The extent of the market and optimal specialization

Summary. In this paper I examine how the socially optimal allocation, and specialization in particular, depends on the extent of the market. I interpret the societys ability to keep transaction records as the extent of the market and measure it by a probability with which the society can update agents past transactions into the public record. The society uses this record to detect potential defections from the optimal allocation and to punish the defectors with autarky. I show that when is small, increasing increases optimal specialization. However, when is close to 1, increasing further has no effect on the optimal allocation. I also show that optimal specialization is gradual over time when there is cost to reduce specialization. Even for small , the process converges to the unconstrained optimum that would occur under .JEL Classification Numbers: D60, C78.An earlier version of this paper was presented at the Society for Economic Dynamics meetings in Stockholm (2001). I thank a referee and the editor for useful comments and suggestions. For financial support, I gratefully acknowledge the Social Sciences and Humanities Research Council of Canada, and the Bank of Canada Fellowship. The opinion expressed here is my own and does not reflect the view of the Bank of Canada.