Firm-Level Distortions, Trade, and International Productivity Differences By Lucas Costa-Scottini ∗ This version: October 2017 Click here to access the most recent version JOB MARKET PAPER Abstract Developing countries are characterized by small firm size, high dispersion of firm-level productivity, and low trade-to-output ratios. Such economies also tend to export disproportionately less to more distant and smaller markets. To rationalize these facts, this paper develops a flexible multi-country general equilibrium model of production and trade in which heterogeneous producers face both domestic size- dependent distortions (SDD) and costly entry into exporting. Since larger firms have greater export-market participation, misallocation induced by SDD dispropor- tionately reduces trade volumes and gains from trade, reinforcing the contraction in aggregate total factor productivity (TFP). I explore the quantitative properties of the model calibrated to firm-level and aggregate data from the manufacturing sec- tor of 77 major economies. I find that productivity gains from alleviating SDD are significantly larger when economies are open to trade. Enhanced firm selection and factor allocation across firms entirely account for this amplification, whereas the con- tribution from changes in firm entry is actually dampened by trade. Furthermore, cross-country differences in SDD can explain a substantial share of international pro- ductivity differences, but only when countries are integrated through trade. JEL classification: F12, F63, L25, O11, O47 Keywords: Misallocation, Firm-Level Distortions, Gravity Equation, International Trade ∗Ph.D. Candidate, Department of Economics, Brown University. Email: lucas [email protected]. I am extremely grateful to Jonathan Eaton, Joaquin Blaum, and Jesse Shapiro for invaluable guidance and insight. I thank Arnaud Costinot, Costas Arkolakis, Sharon Traiberman, Heitor Pellegrina, Michael Peters, Lorenzo Caliendo, and seminar participants at Brown University, Pennsylvania State University, EconCon Conference at the University of Pennsylvania and Midwest International Trade Conference for helpful comments. Finally, I thank Bruce Boucek for helping with the UNIDO industrial dataset and Ana Margarida Fernandes for providing access to the World Bank's Exporters Dynamic Survey. All remaining errors are my own. 1 1 Introduction One of the major recent developments in economic growth and international trade lit- eratures has been the focus on firm-level data. Two strong regularities emerge from the micro datasets: firm-level revenue productivity is highly heterogeneous, particularly in developing countries,1 and large and more productive firms tend to export whereas small and less productive ones do not.2 The first fact may indicate the existence of alloca- tive inefficiencies across firms - with negative effects at the aggregate level. The second fact points to the importance of large producers in shaping international trade and of inter-firm reallocations in driving gains from trade. Various studies have examined these features individually, but the analysis of the consequences of their interplay to aggregate performance remains largely unexplored. This paper puts forward the idea that in the presence of endogenous selection of the most productive firms into exporting, domestic distortions that misallocate capital and labor across firms disproportionately reduce the economy's trade volumes and gains from trade. This effect ultimately contributes to multiply the aggregate TFP losses associated with allocative micro distortions. I then show that this mechanism is quantitatively important to understanding the large observed differences in the volume and geography of trade, aggregate productivity, and standards of living between rich and developing countries. I start out by revisiting some key stylized facts in economic development: developing countries' (i) small average firm size, (ii) high within-industry dispersion of both revenue and physical firm-level productivity, and (iii) low trade-to-output ratios (the \home bias puzzle"). I add to this list a new fact: (iv) developing economies tend to export disproportionately less to more distant and smaller markets. Intuitively, these countries' exports increase faster with importer market size but also decrease faster with bilateral trade costs when compared with sales from rich economies. The standard multi-country trade model with heterogeneous firms reviewed in Arko- lakis et al.