Endowment Versus Finance: A Wooden Barrel Theory of International Trade

This paper develops a theory of international trade in which financial development and factor endowment jointly determine comparative advantage. We apply the financial contract model of Holmstrom and Tirole to the Heckscher-Ohlin-Samuelson (HOS) framework. A key result is what we call the law of a wooden barrel: if the external finance constraint is binding, then augmenting capital stock would have no effect on output and returns. On the other hand, if the external finance constraint is not binding, the standard HOS predictions are resuscitated.