Trade, Technology Diffusion and Misallocation: Trade Partner Matters (Replaces CentER DP 2011-125)

Abstract: This paper suggests that contingent on the productivity level of the trade partner; international trade may create resource misallocation in less productive countries. It theoretically shows how the interaction between technology diffusion induced by trade and cross sectoral heterogeneity in productivity distributions, and technology adoption rates leads to asymmetric pro-competitive effects, which in turn result in misallocation. In this framework trade increases welfare in the long-run due to technology diffusion, even though there is steadystate resource misallocation across industries. Using firm level data from 32 European countries for the period of 1992-2007, it also presents robust empirical evidence supporting the model predictions by showing that trade with more productive regions as a share of purchasing power parity (PPP) GDP (1) increases economy wide markup variation, (2) raises mean sectoral productivity, and (3) decreases productivity dispersion within 4-digit sectors, only in less productive countries.