Trade and Inequality in a Directed Search Model with Firm and Worker Heterogeneity

This paper integrates the insight that exporting firms are typically more productive and employ higher skilled workers into a directed search model of the labor market. The model generates a skill premium as well as residual wage inequality among identical workers. A trade liberalization will cause a reallocation of workers both within and across industries. The within industry reallocation increases the skill premium, increases residual inequality for low-skilled workers, and decreases residual inequality for high-skilled workers. The across industry reallocation induces the well-known Stolper-Samuleson effect. The calibrated model generates results consistent with the prior literature examining the effect of the Canada-U.S. Free Trade Agreement on the Canadian labor market: a significant decrease in employment in manufacturing, but only a small change in wages.