Revisiting the Marriage of Monopolistic Competition and Factor Proportions Theories

Abstract

This paper reconsiders the factor proportions-driven model of trade under a monopolistic competition framework when cost functions are non-homothetic. The pattern of trade is fully analyzed for a two-country, two-sector, and two-factor monopolistic competition model with transport costs. The main results of this transformed cost assumption that differ from previous literature include: (a) the average firm size in relatively capital-abundant countries is smaller; (b) controlling for industry demand, capital-abundant countries support a larger number of varieties in equilibrium; and (c) capital-abundant countries use more capital-intensive techniques in every sector. This model also generates many features of modern trade that cannot be solely explained by traditional horizontal differentiation models using a single factor or even two factors, assuming a homothetic cost function: (1) capital-abundant countries export higher priced varieties; (2) varieties produced using higher capital-intensive techniques have higher prices; (3) capital accumulation leads to increased relative prices over time; and (4) the higher priced manufacturing goods sold by richer countries also capture larger market shares relative to lower priced exports.