Trade liberalization, heterogeneous firms and the soft budget constraint

Alexeev, Michael, and Jang, Yong Joon-Trade liberalization, heterogeneous firms and the soft budget constraint We analyze the interaction between the soft budget constraint (SBC) and international trade by placing Segal's (1998) SBC model within Melitz's (2003) framework of international trade with heterogeneous monopolistically competitive firms. As in Segal's model, SBC may result in moral hazard. The opening to international trade adds another sort of inefficiency. Some firms that would have become exporters in the absence of SBC choose to apply low effort and not export in order to extract a subsidy from the government. This effect takes place when the trade costs are sufficiently low. Overall, however, trade liberalization reduces inefficiencies generated by SBC. The number of firms subject to moral hazard SBC decreases, aggregate effort level increases and aggregate profits lost due to SBC-induced sub-optimal effort decline as trade costs decrease. Journal of Comparative Economics 38 (4) (2010) 449-460. Indiana University, Bloomington, IN 47405, United States; Korea Institute for International Economic Policy (KIEP), Seoul 137-747, Republic of Korea. (C) 2010 Association for Comparative Economic Studies Published by Elsevier Inc. All rights reserved.