International Trade: Issue 2

The previous discussion focuses on market-level distortions. We now turn our attention to distortions that affect firms (or possibly sectors) to differing degrees and how such distortions interact with international trade. An implicit assumption in standard models of trade is that resources are efficiently allocated across firms and sectors, at least conditional on trade costs. Yet, a large body of work has argued that firm-specific frictions or taxes are particularly prevalent in developing countries, resulting in the misallocation of factors of production (e.g. Banerjee and Duflo 2005, Hsieh and Klenow 2009).

A robust prediction from a broad class of trade models is that trade leads to the expansion of larger firms relative to smaller ones (Mrazova and Neary 2019). If we believe that small and unproductive firms are abundant in developing countries because they have preferential access to capital, benefit from barriers to entry, or receive favourable tax treatment, then trade reforms will tend to be efficiency enhancing. If, instead, we think that red tape, crony capitalism and lobbying results in small firms facing larger frictions, trade will tend to increase misallocation. A similar logic applies across sectors—i.e. sets of firms that potentially face similar distortions—depending on whether comparative advantage sectors are more or less distorted.

We summarise the literature that focuses on this interaction between trade reforms and firm- and sector-dependent distortions. In a recent review, Atkin and Donaldson (2022) cover this literature in more detail. In addition they recover firm-specific distortion measures from hundreds of World Bank Enterprise Survey samples across the world that they use to quantify whether reductions in trade barriers are likely to improve or worsen misallocation on net, with the analysis finding improvements for the typical low-income country.

Small and informal firms

Learn more about the informal sector in our VoxDevLit on Informality (Ulyssea et al. 2023).

The vast majority of firms in developing countries are small and informal. For example, Hsieh and Olken (2014) document that nearly all firms in India and Indonesia have fewer than 10 workers, and Nataraj (2011) shows that the median manufacturing firm in India is informal, has two employees, and $235 in capital. Small firms have low value-added per worker and typically operate informally, avoiding both taxes and regulatory barriers.[1]1. The legal framework in which informal firms operate varies from country to country and thus so does the extent of regulations that apply to them. Many countries have multiple tiers of business registration and different taxation and labour regulations often apply to the different tiers. See the VoxDevLit review by Ulyssea, Bobba, and Gadenne (2023) for further discussion.

Despite the overwhelming dominance of small firms and their perceived drag on aggregate productivity, there is little research on how trade affects the firm-size distribution in developing countries.[2]2. This is primarily due to a lack of data on small and informal firms as these firms are not usually covered by administrative data or by large scale surveys that use administrative sources as the sampling frame.  On the one hand, since informal firms face fewer labour-market regulations or other regulatory barriers, increased import competition may expand the informal sector, as it can quickly absorb workers shed by the formal sector, serving as an unemployment buffer. On the other hand, informal firms may contract if they are particularly prominent in importing-competing products or if they compete in factor markets with (formal) exporting firms.

A growing literature demonstrates that informal businesses are indirectly affected by international trade through the labour market. McCaig and Pavcnik (2018) provide a comprehensive analysis. The US-Vietnam Bilateral Trade Agreement expanded market access for Vietnamese firms by lowering the US tariffs on their exports. Since informal firms are typically too small to cover the fixed costs of exporting (and typically need to be formal to navigate export procedures), the removal of trade barriers primarily benefits larger firms. These formal-sector firms expanded, pulling workers from informal firms (the second mechanism above).[3]3. Follow-up work by Asghar and McCaig (2024) shows that workers transitioned into the expanding formal firms from informal firms in both manufacturing and services.  Since formal firms are substantially more productive, this movement raised aggregate productivity. There is also suggestive evidence of reduced misallocation since formal firms have higher average-revenue-products of labour, and thus potentially higher marginal revenue products (which would imply that these firms faced larger distortions).

Using a similar approach of focusing on employment in informal firms, the aforementioned Erten et al. (2019) find that domestic trade liberalisation in South Africa was associated with a decrease in the prevalence of employment in informal firms (and an increase in non-employment). Bas and Bombarda (2024) similarly find a decrease in the prevalence of employment in informal manufacturing firms in Mexico in response to a decrease in the cost of importing inputs due to tariff reductions stemming from the North American Free Trade Agreement. In contrast, Dix-Carneiro and Kovak (2019) and Ponczek and Ulyssea (2022) find an increase in self-employment, a proxy to working in informal firms in the Brazilian context, among low-skilled workers in regions most exposed to domestic tariff reductions; and the latter paper shows this effect varies with labour regulation enforcement, as discussed above. 

