the other by complete specialization in good 2.
We first check that specialization in good 1 is an equilibrium. Letting w denote the
wage in South, then w ¼ l1 p'1 if South is specialized in good 1. The unit cost of pro-
ducing good 2 in South given that all labor is devoted to production of good 1 (and
hence no benefits of clustering are realized) is w/l2. Hence complete specialization
in good 1 is an equilibrium if and only if l1/l2 ) p' . Similarly, complete specialization in
good 2 implies p'2 ¼ w=yl2 , and hence this is an equilibrium if and only if l1/l2 * yp' .
Thus, there is multiple equilibria if and only if the following condition holds,

p' * l1 =l2 * yp' ð1Þ

Without loss of generality, in the following discussion we restrict attention to the case in
which this condition holds with strict inequalities. If there are multiple equilibria, which