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Trade and Market Power in Product and Labor Markets

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When firms have labour market power that depends on their size, more productive firms hire too few workers compared with their less productive local competitors. This misallocation of labour reduces aggregate, or economy-wide, productivity. A key source of welfare gains from opening up to trade is the reallocation of workers and resources from less productive firms to firms that use them more efficiently. Thus, trade can raise aggregate productivity, in part by reducing labour misallocation. But in so doing, trade increases the labour market power of highly productive firms. 

I develop a novel trade model in which firms have size-dependent market power in the markets for their goods and the markets where they hire workers. I use Indian manufacturing data to assess how accounting for labour market power alters the effects of trade liberalization on prices, wages and the gains from trade. 

In the model where firm’s labour market power depends on firm size, there are small additional gains from trade (up 0.14 percent compared with a baseline model where firms have no labour market power).  This happens because the loss of aggregate productivity due to the misallocation of labour is reduced as trade increases. While the gains from trade are larger, the average level of labour market power rises. Therefore, the aggregate real wage gains from trade are smaller (down 0.4 percent compared with the baseline).