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Abstract

In this paper, we consider a two-sector, dynamic economy in which one of the sectors are growing through learning by doing while the other one is stationary along an autarkic balanced growth path. The resulting declining relative price thus implies that accelearated industrialization through production subsidy could improve the lifetime welfare of this closed economy.

This model is used to study the effects of trade between two economies with similar structures. It is shown that trade and the pattern of production depends not only on the characteristics of the economies such as technologies, preferences, knowledge accumulation rates, and labor force endowments, but also on the timing of trade. There are some cases in which the pattern of trade changes and some cases in which the economy exports the "wrong" good in the sense that the actual pattern of trade is not the same as what it would be should no trade be allowed in the first place.

It is shown that whether free trade is beneficial to a small open economy in the long run depends on what good is being produced and exported, and also on when free trade is first allowed. Thus free trade may be be good. This paper also derives the optimal timing of trade and the optimal production subsidy in the presence of trade.