Many producer services are knowledge-intensive, requiring a high initial investment in learning, after which the knowledge can be provided to additional users at low cost. A monopolistic-competition type model is developed to analyze these producer services. Trade only in final goods is an imperfect and inferior substitute for trade in the specialized inputs, due to the complementarity between domestic and foreign specialized inputs, or alternatively the gains from an increased division of labor.

Divide the world into a capital-abundant North and a labor-abundant South. Subdivide the North into two identical regions, East and West. Modern trade theory predicts intra-industry trade in differentiated manufactured goods between East and West, and traditional interindustry trade based on factor endowments between North and South. The model I develop explains both the volume and the direction of trade by combining nonhomothetic preferences with scale economies and differences in endowments.

A theoretical analysis of "optimal" (Nash equilibrium) tariff rates is presented. A numerical general equilibrium model is then used to find Nash equilibrium tariff rates for the United States and Canada. The Nash equilibrium tariffs are small relative to partial equilibrium estimates: 18 percent for the United States and 6 percent for Canada. The United States is essentially indifferent between the Nash equilibrium and free trade, while Canada is better off at the latter by $4 billion. Empirical results support theoretical predictions that the optimal tariff is smaller when the country is smaller, there are scale economies and free entry, and capital is internationally mobile.

I. Contract structure and risk bearing, 257.—II. Asymmetrical information, 263.—III. Unemployment compensation, labor-leisure preferences, and seniority, 266.—IV. Profit sharing as a cooperative game, 271.—V. Summary and conclusions, 273.—Technical appendix, 276.

Introduction, 618. — National Optimum, 619. — International Optimum, 624. — International transfer payments, 627. — Bilateral monopoly power, 629. — Summary, 630. — Appendix, 631.

A theoretical analysis of "optimal" (Nash equilibrium) tariff rates is presented. A numerical general equilibrium model is then used to find Nash equilibrium tariff rates for the United States and Canada. The Nash equilibrium tariffs are small relative to partial equilibrium estimates: 18 percent for the United States and 6 percent for Canada. The United States is essentially indifferent between the Nash equilibrium and free trade, while Canada is better off at the latter by $4 billion. Empirical results support theoretical predictions that the optimal tariff is smaller when the country is smaller, there are scale economies and free entry, and capital is internationally mobile.