Trade Liberalization, Price Distortions, and Resource Reallocation

We construct a time-variant, price-based measure of trade distortions in 28 manufacturing industries for a large sample of countries over the last four decades, documenting facts consistent with the argument that changes in relative prices are an important channel through which an economy’s openness affects outcomes. First, we find that price distortions at the aggregate level are negatively associated with the degree of openness and the speed at which trade volume, exports, and imports grow. The negative association between trade outcomes and price distortions is fundamentally driven by the positive link between openness and price distortions. Second, increases in trade around the time of liberalization are positively related to a decline in aggregate price distortions for the sample of trade-liberalizing countries. Third, the extent of production reallocation is positively associated with the degree of relative price changes that occur around the time of liberalization, particularly across constant-return-to-scale sectors. Fourth, changes in relative prices at the industry level within countries are positively correlated with changes in output, productivity, and firm size, and negatively associated with the number of firms. Finally, we show that the neoclassical theory of trade does a poor job explaining how relative prices change during trade liberalization.