Economies of Scale, International Capital Mobility, and North‐South Inequality

This paper develops a model of North‐South trade with a continuum of goods, external economies of scale and international capital mobility. The North‐South wage gap must exceed any difference in labor quality for South to overcome the established external economies in North. In equilibrium North retains the goods with the largest external economies and South specializes in the remaining goods. While Northern product innovation leads to the production of additional goods in South, it is possible for South to experience a terms‐of‐trade deterioration, a reduction in foreign investment, and an increase in wage and income inequality.