American Economic Association

Vertical Product Differentiation and North-South Trade

Author(s): Harry Flam and Elhanan Helpman
Source: The American Economic Review, Vol. 77, No. 5 (Dec., 1987), pp. 810-822
Published by: American Economic Association
Stable URL: http://www.jstor.org/stable/1810210
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 Vertical Product Differentiation and North-South Trade

By HARRY FLAM AND ELHANAN HELPMAN*

We develop a model of North-South trade in which the North exports high-quality

and the South exports low-qualityindustrialproducts. Faster technicalprogress in
the southern industrial sector leads the North to introduce new high-quality
products and the South to abandon low-qualityproducts. Production of northern
low-qualityproducts is shifted to the South. We also study the effects of technical
progress in the North and population growth.

Economic progress is typically associated varieties, it abandons the production of lower

with the appearance of new products and the
disappearance of old ones, with the former
dominating the latter in available character-
istics. There are countries that are the first to
produce the new products and there are
others that end up producing them after a
time lag. Existing theories of international
trade do not provide satisfactory explana-
tions of these features, including Raymond
Vernon's original product cycle hypothesis
(1966) and its reformulation by Paul Krug-
man (1979) in a framework with horizontally
differentiated products.'
We suggest an alternative model of North-
South trade, which is based on vertical prod-
uct differentiation; that is, differentiation
according to quality. It predicts interesting
patterns of trade dynamics as a result of
population growth and technical progress. In
particular, it predicts the appearance of new,
high quality products, and the disappearance
of old, low quality products (see also Nancy
Stokey, 1986, on this point). It also predicts
a quality-based product cycle; that is, when
the North shifts production to higher quality
quality products whose production is taken
up by the South. The structure of interna-
tional trade is determined by cross-country
differences in technology, income, and in-
come distribution.
The North produces and exports high
quality, high cost varieties, while the South
exports low quality, low cost varieties. Given
an overlap in income distribution, there ex-
ists intraindustry trade.2 We analyze secular
trends in intersectoral and intraindustry
trade, in the available products, and the
quality-based product cycle. Our analysis
sheds light on the Burenstam Linder hy-
pothesis (1961), because, like Rodney Falvey
and Henryk Kierzkowski (1987), we assign a
central role to income distributions.
We develop our model in Section I. In
Section II we discuss the effects of changes
in income distribution. This provides useful
information about economic growth, be-
cause growth is typically associated with
shifts in income distribution. However, since
we do not have an explicit mechanism that
links income distribution to growth, our

*Institute for International Economic Studies, Urn-

versity of Stockholm, S-106 91 Stockholm, Sweden, and
Department of Economics, Tel-Aviv University, Tel-
Aviv 69 978, Israel, respectively. We are grateful for
financial assistance from the Bank of Sweden Tercen-
tenary Foundation and the Foerder Institute for Eco-
nomic Research. An earlier version of the paper cir-
culated under the title "Trade Dynamics." We have
benefited from comments from seminar participants at
Haifa, Konstanz, Stockholm, Tel-Aviv, and Toronto.
'This applies to the recent extensions of Krugman's
work by David Dollar (1986) and Richard Jensen and
Marie Thursby (1986).
2This is also a feature of the model by Falvey and
Kierzkowski (1987), which is a close kin of ours. Fol-
lowing Falvey and Kierzkowski, we define two-way
trade in vertically differentiated products as intrain-
dustry trade. Intraindustry trade is usually referred to in
the literature as two-way trade in horizontally differenti-
ated products (see, for example, Chapter 8 of Helpman
and Krugman (1985)). However, in the type of model
employed in this paper it is reasonable to associate
different qualities of the same good with a single in-
dustry, and therefore also to identify two-way trade in
different qualities as intraindustry trade.

