Misallocation Under Trade Liberalization

This paper formalises a classic idea that in second-best environments trade can induce welfare losses: gains accrued can be outweighed by incremental income losses stemming from distortions. In a Melitz model with distortionary taxes, we derive sufficient statistics for welfare gains from trade, and show that its departure from the efficient case (ACR) can be captured by the gap between an input and output share and domestic extensive margin elasticities. The loss reflects the impact of an endogenous selection of more subsidized firms into exporting. We show sufficient conditions under which conventional formulas overestimate trade gains as well as conditions under which welfare losses can occur. Using Chinese manufacturing data, we demonstrate by taking into account firm-level distortions, welfare losses largely offset conventional gains to trade.