Beyond the Diversification Cone: A Neo-Heckscher-Ohlin Model of Trade with Endogenous Specialization

Abstract: We propose a Neo-Heckscher-Ohlin model of trade that combines comparative endowment advantage, comparative technological advantage, international capital mobility, and trade-specific transaction costs. Unlike competing characterizations, our model is the first of its kind to treat specialization in production endogenously using an inframarginal general equilibrium setting. The results are startling! They suggest that production within the diversification cone – a key assumption of Heckscher-Ohlin theory that is required for its core propositions (such as factor price equalization) to hold – may only prevail on the razor’s edge, or under exceptional circumstances. In addition, our findings nominate a mechanism by which improvements in transaction efficiency facilitate international trade thereby stimulating cross-country division of labor. Contrary to other generalizations of the Heckscher-Ohlin (such as the various derivatives of the Kemp-Jones model of trade), our model does not assume a purely Ricardian character: comparative endowment advantage may determine the pattern of trade even in the presence of opposing technological differences, as long as total factor productivity coefficients adjusted fo