This paper builds a dynamic industry model with heterogeneous firms that explains
why international trade induces reallocations of resources among firms in an industry.
The paper shows how the exposure to trade will induce only the more productive firms
to enter the export market (while some less productive firms continue to produce
only for the domestic market) and will simultaneously force the least productive
firms to exit. It then shows how further increases in the industry's exposure to
trade lead to additional inter-firm reallocations towards more productive firms.
These phenomena have been empirically documented but can not be explained by current
general equilibrium trade models, because they rely on a representative firm framework.
The paper also shows how the aggregate industry productivity growth generated by
the reallocations contributes to a welfare gain, thus highlighting a benefit from
trade that has not been examined theoretically before. The paper adapts Hopenhayn's
(1992a) dynamic industry model to monopolistic competition in a general equilibrium
setting. In so doing, the paper provides an extension of Krugman's (1980) trade model
that incorporates firm level productivity differences. Firms with different productivity
levels coexist in an industry because each firm faces initial uncertainty concerning
its productivity before making an irreversible investment to enter the industry.
Entry into the export market is also costly, but the firm's decision to export occurs
after it gains knowledge of its productivity.