Estimating the Gains from Trade in Frictional Local Labor Markets

We develop a theory and an empirical strategy to estimate the welfare gains from trade in economies with frictional local labor markets. We obtain a welfare formula that nests several standard market structures and features an additional adjustment margin, via the employment rate. To obtain causal estimates of the two key parameters for counterfactual analysis, the trade elasticity and the elasticity of substitution in consumption, we propose a theoretically-consistent identification strategy that exploits variation in industrial composition across local labor markets. We examine Germany’s recent trade integration with China and Eastern Europe. Under monopolistic competition with free entry and firm heterogeneity, the welfare gains are 5.5% larger than in the corresponding frictionless setting. The relative welfare gains are more modest under alternative market structures