Trade, Foreign Investment, and Industrial Policy for Developing Countries 4049

specialized in 1 this goes together with low levels of both types of capital and a lower
level of TFP than if it were specialized in sector 2 (Ciccone & Matsuyama, 1996;
Rodrı́guez-Clare, 1996). A policy to shift resources toward sector 2 would then gen-
erate endogenous accumulations of capital, as observed in East Asian countries. In other
words, some LDCs may have low capital stocks as well as low TFP as a consequence of
not exploiting their latent comparative advantage.8
2.1.3 Dynamic externalities
Here we extend the model to allow for dynamic Marshallian externalities, as in Bard-
han (1970), Krugman (1987), Lucas (1988), Redding (1999), and Melitz (2005). To do
so, we assume that productivity in sector 1 in country i is l1i, just as above, whereas
! ; L 2it Þ%. Letting
productivity in sector 2 in country i at time t is now Ait l2i ½1 þ aMinðL
aSt & min {ASt/ANt, 1} and aNt & min {ANt/ASt, 1}, we assume that Ait grows thanks
to both learning by doing (which happens if country i has a cluster in sector 2, that
is, L2it > 0) and international spillovers (which happens if ait < 1). Formally, we
assume that

A_ it ¼ ðg=L
! ÞminðL
! ; L 2it ÞAit þ eð1 ( ait ÞAit

where e > g > 0. Productivity increases caused by dynamic externalities in one country
eventually diffuse to the other country even if there is no cluster there. Thus, in this
model clusters are important to generate knowledge but are not critical to benefit from
knowledge spillovers.
Note that if the North has a cluster but the South does not, then A_ St ¼ eð1 ( aSt ÞASt .
There are “benefits of backwardness,” in the sense that a lower relative productivity in
South (i.e., lower aSt) leads to a faster rate of productivity growth. This implies that
given e > g there is a steady state productivity gap ASt =ANt ¼ ^aS given implicitly by
g ¼ eð1 ( ^aS Þ: if aSt < ^aS ðaSt > ^aS Þ then aSt increases (decreases) toward ^aS . For future
reference, note that the productivity of North relative to South in this steady state is
ðl2N =l2S Þy=^aS : the first-term captures pure Ricardian productivity differences,
whereas the second- and third-terms capture the impact of static and dynamic benefits
of clustering, respectively. Starting from such a steady state, if South acquires a cluster
in sector 2, so that now L 2St ) L ! , then there will be full convergence as aSt increases
from ^aS toward 1.
As before, assume that prices are wholly determined in North. Then p*1 ¼ 1=l1N
and p*2t ¼ 1=AN t yl2N , and assume that condition (CA) holds. Focusing on South,
complete specialization in 1 is a steady state equilibrium if

l2S =l1S
+ y=^aS ð4Þ
l2N =l1N