Firm-Level Distortions, Trade, and International Productivity Differences

Developing countries typically exhibit small firm size, high dispersion of firm-level productivity, and low trade-to-output ratios. They also tend to export particularly less to more distant and smaller markets. To rationalize these facts, this paper develops a flexible, multi-country general equilibrium model of production and trade in which heterogeneous producers face both domestic size-dependent distortions (SDD) and costly entry into exporting. Since larger firms have greater export-market participation, misallocation induced by SDD reduces the economy’s market access, trade volumes, and gains from trade, reinforcing the contraction in aggregate total factor productivity (TFP). I explore the quantitative properties of the model calibrated to firm-level and aggregate data from the manufacturing sector of 77 major economies. I find that productivity gains from alleviating SDD are significantly larger when economies are open to trade. Enhanced firm selection and factor allocation across firms fully explain this amplification, whereas the contribution from changes in firm entry is actually dampened by trade. Furthermore, cross-country variation in SDD explains a substantial share of international productivity differences, but only when countries are integrated through trade. JEL classification: F12, F63, L25, O11, O47