Foreign productivity improvements and domestic welfare effects

Purpose - This paper aims to shed light on two mechanisms that show how foreign productivity improvement affects domestic welfare. Design/methodology/approach - First, this study applies a general equilibrium model that takes into account how wages respond to productivity improvements. Second, this study uses a monopolistic competition model that shows how benefits or losses from foreign productivity changes are distributed within domestic economy. Findings - First of all, this study shows that a region’s productivity improvement is beneficial for the region itself as well as for its trading partner. Moreover, the study finds that productivity improvement in a developing region is beneficial for the entire economy, benefits all unskilled workers in the economy and skilled workers in the developing region and hurts those in the developing region’s trading partner. Originality/value - This study contributes to the existing literature in two key aspects. First, the study applies a two-region, two-factor, one-sector general equilibrium model with flexible wages, and second, the study uses a two-region, two-factor, two-sector monopolistic competition model, relaxing the single-factor (labor) assumption, which is used in other works. Under the single-factor assumption, foreign productivity changes do not have any impact on domestic income distribution. In reality, however, any productivity change between countries creates losers and winners within each country. Hence, the author believes that it is imperative to study how benefits or losses that come from foreign productivity changes are distributed between domestic production factors.