Inter-industry trade and heterogeneous firms: Country size matters

This study investigates how industries with different patterns of firm heterogeneity are distributed across countries by developing a three-sector general-equilibrium model. There are two manufacturing industries in our setting: one in which firm productivity is homogeneous and the other in which it is heterogeneous. The higher degree of firm heterogeneity in the latter reflects the larger difference in firm heterogeneity between industries. We show that the larger country is more specialized in the industry with heterogeneous (homogeneous) firms when trade costs are low (high) and that an increase in the inter-industry difference in firm heterogeneity fosters the larger country's degree of specialization in the industry with heterogeneous firms. We also disclose the trade patterns across countries and show how they respond to trade liberalization. Moreover, wages are found to be higher in the larger country, with an increase in the inter-industry difference in firm heterogeneity enlarging the wage inequality across countries.