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Financial Frictions, the Rationalization Effect, and Gains from Trade

30 Pages Posted: 3 Oct 2014  

Winston W. Chang

State University of New York at Buffalo - Department of Economics

Youhui Wu

State University of New York (SUNY) at Buffalo

Date Written: September 22, 2014

Abstract

This paper identifies a new source of gains from trade from asset heterogeneity among firms. Under financial frictions, a firm's capital rental is constrained by its own assets. We show that, with or without productivity heterogeneity, trade openness or liberalization will always force the least wealthy firms to close; induce the rationalization effect which shifts capital and labor from small, less wealthy firms to large, wealthier ones; and as a result, improve social welfare and total factor productivity (TFP) due to increasing returns to scale. According to our simulation, the higher the financial frictions or the greater the asset inequality among firms, the larger the gains from trade from this new source. We also show that some existing results in the heterogeneous firm trade models need to be modified under financial frictions. For example, the cutoff productivity to export may increase with trade liberalization and the total number of export firms may decrease with financial liberalization.

Keywords: Entrepreneurship; Financial Frictions; Rationalization Effect; Gains from Trade

JEL Classification: F10, F12, F36, G20, G32

Suggested Citation

Chang, Winston W. and Wu, Youhui, Financial Frictions, the Rationalization Effect, and Gains from Trade (September 22, 2014). Available at SSRN: https://ssrn.com/abstract=2504046 or http://dx.doi.org/10.2139/ssrn.2504046

Winston W. Chang (Contact Author)

State University of New York at Buffalo - Department of Economics ( email )

453 Fronczak Hall
Department of Economics, SUNY at Buffalo
Buffalo, NY 14260
United States
716-645-8671 (Phone)
716-645-2127 (Fax)

HOME PAGE: http://economics.buffalo.edu/facultyprofiles/winston-chang/

Youhui Wu

State University of New York (SUNY) at Buffalo ( email )

12 Capen Hall
Buffalo, NY 14260
United States

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