Trade Liberalization, Agency Problem and Aggregate Productivity

Abstract

Evidence shows that trade liberalization mitigates the agency problem inside firms that have production inefficiencies and incentivizes these firms to improve management quality. In order to strengthen our understanding of this phenomenon, I propose an industry equilibrium trade model with heterogeneous firms. When an economy opens up to trade, managers of the least productive surviving firms are incentivized to exert more effort, although they face shrinking market size in the open economy. This leads to improved productivity within these firms. I then show that managerial incentives have a non-monotonic impact on the aggregate productivity gains from an episode of trade liberalization. Finally, I calibrate the model using plant-level data from Colombia, and find that the interaction between managerial incentives and trade liberalization has a quantitatively sizable effect on the productivity gains from trade.