810

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VOL. 77 NO. 5 FLAM AND HELPMAN: NORTH-SOUTH TRADE
analysis of this issue is not complete. Section
III is devoted to the study of changes in the
pattern of trade that result from population
growth, and in particular from a differential
rate of population growth, with the rate being
higher in the less developed country. Techni-
cal progress is studied in Section IV. Here
we emphasize a catch-up process in which
the rate of technical change is faster in the
less developed country. Section V is a
summary.
I. The Model
It is assumed that two commodities exist:
a homogeneous product and a vertically dif-
ferentiated product. The homogeneous prod-
uct can be consumed in every desirable
quantity, whereas the consumption level of
the differentiated product is fixed at unity.
However, the consumer can choose the qual-
ity of the differentiated product from those
available in the market. Consumer prefer-
ences are represented by a quasi-concave
utility function u(y, z), where y is the quan-
tity of the homogeneous product and z is
the quality of the differentiated product.
Larger values of z represent higher quality.
Therefore, u(.) is increasing in both argu-
ments.
All individuals are identical except for
income levels. An individual with income I
choses a consumption level of the homoge-
neous product and a quality level of the
differentiated product to solve the following
problem:
(1) maxu(y,z) s.t. y+p(z) I such as point A. An individual with a higher
y0 zE Z,
where p(z) is the price of quality z, the price
of the homogeneous product is one, and Z is
the set of qualities available in the market. If
the solution to this problem results in a
utility level that is higher than the utility
level that obtains from consuming only the
homogeneous product, then the individual
consumes both goods. Otherwise, the person
consumes only the homogeneous product.
We conduct the analysis under the assump-
tion that every consumer finds it desirable to
consume both products.
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811
Two countries exist: a home country
(North) and a foreign country (South). One
unit of labor produces one unit of the homo-
geneous product in both countries. However,
labor input per unit output of the differenti-
ated product differs across countries. Let
a(z) and a*(z) be labor input per unit out-
put of quality z in the North and South,
respectively. These functions are convex and
increasing in z. The North has comparative
advantage in high quality products; that is,
a(z)/a*(z) is declining in z. Now, assuming
that the South produces the homogeneous
product, its wage rate is equal to one (in
terms of the homogeneous product) and the
North's wage rate w is at least as large as
one. The supply price of quality z is (see
Sherwin Rosen, 1974):
(2) p(z) = min[wa(z), a*(z)].
This is also the price profile in a competitive
equilibrium. Given the structure of compara-
tive advantage, (2) implies that the South is
the supplier of low quality products and the
North is the supplier of high quality prod-
ucts. The break-even point in the chain of
comparative advantage is a quality z that
satisfies wa(z) = a*(z-) (see Rudiger Dorn-
busch et al., 1977).
The consumer problem (1) can be repre-
sented graphically, as in Figure 1. The budget
curve is y = I - p(z). There is a set of usu-
ally shaped indifference curves representing
u(y, z). The consumer chooses a combina-
tion of (y, z) on the budget curve at the
point of tangency with an indifference curve
income faces a higher budget curve.
In what follows we use specific functional
forms of the utility and unit labor input
functions. The following equations prove to
be convenient:
(3) u(y,z)=yeaz
(4) a (z) =eYZ/A
(5) a*(z) = eY*z/A*
with a> 0 and -y*, y> 0. The North has
812 THE AMERICAN ECONOMIC RE VIEW DECEMBER 1987

pricing equation (2), we obtain

(6) I= weYz(1I+-A forI Id

(7) I=e*y*z1? ) A* forIId

a

(8) z =-[log + log Id

a+ y
A 'Y

+ log A-log wl

(9) z =-log * + log Id+ log A*.

oO~~~~~~~~~~~~.
~~z- zz + Z
Since p(z) )wexp(yz)/A for z > z + and
FIGURE 1
p(z) = exp(y*z)/A* for z < z-, equation (6)
implies that individuals with income above
Id -who buy northern-produced varieties
-spend a share a/(a + y) of income on the
comparative advantage in high quality prod- differentiated product, while individuals with
ucts if and only if y* > y. income below Id-who buy southern-pro-
The utility function (3) has the property duced varieties-spend a share a/(a + y*)
that the marginal rate of substitution be- of income on the differentiated product. This
tween z and y depends only on y. Hence, feature of our demand system makes it most
the income expansion path for a given level convenient for the applications that follow.
of the marginal rate of substitution in con- Now, from the definition of Id, it satisfies
sumption is horizontal in Figure 1. This im- u[Id - p(z ), Z ] = U[Id -
P(Z ), Z ],

plies that individuals with higher income
consume more of the homogeneous product
and a higher quality differentiated product
(this is, of course, a feature of many other
utility functions as well). Hence, if there
exists an income level at which a southern-
produced quality is demanded, and a higher
income level at which a northern-produced
quality is demanded, then there exists an
intermediate income level-denoted by Id
- at which the consumer is indifferent be-
tween the consumption of a southern-pro-
duced quality z- and a northern-produced
quality z+. The choice problem of a con-
sumer with income Id is also depicted in
Figure 1. It is clear from this analysis that no
demand exists for qualities in the range
(z -, z+ ). This type of phenomenon ap-
pears also in previous studies (for example,
Elhanan Helpman, 1985; Falvey and Kierz-
kowski, 1987).
Using the first-order conditions for prob-
lem (1), the functional forms (3)-(5), and the
which with the help of (2)-(5) and (8)-(9)
yields
(10) Id`(1Y- l/y*) = Bwa/Y( A*a/Y*/A/'Y),
where
= y*aa/y*(a + )(a+ Y)/Y
B +
yaci/y(a + *)(a y)/y*
Equation (10) describes the equilibrium rela-
tionship between Id and the North's wage
rate (the South's wage rate is equal to one).
This relationship depends on the productiv-
ity parameters A and A*, a feature that will
be explored in our discussion of trade dy-
namics.
Every country is populated by a con-
tinuum of individuals, and a nondegenerate
distribution of skills in the population exists.
Differences in skills are reflected in dif-
ferences in the endowment of effective labor
supply. This is represented by means of in-

