Beyond the Diversification Cone: A Neo-Heckscher-Ohlin Model of Trade with Endogenous Specialization Christis G. Tombazos, Xiaokai Yang, and Dingsheng Zhang * Abstract: We propose a Neo-Heckscher-Ohlin model of trade that combines comparative endowment advantage, comparative technological advantage, international capital mobility, and trade-specific transaction costs. Unlike competing characterizations, our model is the first of its kind to treat specialization in production endogenously using an inframarginal general equilibrium setting. The results are startling! They suggest that production within the diversification cone – a key assumption of Heckscher-Ohlin theory that is required for its core propositions (such as factor price equalization) to hold – may only prevail on the razor’s edge, or under exceptional circumstances. In addition, our findings nominate a mechanism by which improvements in transaction efficiency facilitate international trade thereby stimulating cross-country division of labor. Contrary to other generalizations of the Heckscher-Ohlin (such as the various derivatives of the Kemp-Jones model of trade), our model does not assume a purely Ricardian character: comparative endowment advantage may determine the pattern of trade even in the presence of opposing technological differences, as long as total factor productivity coefficients adjusted for transaction efficiency and factor intensity do not confer unambiguous comparative (technological) advantage. Still, “efficiency intensity”-adjusted comparative technological advantage supersedes factor endowments in determining the flow of trade. Running title: Beyond the Diversification Cone J.E.L. Classification codes: F11, F21 Keywords: Heckscher-Ohlin trade theorem, capital mobility, exogenous comparative advantage, trade-specific transaction costs, inframarginal analysis, diversification cone, endogenous production patterns, specialization * Tombazos: (corresponding author) Department of Economics, Monash University, Clayton, VIC 3800, Australia (e-mail christis.tombazos@buseco.monash.edu.au, phone ++61-3-9905-5166, fax ++61-3-9905-5476); Yang: Department of Economics, Monash University, Clayton, VIC 3800, Australia; Zhang: Institute for Advanced Economic Studies, Wuhan University, China, and Department of Economics, Monash University, Clayton, VIC 3800, Australia (e-mail: dingsheng.zhang@buseco.monash.edu.au). We, Tombazos and Zhang, would like to dedicate this paper to our dear friend and colleague Xiaokai Yang who died earlier this year. It is with a heavy heart that we acknowledge this contribution as our last co- authored paper with Xiaokai. This research has benefited considerably from discussions with Hugo Sonnenschein and Peter Neary whom we also thank, together with Ron Jones, Murray Kemp and Ed Ray for very constructive suggestions on earlier drafts of this paper. We also thank the participants of the 2004 conference of the Economic Society of Australia for useful comments. Financial support from Monash University is gratefully acknowledged.