This paper analyses the effects of reducing trade costs on the location of manufacturing firms that are vertically linked and differ in factor intensities. I extend the new economic geography literature, by embedding a model with vertical linkages within a Heckscher-Ohlin framework.
Firms can choose to locate either in a labour abundant country or a capital abundant country.
I show that lower trade costs on intermediate inputs and final goods can lead to an agglomeration of all upstream and downstream firms in one country, even when they differ in factor intensities. Hence, for some range of trade costs, industries may locate in countries where standard trade models would suggest they would not locate. For example labour intensive industries may locate in capital abundant countries. This also has implications for whether trade liberalisation leads in the direction of factor price equalisation. An earlier version of this paper, in a partial equilibrium model, is entitled, Will Labour Intensive Industries Always Locate in Labour Abundant Countries , La Trobe University Discussion Paper A98.2.