Imperfect Labor Contracts and International Trade

In an economy with imperfect labor contracts, differences in the distribution of human capital are an independent source of comparative advantage. I study a world economy with two sectors, one where output is produced by teams and another where individuals can work alone. When worker’ abilities are private information and workers cannot verity the value of their output or the level of profits, feasible labor contracts fail to generate efficient matching of workers within teams. The general equilibrium has the least talented individuals entering the team sector, while the most talented opt to work alone. The inefficiencies are more severe in the country with the more heterogeneous labor force, which causes this country to specialize relatively in the good produced by individuals. Trade exacerbates the “polarization” of the more diverse society. National income could be raised and the distribution of income improved, by a marginal expansion in the size of the team sector.