Analysis of a two country version of Eaton-Kortum model of trade

Abstract

This is a analysis of Eaton-Kortum model in two countries version based on the paper written by Fernando Alvarez and Robert E. Lucas “General Equilibrium Analysis of the Eaton- Kortum Model of international trade”. The EK Model is a versatile and tractable probabilistic parameterization of the deterministic DFS Ricardian model. Production technology describes by two parameters, ѳ and ë. In this simple analysis we explore the implications of ѳ, different variance of individual productivity, by keeping the ë to be the same across country. It show that gains from trade exist when two countries with same factor endowments trade with each other. Welfare to consumers in both countries will increase in trade situation as long as there is existence of heterogeneity in individual productivity. The bigger is ѳ, the more gains from trade. Further more, this analysis shows also that any positive adjustment of trade barriers, for example increasing in transportation cost, will reduce the trade volume by creating a range of non-traded goods. The higher value of ѳ, which means low dispersion of efficiency across goods, the large will be the reduction in quantity of trade.