Small-Scale Firms and Trade Liberalization

We explore how integrating into the world economy affects the incomes of manufacturers in less developed countries (LDCs). We show that cutting back trade barriers has asymmetric effects on the incomes of the two typical groups of entrepreneurs. Whereas access to foreign markets benefits those entrepreneurs who are able to run large-scale factories, credit-rationed entrepreneurs running a micro firm lose. The reason is simple. After the liberalization has taken place, wealthy entrepreneurs are no longer restricted to their small home markets and increase factor demand. The resulting increase in factor prices, in particular the rise of the interest rate, hurts the relatively poor borrowers. We suggest that these distributional consequences help to understand why attempts to implement free trade policies may fail in LDCs characterized by a highly unequal size-distribution of firms. JEL classification: O11, F13, O16