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VOL. 77 NO. 5 FLAM AND HELPMAN: NORTH-SOUTH TRADE 813

come classes. The set of income classes is
chosen to be the unit interval [0,1]. The
distribution of effective labor units across
income classes is described by the density
function f(h) in the North and f *(h) in the
South. That is, if L stands for the quantity
of labor available to the North, then
f(h)Ldh of labor is supplied by northern
individuals in income classes [h, h + dh), h E
[0,1), and similarly in the South. The distri-
bution of the population over income classes
is represented by the functions n(h) and
n*(h) and population sizes are N and N*.
Hence, the income level of a northern indi-
vidual in income class h is f(h)wL/n(h)N,
and similarly for the South. We choose higher
values of h to represent higher income
classes. It is therefore assumed that f (h)/
n(h) and f*(h)/n*(h) are increasing in h.
In the remaining part of this section we
describe an equilibrium in which the homo-
geneous product is produced only in the
South, both countries produce some varieties
of the differentiated product, and some of
both countries' varieties are consumed in
each one of them. We refer to this as the
central case. Other patterns of specialization
and consumption will be discussed in the
sequel.
Since northern- and southern-produced
varieties are consumed in both countries,
there exists an income class h d in the North
and an income class h* in the South, such
that individuals who belong to them earn
precisely Id. Hence,
wLf( h d)
( (11)
1) Id =
~~~Nn(h
d)
tive distribution function associated with
f(-) and similarly for F*(-). Therefore, equi-
librium in the northern labor market re-
quires
a
a?+y {[1-F(hd)]wL
+ [1-F*(hd)]L*) =wL,
which reduces to
(13) wL[yy+aF(hd)] = aL*[1-F*(hd?)].
The same condition can be derived from
labor market clearing in the South or from
the balancing of the trade account.
Equations (10)-(13) constitute a set of
equilibrium conditions that determine Id,
w, hd, and hd . Having the values of those
variables, one can use (8) and (9) to calculate
z- and z +, and (6) and (7) to calculate the
varieties consumed by individuals who have
different income levels. Of particular interest
is the range of varieties consumed by each
country. For this purpose, we need to calcu-
late the maximal and the minimal quality
consumed in each country. Since the lowest
quality is consumed by income class h = 0
and the highest quality is consumed by in-
come class h = 1, (8) and (9) imply:
1 [ a
(14a) Zmax= log
Y a+ Y
+ log[ wLf (1)/N ] + log A -log w]
-1 -
a
(14b) Zmin= -* log

(12)
( 12) Id n*(h
~~L*f (h *)) + log [ wLf (O)/N] + log A*

(11a)
Northern individuals in income classes
max
(hd,l] and southern individuals in income + Y
classes (hI*,1] consume northern-produced
differentiated products, and each one of them + log[ L*f *(1)/N*I + log A -log w
spends a proportion a/(a + y) of personal
income on the differentiated product. Hence,
total spending on northern varieties is the (l5b) Z*in= log
share a/(a + y) of the aggregate income of
these two groups, which is [1- F(h )]wL + +log[L*f*(O)/N*] +logA*jl
[1- F*(h *)]L*, where F(-) is the cumula-

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814 THE AMERICAN ECONOMIC REVIEW DECEMBER 1987

The range of qualities purchased by northern
consumers is [Zmin, Z-1 U [(z+, Zm,ax and the
range of qualities purchased by southern
consumers is [z *i Z U [z,+ z *a]
All these calculations are, of course, valid
only if the patterns of specialization and
consumption that we have chosen are equi-
librium patterns. Namely, only if the un-
derlying parameters and distribution func-
tions imply that the valuesof (Id, w, hd, ha),
which solve (10)-(13), satisfy w >1 and 0 <
hd, h * < 1. This is the central case; we will
consider other patterns of consumption and
specialization in due course.
In the central case the pattern of trade is
as follows: The North exports high quality
differentiated products and imports low
quality differentiated products as well as the
homogeneous product. Since trade is bal-
anced, the volume of trade-defined as the
sum of all exports-is twice the exports of a
single country. In particular, it equals twice
northern exports. Due to the fact that the
South imports only differentiated products,
that only individuals in income classes above
h d purchase imported varieties, and that
each one of these individuals spends a share
a/(a + y) of personal income on the differ-
entiated product, the volume of trade can be
represented by
(16) VT= 2-- [1- F*(hdd )] L*
a+
2 -1
of these individuals spends a share a/(a +
.y*) of personal income on the differentiated
product. Hence, the volume of intraindustry
trade is 2aF(hd)wL/(a + y*), and the share
of intraindustry trade is (using (16))
(7
a+y wL F(hd)
1 I-l
+y* L* 1-F*(h*)
a+y aF(hd) a
a+y* y+aF(hd) a+y*
We see that the share of intraindustry trade
depends on relative country size (as mea-
sured by relative GNP levels), on the income
distribution in both countries, and the divid-
ing income classes. The higher the relative
income of the North and the larger the share
of income of southern individuals that con-
sume imported varieties, the larger is the
share of intraindustry trade. Due to bal-
anced trade, however, the share of intrain-
dustry trade is larger, the larger the share of
income of northern consumers that purchase
imported differentiated products. The upper
bound on the share of intraindustry trade is
a/(a + y*).
