Size-dependent Exit Restrictions and Efficiency Gains from Trade

This paper examines the impact of size-dependent exit costs on intra-industry reallocation and productivity gains resulting from trade openness. In an open-economy competitive industry dynamics model, I incorporate severance pay for both continuing and exiting firms. I find that firing costs upon exit decrease the efficiency gains from trade, while conversely, firing costs for continuing firms increase these gains. This effect of exit firing cost is further broken down into three channels: curbing the exit of large, less-productive firms; impeding the growth of small and productive firms; and discouraging entry. Utilizing multiple measures of employment protection in China, I show empirical evidence supporting the model's premise that firm exit incurs firing costs, and that firing costs indeed reduce the efficiency gains from China’s WTO accession.