External Economies and International Trade Redux

May 2010
With Gene M. Grossman, The Quarterly Journal of Economics, Vol. 125 (2)

We study a world with national external economies of scale at the industry level. In contrast to the standard treatment with perfect competition and two industries, we assume Bertrand competition in a continuum of industries. With Bertrand competition, each firm can internalize the externalities from production by setting a price below those set by others. This out-of-equilibrium threat eliminates many of the “pathologies” of the standard treatment. There typically exists a unique equilibrium with trade guided by “natural” comparative advantage. And, when a country has CES preferences and any finite elasticity of substitution between goods, gains from trade are ensured.