The comparative statics of the equilibrium
conditions (10)-(13) can be derived by direct
differentiation that yields the following lin-
ear system:
a ___ -- 0
O
'Y Y* 'Y
I
-E

+
a+y [y aF(hd)IwL, (18) 0*
=- 1 0 0 -
1 ,ad f*d
0 1
where the last equality derives from (13). y+aF 1- F*
The volume of intraindustry trade is
calculated in the usual way, as twice the sum
across industries of the minimum across
=, ?1 _f fh
I~d d-r12
countries of exports of differentiated prod- Xw _dv Ill
ucts. The fact that the North exports only hd dqTl 2
differentiated products, the South exports
homogeneous and differentiated products,
and trade is balanced, implies that the where e is the elasticity of f(-)/n(-) with
volume of intraindustry trade equals twice respect to h evaluated at hd, -* is the elastic-
southern exports of differentiated products. ity of f *( -)/n*( ) with respect to h evaluated
Varieties produced in the South are con- at h , a caret over a variable indicates a
sumed by northern individuals whose in- proportional rate of change, and dri, i = 10,
come is not larger than Id; that is, by indi- 11, 12, 13, represents the exogeneous shift in
viduals in income classes h < hd. Each one equation (i). All of our comparative statics

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VOL. 77 NO. 5 FLAM AND HELPMA N: NOR TH-SO UTH TRADE
exercises can be performed by means of (18)
with an appropriate substitution of values
for dvi. For explicit calculations of many of
the results given in the following sections, we
refer to Harry Flam and Helpman (1986).
The determinant of the matrix on the left-
hand side of (18) is
(19) A
(Y 7 )
a afhd * a f*h*
+ E-*+-
y* y?+aF y 1-F*
II. IncomeDistributionEffects
In this section we consider the effect of
income distribution on trade and produc-
tion. In order to deal with this issue, suppose
that the cumulative income distribution
functions can be decomposed as follows:
(20a) F(h) = F(h) ?+ G(h)
(20b) F*(h) = F*(h) ?t*G*(h),
+ Consequently, prices of varieties that are
where F(-) and F*(.) are distribution func-
tions, while the functions G(-) and G*(.)
equal zero at h = 0 and h = 1, they are non-
decreasing on an interval of low values of h,
and nonincreasing on its complement with
higher values of h. Then, starting with ji =
P* = 0, a small increase in j represents a
switch toward a more even income distribu-
tion in the North and a small increase in [t*
represents a switch toward a more even in-
come distribution in the South.
We restrict our analysis to income redistri-
bution schemes that shift income from in-
come classes above the dividing ones, h d
and h *, to income classes below the dividing
ones. In this case, G(-) reaches a maximum
at hd and G*(.) reaches a maximum at h .
Assuming differentiability at these points, we
have
f(hd) =f(hd)+?G'(hd)
=f(hd) for all i,
f*(h*) f*(h *)?+ *G* (h*)
=f*(h*) forall,i*.
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815
Under these circumstances, starting with ji
= * = 0, the effects of changes in ji and jI*
can be described by means of (18) with
d7gio = drT11= d7Tr2= 0,
G*(hd*) aG(hd)
d7T13=-1-F*(h *) -y + aF(hd)
This implies a decline in the dividing income
level, in the North's wage rate, in the di-
E > O.
viding income class in the South, and in the
dividing income class in the North. We have:
I<O,W^ < O, hd < O, hd* < ?.
These results stem from the fact that an
income redistribution from individuals in in-
come classes above the dividing ones toward
individuals in income classes below the di-
viding ones shifts demand away from north-
ern products, and toward the lower quality
products that are produced in the South.
produced in the North decline, and so does
its wage rate; the terms of trade move in
favor of the South. Consumers face now a
relatively lower price of qualities z > z +, and
those in income class h * switch to a higher
quality imported product. Hence, the di-
viding income class in the South declines.
Northern consumers suffer a real income
loss. Those in the dividing income class can
mitigate some of this loss by switching to a
now relatively cheaper home-produced, high-
er quality product, which they do, and the
northern dividing income class declines.
In order to derive the effects of these
changes on the share of intraindustry trade
in the case in which income is redistributed
only in the South, we use (20a) to calculate
dF( h d). Then, since the dividing income class
h d declines and ji does not change, the share
of northern income spent on imported
differentiated products decreases. Conse-
quently, the share of intraindustry trade de-
clines (see (17)). In other words, the equali-
zation of income distribution in the South
moves the terms of trade in favor of the
South and decreases the share of intrain-
dustry trade.
816 THE AMERICAN ECONOMIC REVIEW
I N
mi
5; jz |z+ ma
Z*a
FIGURE 2
Figure 2 describes the shift in product
spectrum that results from a more equal
income distribution in the South. The middle
line describes the initially assumed critical z
values. The final values are described on the
upper and lower lines. The North expands
its product range by adding lower quality
product lines. The South contracts its prod-
uct range by abandoning both the highest
and the lowest quality products.3
Finally, it should be observed that in-
come redistribution within the open intervals
(0, hd), (hd, 1), (0, hd ) or (hd ,1) do not affect
the variables that we have discussed. Thus,
they do not change wages and dividing in-
