endogenous.
In our model the role of the government is crucial. It has an indirect in-
fluence on production patterns through its education policy that determines
the distribution of skills in the economy. Traditionally, in trade models deci-
sions on human capital accumulation are taken by agents according to their
level of ability.5 In our model all agents are identical and the distribution of
skills in the economy is entirely determined by the government’s education
policy. Our choice for modeling human capital accumulation is motivated
by the fact that we think this is more relevant for developing nations. For
these nations the means available for individual investment in human capital
are quite limited for the majority of the population. Hence, the allocation
of a limited government budget is a far more important determinant of the
overall distribution of educational opportunity (and human capital) than
individual decisions. Hence, we focus on government policy as the main
determinant of the distribution of human capital.6
Our economy consists of two sectors, a low-skill sector that produces a
primary commodity and a high-tech sector that employs high-skill workers.
The productivity of each worker depends on both her sector of employment
and her level of education. Both product and labor markets are competi-
tive. Initially, we consider the closed economy case and derive the optimal
education policy that maximizes aggregate welfare under autarky. Next, we
allow the economy to trade keeping the skill distribution in the economy the
same. Finally, we allow the government to adjust its education policy and
we derive the new patterns of trade.78
We find that depending on the terms of trade, a move up the skills chain
5The relationship between human capital accumulation and trade was first considered
by Findlay and Kierzkowski (1983) within the H-O framework. For some more recent
work, see Cartiglia (1997), Ranjan (2001) and Long, Riezman and Soubeyran (2007).
What limits human capital accumulation in these papers is private wealth constraints.
In contrast, Deardoff (1997) and Janeba (2000) examine the effects of public policy on
human capital accumulation and the distribution of income but not on trade patterns..
6Our model implies that the distribution of wealth in the economy entirely depends on
government policy and not on personal characteristics. It is only to keep things simple
that we have not introduced any heterogeneity among agents by specifying a distribution
of ability. Had we done so governemrnt policies would still detrmine the distribution of
education attainment but in that case efficiency would require that the level of education
attainment for each agent depends on his level of ability.
7In a recent paper, Egger, Egger, Falkinger and Grossmann (2005) follow a similar
procedure to consider how individual educational choice is affected by the integration of
capital markets.
8Our focus is on long-term trends and thus we have ignored any short-term adjustment
costs. For some potential pitfalls of our approach, see Davidson and Matusz (2002, 2004).