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This paper develops a two-country model of intra-industry trade with trade costs that can be reduced by public investment in an international infrastructure capital, the stock of which accumulates over time. Depending on the trade costs and international distribution of manufacturing firms, equilibrium patterns of trade are determined, and national welfare in each country is affected by these trade patterns. Taking into account the relationship between trade costs and national welfare, the governments carry out a dynamic game of public investment. We show that the dynamic equilibrium of the policy game may exhibit history dependency; if the initial stock of international infrastructure is smaller (larger) than a threshold level, the infrastructure stock decreases (increases) over time, and the world economy will end up in autarky (two way free trade) in the long run. We also show that international cooperation is beneficial in the sense that it may enable the world economy to escape from a “low development trap”.

Strategic Investment in an International Infrastructure Capital: Nonlinear Equilibrium Paths in a Dynamic Game between Two Symmetric Countries