Misallocation Under Trade Liberalization

Yan Bai University of Rochester NBER
Keyu Jin LSE CEPR
Dan Lu * The Chinese University of Hong Kong

Abstract

This paper formalizes a classic idea that in second-best environments trade can induce welfare losses. In a framework that incorporates distortion wedges into a Melitz model, we analyze a channel in which trade can reduce allocative efficiency arising from the reallocation of resources. A key aggregate statistics that captures this negative selection is the gap between input and output shares. We derive sufficient conditions for reallocation loss due to trade under important distributions. Using Chinese manufacturing data, we show that this reallocation term is significantly negative, largely offsetting conventional gains to trade.

Keywords: wedges and distortions, misallocation, trade liberalization, gains from trade JEL classification: E23 F12 F14 F63 L25 O47