come classes. Therefore, they also do not
change the share of intraindustry trade as
well as production and consumption product
ranges. They do, however, change quantities
of products that are consumed by the affected
income classes.
III. Population Growth
In this section we discuss trade dynamics
that result from population growth. Con-
sider the case in which the southern popula-
tion increases at the same rate as the number
of effective labor units, and at the same
rate in every income class. Then we have
d7T13=N* = L* > 0 and d7TrO = d7Tr1= d7TI2
3The figure shows no change in z *a, which is not
strictly correct; it may increase or decline, depending on
how much income is taken away from h * =1 in the
redistribution process. If, for example, no income is
taken away from the richest individuals, then z *ma
increases due to the fact that these individuals' income
increases in terms of the variety that they used to
consume as well as in terms of higher quality products.
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DECEMBER 1987
= 0. By substituting these values into (18),
we find that
fd>o W> 0, hd >, and h*> ?
Opposite effects result from a uniform popu-
lation increase across income classes in the
North. Moreover, when population increases
at the same rate in both countries, there is
no change in the structure of the equi-
librium, except that output and trade vol-
umes increase at the common rate of popula-
tion growth. The share of intraindustry trade
does not change.
When the southern population rises pro-
portionately more than the northern popula-
tion, demand for northern differentiated
products rises by more than their supply.
Consequently, the wage rate and output in
the North increase, and the terms of trade
move against the South.4 These changes
cause consumers in income class h d to
abandon consumption of the high quality
variety that is produced in the North, and to
switch to a locally produced lower quality
product, whose relative price has fallen. They
also cause consumers in income class hd to
abandon consumption of the domestically
produced variety and to switch to a rela-
tively cheaper, imported lower quality vari-
ety. The result is that the dividing income
level Id and the dividing income classes rise.
It can be shown that the dividing income
level rises proportionally more than the wage
rate in the North. Hence, the lowest quality
variety produced in the North, z+, and the
highest quality variety produced in the South,
z-, increase (see (8) and (9)). Since prices of
varieties consumed by the lowest income
classes in the South do not change, the variety
consumed by the lowest income class z*n
does not change as well (see (15)). Hence,
the range of qualities produced in the South
expands. On the other hand, the range of
qualities produced in the North contracts,
because the richest consumers in the North
do not change the quality that they consume,
Zmaxj whereas we have seen that the lowest
4This result is common to many models; it appears,
for example, in Krugman (1979).
VOL. 77 NO. 5 FLAM A ND HELPMAN: NORTH-SOUTH TRADE
*
zmin n z
/I58I
z
*
Zmx
z ~~~~~z'
+~\ I 91
L*>L ;= N* L-- N
FIGURF 3
quality produced in the North is abandoned
(see (9) and (14)). The resulting changes in
the range of varieties produced and con-
sumed in each country are represented
graphically in Figure 3, where the initial
ranges are described on the middle line. (The
gap between z+ and z- is narrowed, as can
be seen from equations (8) and (9).)
The cross-country distributional effects of
this differential population increase are as
follows. All northern consumers gain, south-
ern consumers who are in income classes
above h * lose, and southern consumers who
are in income classes below h d are not
affected. All northern consumers gain, be-
cause their income in terms of the homoge-
neous product increases. In addition, income
in terms of the differentiated product in-
creases for those in income classes below hd
and does not change for those in income
classes above hd* In the South income classes
below h d are not affected, because their
income remains the same in terms of both
the homogeneous and the differentiated
product. On the other hand, income classes
above h d lose, because their income in
terms of the homogeneous product does not
change, and their income in terms of the
differentiated product declines.
Finally, since hd increases, northern con-
sumers spend a larger share of income on
imported varieties. This leads to an increase
in the share of intraindustry trade (see (17)).
Our analysis implies the following trade
dynamics. When the rates of population
growth are the same in both countries, there
is no change in the patterns of consumption,
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817
production, and trade. However, quantities
consumed, produced, and traded are chang-
ing over time; all of them increase at the rate
of population growth.
In the more interesting case in which the
rate of population growth is higher in the
South, we have seen that the northern wage
rate, the dividing income classes in both
countries, and the share of intraindustry
trade, all increase over time. The dynamics
of product ranges in consumption and pro-
duction are described in Figure 3. Although
product ranges change over time, there can
be no qualitative change in the patterns of
trade and production (see our working paper
for a proof). Observe, however, that despite
the fact that these patterns do not change,
