Stephen Yeaple, Professor of Economics, Penn State University
Ex-post firm heterogeneity can result from different strategies to overcome labor market imperfections by ex-ante identical firms—with far-reaching consequences for the welfare effects of trade. With asymmetric information about workers’ abilities and costly screening, in equilibrium some firms screen and pay wages based on the true productivity of their workers, and some firms do not screen and pay wages based on the average productivity of their workforce. Screening firms are larger, attract better workers and pay lower effective wages. This results in excessive consumption of resources by large firms relative to the social optimum. Trade liberalization then has an ambiguous effect on aggregate welfare: lower trade costs improve access to foreign goods but also exacerbate the labor market distortion as more resources are transferred to large firms. The model highlights the need to know why firms “excel” before drawing welfare conclusions regarding cross firm reallocations of resources.