Endogenous Firm Heterogeneity and the Dynamics of Trade Liberalization

In this paper, we build a dynamic model with endogenous firm-level productivity that generates firm heterogeneity as an equilibrium outcome. Firm heterogeneity arises in equilibrium from the gradual diffusion of a technological innovation through the industry. We investigate the effects of international trade on technological diffusion and show that trade has a generally positive impact on the equilibrium rate of adoption (and hence firm-level productivity). In addition, the model can replicate the stylized fact that exporters are larger and more productive than non-exporters. Finally, we show that the model can explain two puzzling facts from the Canadian experience with NAFTA: Why US tariff reductions decreased the number of Canadian firms; and why Canadian tariff reductions lowered the productivity of the most productive Canadian firms but raised it for the least productive firms