Vertical and Horizontal Dimensions of Trade Liberalization

FDI introduces competition between foreign and domestic firms at the factor market level. If the latter are technology backward, cost pressures render them uncompetitive, and absolute advantage determine the pattern of foreign and domestic firms’ production. To compensate for technology deficiencies, countries introduce distortions in product and factor markets. Trade liberalization, i.e., the removal of these distortions, have important implications for production and employment patterns, wages and capital flows. I provide evidence that China’s policies to protect domestic -specially state-owned- firms match the model’s prediction on the structure of interventions.