Gains from Trade Liberalization between Heterogeneous Countries: Implications for Korea-Japan FTA

We study the welfare implications of a bilateral free trade agreement. The model is based on the recent trade literature that considers search and matching frictions in the labor market. We extend the model by incorporating country-level heterogeneity in terms of production technology, population, and productivity endowment. Model simulation results show a simultaneous tariff cut between symmetric countries to reduce unemployment rates and increase prices in the product market due to higher long run demand, while nevertheless benefiting the economy owing to a more rapid rise in consumer income. In the case of asymmetric countries, we find that larger gains from greater openness to trade accrue to a country with (relatively) more elastic supply occasioned by capital-intensive production technology that accommodates more flexible adjustments to output in response to increased demand. We calibrate the model to Korean and Japanese data in order to assess the expected outcome of the potential trade liberalization between those countries. With a scenario of symmetric level of trade liberalization (in terms of trade cost reduction), when we assume the same population size in a counterfactual way, we find Japan to receive greater benefits from the opening because its relatively more capital intensive production allow for quicker output adjustment upon trade liberalization. When we presume, however, that Japan's population is 2.5 times that of Korea, the results show Korea to enjoy a slightly more surplus due to the market size effect.