Abstract
This study constructs a trade model between a developed and a developing country with binary preferences and heterogeneous productivity, finding that firm selection brings four new results with the possibility of arbitrage. First, we observe a price reversal, such that the price in the developed (high-income) country is lower than that in the developing (low-income) country. Second, we demonstrate the existence of export-only firms in the developing country due to the significant cross-country price differential; additionally, some firms in the developed country do not export despite having the ability. Third, the selection effect of domestic supply is stronger in the small country when trade is more liberalized. Finally, a higher degree of heterogeneity simultaneously enlarges the gains from trade in the developed country and losses from trade in the developing country.
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