Border Effects Within A Dynamic Equilibrium Trade Model

A dynamic general equilibrium model is developed in which border effects are present. It is shown that despite very low trade barriers the presence of national borders can choke off a significant fraction of cross-border trade when firms experience start-up costs in establishing new markets. It is also revealed that country size, as measured by the number of markets in a country, can have a significant effect on how quickly firms grow. Also, it is shown that a decrease in trade barriers will increase the rate at which firms expand into both foreign and domestic markets. Furthermore, an increase in fixed costs at the production level is shown to increase trade flows. This helps explain why developed countries trade more than less developed countries. This article also develops a novel way to solve dynamic optimization problems when “state-space” constraints are present. The solution strategy is applicable to a wide variety of problems in which agents are not constrained now but are expected to be constrained in the future.