the range of qualities that are produced in
every country and the range of qualities that
are consumed in every country change over
time. In particular, the North is continuously
abandoning production of its lower quality
products and the South is continuously
adopting higher quality products. If the ini-
-
tial gap between z ? and z is not too large,
then the South eventually adopts varieties
that were produced in the North. Hence,
there emerges a product cycle for medium
quality products, with a time lag between the
cessation of production of a variety in the
North and the adoption of the same variety
in the South. This product cycle is different
from Vernon's, but it is a product cycle
nevertheless. Casual observation suggests
that quality-based product cycles are im-
portant empirical phenomena.
IV. TechnicalProgress
Next, consider productivity changes. Pro-
ductivity changes can come about in several
ways. They can result from an overall labor
productivity improvement that does not
affect population size but changes effective
labor supply, or they can be specific to the
homogeneous product or to the differenti-
ated product industry. In the latter case,
they can be uniform across varieties or bi-
ased in favor of certain qualities. We will, of
course, not analyze all of these possibilities,
but rather choose some that are of particular
interest.
818 THE AMERICAN ECONOMIC REVIEW
The most interesting case seems to be
technical progress in the industrial (differen-
tiated product) sector; it permits an analysis
of a widening or narrowing technology gap
between the less developed and the advanced
country. But this too can be done in two
ways. One can assume that technical pro-
gress takes place through changes in the
productivity parameters A and A*, or
through changes in the parameters -yand -y*.
In the former case the difference in compara-
tive advantage is preserved, while in the latter
case the degree of comparative advantage
changes as well. Only the former case is
discussed below, because the latter intro-
duces complications without adding insights
of comparable value.
In the case of uniform productivity in-
creases in all varieties (increases in A and
A*), we have
(A* A precise condition for the sign on the change
,
dS10=a__
'Y 'Y
d7gii = d =l2 dsT3 =0.
By substitution of these values into (18), one
obtains
W/d7T10<O hd/dTlo > O, and
(21) sign [fd/dTlo] =sign[ h^/d7T1]
=signe- aFh
L y +aF
Hence, an increase in southern productivity
affects adversely the North's wage rate and
induces the northern income class h d to
switch consumption from domestic to for-
eign varieties. These changes result from the
fact that when southern productivity rises,
southern prices of differentiated products
decline, bringing about a demand shift to-
ward southern varieties. Consequently, de-
mand for northern varieties declines, and so
does the demand for its labor. The result is a
wage cut. However, northern wages do not
decline in proportion to the South's produc-
tivity increase, so that after the adjustment
relative prices of southern varieties remain
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DECEMBER 1987
lower. This induces some consumers in the
North to switch to southern lower quality
products.
Southern consumers experience an in-
crease in income in terms of differenti-
ated products because differentiated product
prices decline in both countries. Whether
this induces consumers just above the divid-
ing income class h * to switch consumption
to southern varieties; that is, whether h d
increases or decreases, depends on income
and price effects. If relative prices of south-
ern-produced varieties fall to sufficiently low
levels, that is, the wage rate w falls only
slightly, consumers in income classes just
above h * switch to varieties produced in the
South. If, on the other hand, relative prices
of southern-differentiated products fall only
slightly, then the income effect dominates,
and consumers in income classes just below
hd switch to higher quality products. The
in h * is given in equation (21).
Despite the ambiguity in the response of
the dividing income class hI to the produc-
tivity increase in the South, there is no am-
biguity in the response of the share of in-
traindustry trade. Due to the fact that hd
increases, the share of intraindustry trade
increases as well (see (17)). Thus, higher
productivity (of the proportional type) in the
southern industrial sector increases the share
of intraindustry trade.
All the results that were reported so far
are reversed when productivity increases
proportionately in the northern industrial
sector. Thus, for example, the share of in-
traindustry trade declines and northern
wages increase. And if there is a simulta-
neous productivity increase in both countries
such that A/y = A*/y*, then all these vari-
ables do not change. However, despite the
mirror image response of these variables to
southern- and northern-productivitychanges,
no such symmetry exists when it comes to
quality ranges in production and consump-
tion.
The shifts in quality ranges that result
from a productivity increase in the South are
described in Figure 4. The highest available
quality does not change. However, the range
of products produced in the North contracts
VOL. 77 NO. 5 FLAM A ND HELPMA N: NORTH-SOUTH TRADE 819

?> af hd
Y+ocF

min zm mI/ I
F~ r\
\I\I~~~~~i Z z Zmax

Zrnin mI Zrax
_ L 2 L~~~~~z
A >O
A >0
FIGURE 4
FIGURE 5

as a result of its abandoning the production

of some low quality varieties, and the South
