Financial Frictions, the Rationalization Effect, and Gains from Trade

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