We develop a quantifiable general equilibrium model of trade and multinational production (MP) in which countries can specialize in innovation or production. Home market effects or comparative advantage leads some countries to specialize in innovation and relegate manufacturing operations to other countries via outward MP. Counterfactual analysis reveals that the reduction in the cost of MP or the integration of China into the world economy may hurt countries that are driven to specialize in production, although these losses tend to be very small. Contrary to popular fears, production workers gain even in countries that further specialize in innovation. (JEL D58, F12, F14, F23, L60, O31)

Because of scale effects, idea-based growth models have the counterfactual implication that larger countries should be much richer than smaller ones. New trade models share this same problematic feature: although small countries gain more from trade than large ones, this is not strong enough to offset the underlying scale effects. In fact, new trade models exhibit other counterfactual implications associated with scale effects -in particular, domestic trade shares and relative income levels increase too steeply with country size. We argue that these implications are largely a result of the standard assumption that countries are fully integrated domestically, as if they were a single dot in space. We depart from this assumption by treating countries as collections of regions that face positive costs to trade amongst themselves. The resulting model is largely consistent with the data. For example, for a small and rich country like Denmark, our calibrated model implies a real per-capita income of 81 percent the United States's, much closer to the data (94 percent) than the trade model with no domestic frictions (40 percent).

Much attention has been devoted to the quantification of the gains from trade. In this paper we pursue a broader and arguably more important exercise by quantifying the gains from openness. This notion includes not only trade but all the other ways through which countries interact. We focus our attention here on multinational production (MP), which in 2004 was more than twice as large as trade flows. We present and estimate a model where countries interact through trade as well as MP, and then quantify the overall gains from openness and the role of both of these channels in generating those gains. We build a model where trade and MP are alternative ways to serve a foreign market, which makes them substitutes, but MP also relies on imports of intermediate goods from the home country, which make them complements. The model also allows for "bridge" MP, or export platforms, creating an additional channel for complementarities between trade and MP. Our results imply that the gains from openness are much larger than the gains from trade -this is thanks both to the large gains from MP and to our finding that trade and MP behave as complements. * We benefited from comments by participants at various conferences and seminars. We have also benefited from comments and suggestions from

We present a comprehensive data set on the bilateral activity of multinational firms, with focus on two variables: affiliate revenues and the number of affiliates across country pairs. Our basic data are from UNCTAD and include 59 countries, an average over 1996-2001. We implement an extrapolation procedure that fills in missing values using, alternately, FDI stocks and the bilateral number of M&A transactions. Our dataset allows for the analysis of new patterns of multinational production activities across countries, by taking into account firm rather than balance of payment variables, and both the intensive and extensive margins of multinational activities.

as well as seminar participants at several seminars and conferences for insightful comments. We also thank Jakub Kominiarczuk, Xiangliang Li, Xiao Ma, and Masayuki Sawada for excellent research assistance. Rodríguez-Clare and Yeaple would like to thank the Human Capital Foundation, Rodríguez-Clare the Center for Equitable Growth, and Arkolakis the National Science Foundation for support. All remaining errors are our own. The statistical analysis of firm-level data on U.S. multinational corporations reported in this study was conducted at the International Investment Division, U.S. Bureau of Economic Analysis, under arrangements that maintained legal confidentiality requirements. Views expressed are those of the authors and do not necessarily reflect those of the Bureau of Economic Analysis or the National Bureau of Economic Research.NBER working papers are circulated for discussion and comment purposes. They have not been peer-reviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications.© 2013 by Costas Arkolakis, Natalia Ramondo, Andrés Rodríguez-Clare, and Stephen Yeaple. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source. ABSTRACTThe decline in the costs of multinational production (MP) has led some countries to specialize in innovation and others to specialize in production. To study the aggregate and distributional implications of this phenomenon, we develop a quantifiable general equilibrium model of trade and MP. Specialization is endogenously determined as a result of comparative advantage and home market effects (HME) that arise from the interaction between increasing returns to innovation and geographical frictions. The model yields simple structural expressions for bilateral trade and MP that we use to calibrate it across a set of OECD countries. Comparative statics exercises reveal that the reduction in the cost of MP or the integration of China into the world economy may hurt countries that are driven to specialize in production due to HMEs, although these losses tend to be very small. Contrary to popular fears, we find that production workers gain even in countries that further specialize in innovation.