[2012] (ACR henceforth) do not square with the facts above. First, the model predicts that market-based reallocation should eliminate within-industry dispersion of revenue productivity across firms.3 With CES demand and monopolistic competition, a highly productive firm should expand its size to the point that its revenue productiv- ity equalizes the one from its less productive competitors. Second, the model assumes that firm size distribution is invariant across countries. With Pareto distribution, this invariance implies that trade elasticities are also constant across exporters. Finally, the theory predicts that high microheterogeneity should lead to larger incentives to trade and to aggregate exports that are less sensitive to trade costs - the opposite of what is observed in the data. 1See Hsieh and Klenow[2009], Bartelsman et al.[2013], Peters[2013], and Asker et al.[2014]. 2See Bernard et al.[2007] and Eaton et al.[2011]. 3The presence of fixed costs can also generate dispersion of revenue productivity. However, when fixed costs are calibrated to match usual estimates of survival rates, the amount of dispersion generated is way lower than what is found in the data. See Bartelsman et al.[2013] and Hsieh and Klenow[2014]. 2 To reconcile the theory with the facts in a parsimonious fashion, I incorporate two key elements from the macro-development literature into a quantitative multi-country model of production and trade in the spirit of Eaton et al.[2011] and Di Giovanni and Levchenko[2012]. First, I allow for the Pareto shape parameter that controls the dis- tribution of microtechnologies to be country-specific. This assumption gives the model flexibility to match the fact about the dispersion of firm-level physical productivity. Sec- ond and more important, I assume that firms face revenue distortions that increase in firm size, which I refer to as size-dependent distortions (SDD). These distortions capture domestic policies, institutions, and market frictions in developing countries that system- atically coddle small firms at the expense of their more productive competitors.4 The remaining elements of the model are standard. Economies are comprised of a competitive service sector that produces the final good and a tradable sector with monopolistic com- petition, CES demand, and free entry. Markets are separated by iceberg and fixed trade costs, and factors (labor and capital) are mobile within but not between countries. SDD play a dual role in the model. First, they create dispersion of revenue produc- tivity across firms, which results from high-productivity plants employing less capital and labor than in the first-best equilibrium relatively to low-productivity plants. Sec- ond, due to the high fixed costs to access foreign markets, SDD disproportionately reduce firms’ incentives to export. In addition, these distortions compress the sales distribu- tion of incumbent exporters. These two factors together make the extensive margin of aggregate exports more sensitive to trade costs and importer market size. For instance, in a more distorted economy, an increase in trade costs crowds out of the export sec- tor a larger number of firms, whose sales aren't so much smaller than the sales of the remaining exporters. As a result, the proportional reduction in aggregate exports is larger. Therefore, more distorted economies export less in general and particularly less to \harder" destinations, i.e., smaller and more distant import markets. Having built a model consistent with the empirical facts, I turn to analyzing the channels through which SDD affect aggregate TFP. More severe SDD decrease the ex- pected value of entry, reducing the measure of firms in the economy. SDD also hinder the expansion of the most efficient firms, which in equilibrium weakens the competitive pressure on less efficient firms, reducing average firm size and worsening the selection of producers in the market. Finally, distortions increase the dispersion of marginal rev- enue productivity, aggravating the misallocation of factors among incumbent producers. All these channels have been highlighted by the recent macro-development literature based on closed-economy models - see Hsieh and Klenow[2009] and Bartelsman et al. [2013]. The contribution of my model is to bring into the picture the consequences of SDD to trade volumes and the gains from trade. As in ACR, the contribution of trade to aggregate TFP is a function of three sufficient statistics: the home share of spending on 4Examples of detailed mechanisms that would map into SDD include: quality of the managerial delegation environment (Akcigit et al.[2016]), frictions in factor markets (Hopenhayn and Rogerson [1993] and Midrigan and Xu[2014]), rent-seeking and unequal regulation enforcement (Aterido et al. [2007]), and size-dependent policies (Guner et al.[2008] and Garicano et al.[2016]). 3 tradable goods (an inverse measure of trade openness), the importance of the tradable sector, and the trade elasticity. By hindering the reallocation of factors from small to large producers, SDD reduce the efficiency