Trade Induced Selection Effects: Factor Intensity Difference in Entry and Production Costs

This paper develops a two-factor model of trade in intermediate goods and final goods between countries differing in relative factor endowments with monopolistically competitive firms of heterogeneous productivity. Unlike previous studies, I show that even without trade cost selection effects are present and are guided by factor proportions. Free trade causes a lower wage-rental ratio and weaker selection in the capital abundant country while the opposite happens in the labor abundant country. Under free trade, in a departure from the Stolper-Samuelson result, the real reward to labor rises in the capital abundant country while the change in the real reward to labor is ambiguous for the labor abundant country. Further, the model predicts, for costly trade, a rise in the wage-rental ratio reallocates labor away from capital intensive intermediate goods sector and towards labor intensive final good sector, and vice-versa. Also, in a move to costly trade, if the wage-rental ratio rises then selection becomes stricter, and vice-versa. These results are confirmed by a numerical simulation of bilateral liberalization in the model.