Comparative advantage and heterogeneous firms

Abstract

This paper examines how country, industry, and firm characteristics interact in general equilibrium to determine nations’ responses to trade liberalization. When firms possess heterogeneous productivity, countries differ in relative factor abundance, and industries vary in factor intensity, falling trade costs induce reallocations of resources both within and across industries and countries. These reallocations generate substantial job turnover in all sectors, spur relatively more creative destruction in comparative advantage industries than in comparative disadvantage industries, and magnify ex ante comparative advantage to create additional welfare gains from trade. The improvements in aggregate productivity as countries liberalize dampen and can even reverse the real-wage losses of scarce factors. How do economies respond to trade liberalization? Neoclassical trade theory, with its emphasis on comparative advantage, stresses the reallocation of resources across industries and countries as well as changes in relative factor rewards but provides no role for firm dynamics. More recent research on heterogeneous firms emphasizes the relative growth of high-productivity firms within industries but ignores comparative advantage by considering just a single factor and industry. Until now, very little has been known about how these two sources of reallocation combine in general equilibrium. This paper derives new—and more realistic—predictions about trade liberalization by embedding heterogeneous firms in a model of comparative advantage and analysing how firm, country, and industry characteristics interact as trade costs fall. We report a number of new and often surprising results. In contrast to the neoclassical model, we find that simultaneous within- and across-industry reallocations of economic activity generate substantial job turnover in all sectors, even while there is net job creation in comparative advantage industries and net job destruction in comparative disadvantage industries. We show that steady-state creative destruction of firms also occurs in all sectors but find that it is more highly concentrated in comparative advantage industries than in comparative disadvantage industries. We demonstrate that the relative growth of high-productivity firms raises aggregate productivity in all industries, but this productivity growth is strongest in comparative advantage sectors. The price declines associated with these productivity increases inflate the real-wage gains of relatively abundant factors while dampening, or even potentially overturning, the real-wage losses of relatively scarce factors. Finally, we