also moves its production range up the qual-
ity spectrum; that is, to higher quality prod-
ucts. In both countries consumption shifts to
higher quality varieties, except for the top
ones in the North.
When productivity increases in the North,
there are two possibilities, depending on
whether the expression in (21) is positive or
negative. If it is positive, the dividing income
level and the dividing income classes decline,
while the wage rate increases in the North.
In this case, the increase in northern wages is
proportionately smaller than the productiv-
ity increase, bringing about a fall in prices of
differentiated products that are produced in
the North. The resulting shifts in product
ranges are described in Figure 5; the North
produces a wider range of products, both of
higher and lower quality, and the South pro-
duces a narrower range of products, aban-
doning the highest qualities. All northern
consumers switch to higher quality products,
while in the South only consumers in income
classes above h * switch to higher quality
products. Other southern consumers do not
change consumption patterns. Consequently,
the spectrum of consumed varieties expands
toward higher qualities.
When the sign in (21) is negative, one
obtains the paradoxical result that northern
wages rise proportionately more than the
productivity increase. In this case, prices of
differentiated products that are produced in
the North increase, and so do the dividing
income level and the southern dividing in-
come class. The northern dividing income
xafhd
Y+MF
z
A
/ /
minmZmm I \Iz
~j />
z
A >
FIGURE6
class declines as before; the income effect of
a higher w dominates the relative price effect.
The resulting changes in product ranges are
described in Figure 6. The North shifts pro-
duction to higher quality products and the
South expands its product range by adding
higher quality product lines. All northern
consumers switch to higher quality products,
while in the South consumers in income
classes above h d switch to lower quality
products and consumers in income classes
below h * do not change their consumption
pattern.
It is clear from this discussion that all
northern consumers gain from this produc-
tivity increase, while (some) southern con-
sumers gain only when the sign in (21) is
positive; they lose when it is negative.
Our analysis implies the following dy-
namics. When the rate of technical change is

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820 THE AMERICAN ECONOMIC REVIEW
different across countries, but such that
A
A A
A*
y *y
'Y 'Y
the rate of technical change is faster in the
South, since we assume y < y*. We saw in
this case that the wage rate w, the dividing
income level, and the dividing income classes
do not change. Hence (8), (9), (14), and (15)
imply that z+, z-, Zma, Z,nin, z and z*-n
all change at the rate 4 per unit time, so that
all product ranges also shift upward at the
rate (. Parallel to this uniform upgrading of
qualities, every consumer upgrades at the
rate ( the quality that he consumes (see (6)
and (7)). Thus, production and consumption
move continuously to higher qualities at a
uniform rate. In this steady state, new higher
quality products are introduced in produc-
tion by the North, and old low quality prod-
ucts are abandoned by the South. Also, the
North abandons products that are adopted
with a time lag by the South. A product
cycle emerges again, but in this case it is a
steady-state product cycle.
If technical progress takes place only in
the South, then, as we have argued above, it
leads to a decline in the North's wage rate
and to an increase in its dividing income
class. The South's dividing income class in-
creases if and only if -> ajhd/'(y +aF).
The resulting shifts in product ranges are
described in Figure 4. It is clear that as long
as the central case equilibrium is preserved,
production and consumption move to suc-
cessively higher quality products in both
countries except for the highest qualities.
Here too a product cycle emerges; qualities
that are abandoned by the North are adopted
with a time lag by the South. However, once
this process is set in motion, the increase in
hd and the decline in w will eventually lead
to a change in the patterns of production
and trade, because when the wage rate w
becomes equal to one, the North becomes
competitive in the production of the homo-
geneous product, and when hd becomes
equal to one, northern consumers cease to
consume domestically produced differenti-
ated products. On the other hand, the divid-
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DECEMBER 1987
ing income class h * cannot reach its upper
bound as long as hd is positive and w is
larger than one, as one can see from (13).
Hence, two possibilities exist; either hd be-
comes equal to one while w is larger than
one, or w becomes equal to one while hd is
smaller than one. We only consider the latter
possibility here; the former possibility is
analyzed in our working paper.
In the case when w reaches one before hd,
the equilibrium conditions become (11) with
w = 1, (12), and
A*a/Y*
(10') P(11/y-1/y*) = BAa/Y
(13') Lt[y+aF(hd)]-(a+ y)Y
-aL*[1 -F*(h )].
The four equilibrium equations determine
changes in Y, Id, hd, and h , where Y is
output of the homogeneous product in the
North. Continuing technical progress in the
South leads to increases in Id, hd, and h*,
and therefore also to higher output levels
and lower imports of homogeneous goods in
the North. The top qualities demanded, Zmax
and z *, remain constant (see (14) and (15)).
At the same time, zmin,Z*n Z+, and z- all
increase (see also (8) and (9)). The range of
differentiated products that are produced in
the South moves up to higher qualities. The
North abandons low quality products, and
its range narrows down. Again we find a
product cycle; that is, varieties that are
abandoned by the North are adopted by the
South after a time lag.
As the process continues, it is not h d that
reaches a value of one first, but rather hd
This follows from (13'). Therefore, a new
equilibrium is eventually reached in which
the South has ceased to demand northern
varieties, while the North is still demanding
imported varieties. In the new equilibrium,
the North exports homogeneous goods in
return for low quality differentiated prod-
ucts. In fact, the pattern of trade is reversed
at an earlier stage, when Y reaches the level
y-[_ , F(hd)+ + [1 -F(hd)]J
VOL. 77 NO. 5 FLAM AND HELPMAN: NORTH-SOUTH TRADE
If now technical progress continues in the
South, then production of differentiated
products will cease in the North; that is, hd
will reach one.
V. Summary
It has been demonstrated that our model
of North-South trade, which incorporates
vertical product differentiation, generates
rich patterns of trade dynamics. A particu-
larly appealing feature of these dynamics is
that they explain the introduction of new
high quality products and the disappearance
of old low quality products, as well as the
existence of a product cycle in which the less
developed country begins to produce vari-
eties that were produced in the advanced
country. These are empirically relevant fea-
tures.
Our model explains intertemporal shifts in
intraindustry and intersectoral trade. In-
traindustry trade arises because consumers
who have different incomes demand different
quality products, and because in a given
country the range of produced qualities does
not correspond precisely to the demanded
range of qualities. The pattern of intrain-
dustry trade reflects differences in technol-
ogy and in income distribution; the South
exports low quality, low cost varieties, while
the North exports high quality, high cost
varieties. This pattern is observed in many
industries (for example, textiles, toys, radios).
Economic growth is typically associated
with shifts in income distribution. We have
not modeled this link. We did, however,
analyze the pure effects of income redistri-
butions. Equalization of the income distribu-
tion in the South, by shifting income from
consumers who purchase high quality man-
ufactures that are produced in the North to
consumers who purchase low quality manu-
factures that are produced in the South, was
shown to lower the wage rate in the North,
to decrease the number of consumers that
purchase manufactures from the South, and
to decrease the share of intraindustry trade.
The range of differentiated products that are
produced in the South contracts, because it
is led to abandon the production of its
highest as well as lowest qualities. The North
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821
continues to produce its top quality varieties
and adds product lines at its lowest quality
end. Consequently, its product spectrum in-
creases.
Faster population growth and faster tech-
nical progress in the South are probably the
most interesting forces of economic growth
that we have considered. We have shown
that the former leads to a secular increase in
the share of intraindustry trade and to a
product cycle in middle-range quality prod-
ucts. However, it does not bring about
changes in the available qualities at the lower
and upper ends of the product spectrum.
Hence, the pattern of trade does not change,
although as time goes by fewer varieties are
produced in the North and more varieties
are produced in the South.
More rapid population growth in the South
widens the income per capita gap between
the North and the South. On the other hand,
a higher rate of technical progress in the
South narrows down this gap because it
brings about a decline in the North's wage
rate. The falling wage rate and the South's
increasing relative efficiency in the produc-
tion of industrial goods lead eventually to a
switch in the patterns of production and
trade. This is a necessary outcome of this
process because: 1) the cost advantage of the
South in production of homogeneous goods
diminishes over time as a result of the fall in
the North's wage rate, and 2) the South
becomes successively more competitive in
the production of differentiated products be-
cause the rate of technical progress proves to
be more rapid than the fall of the North's
wage rate. At the end of this process (if
indeed it continues indefinitely), the North
becomes specialized in the production of
homogeneous goods and the South produces
only differentiated products. However, be-
fore this final stage is reached, a product
cycle exists, as the North is abandoning low
quality varieties that are produced after a
time lag in the South.
The above-described reversal in the pat-
terns of production and trade can be reached
along different trajectories, depending on the
rate at which relative wages are falling. The
major interest is in fact in the nature of these
trajectories because they are relevant even
822 THE AMERICAN ECONOMIC REVIEW
when the endpoint is never reached. Differ-
ent trajectories are associated with different
intermediate patterns of production and
trade.
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