Collectively, these studies point to informal firms being affected by changes in international trade and highlight the importance of differences in context (see Section 4.1). However, they do not directly document the effects on the small and informal firms themselves. Nataraj (2011) examines this question, specifically how India’s major trade reforms affected informal firms. She finds that declines in tariffs on final goods raised productivity among informal firms and that the smallest and least productive firms exited the market. However, the inability to follow firms over time or to see them switch in and out of formality makes isolating mechanisms difficult.

The link between trade, informality and firm size distribution remains very much an open area of research. Dix-Carneiro et al. (2024) make progress by developing a model of trade with heterogeneous firms (both formal and informal), unemployment, and regulations. Crucially, regulations cannot be perfectly enforced, leading to size-dependent costs of informality. In this environment, large and productive firms sort into the formal sector while small and unproductive firms sort into the informal sector. In equilibrium, large, formal, and productive firms are highly distorted and underproduce relative to the social optimum, whereas small, informal, and unproductive firms are less distorted and overproduce. Estimating the model using Brazilian data, first they find that increased trade openness leads to a reallocation of labour and output from informal to formal firms. Second, the productivity gains from trade can be severely understated when the informal sector is omitted. Third, trade openness leads to increases in wage inequality in the formal sector—consistent with Helpman et al. (2017)—but reduces overall wage inequality once the informal sector is incorporated into the analysis. Fourth, the informal sector operates as an unemployment buffer, but not a welfare buffer, from negative economic shocks as resources are reallocated to less productive firms.

In summary, there is growing evidence that the overall size of the informal sector is affected by international trade and this has quantitatively important effects on aggregate productivity. Additionally, these effects depend on the nature of the trade shock and the local context of the informal sector.

However, there is much we don’t know. Direct evidence on how small and informal firms are affected by international trade is scarce, largely due to data constraints. We need well-structured evidence on the link between trade and the complete firm size distribution, and evidence for whether small informal firms are more or less distorted than larger ones. In particular, studies tracking informal firms over time are needed to help understand the mechanisms (entry, exit, expansion, contraction, and formalisation) behind previous empirical studies. Work is also needed to better understand how trade shocks may propagate to informal firms from formal firms through buyer-supplier relationships or changes in product market competition.

Do politically-connected firms capture the gains from trade?

Many industries in developing countries are dominated by politically-connected firms, often in the form of state-owned enterprises (SOEs). Political influence also stems from large business groups owned by political parties, through state-owned banks that dominate lending to the private sector, and through crony capitalism. The result is that resource allocation decisions may be made to advance objectives beyond firm-level profit maximisation and thus potentially result in misallocation. A widely cited study by Fisman (2001) provides “smoking gun” estimates of the value of political connections in Indonesia by tracking the stock price of companies connected to the government as rumours of President Suharto’s health spread.

A handful of recent papers explore how international trade affects misallocation through its impacts on state-owned firms. These state-run firms are well-capitalised and large but often extremely inefficient and so do not map easily into standard models of firm heterogeneity in which the most productive firms grow the largest. Ex ante, it is unclear whether these firms will expand or contract with trade liberalisations. The former Premier of China, Zhu Rongji, used the phrase “rapid waters should wash away dirty sands” to describe the potential impacts of China’s WTO Accession on its SOEs. In this view, lower trade barriers can drive out inefficient SOEs. However, SOEs may be some of the only firms with sufficient capital to take advantage of improved export opportunities or respond to competitive pressures from imports, or they may receive additional aid or protection to remain sizable despite becoming increasingly uncompetitive.

Khandelwal et al. (2013) study the consequences of trade liberalisation in a sector with a large presence of state-owned activity: China’s textile and clothing (T&C) sector. Prior to 2005, some of China’s T&C exports were subject to quotas. Standard heterogeneous-firm models predict that the most productive firms would buy the export licences, and when the quotas were removed, these incumbent firms would expand. Instead, unproductive SOEs obtained a large share of export licences, and upon liberalisation, there were substantial market share reallocations towards new and more productive private-sector enterprises. Their estimates suggest that the welfare gains from alleviating this misallocation are substantially larger than from removing the actual distortion caused by quota itself. The broader implication is that in countries with weak institutions, the harmful distortion may not be trade costs, which are the standard friction of interest in trade models, but the additional distortions that trade costs engender. Customs facilitation, license allocation, and tariffs and non-tariff barriers may all favour politically-connected firms. Thus, consistent with Premier Zhu’s belief, liberalisation in this setting generated magnified gains because it simultaneously removed deadweight losses and resource misallocation.

However, two recent papers that have examined SOE responses to trade reforms across multiple sectors support the opposite view. Brandt et al. (2017) examines how China’s WTO entry affected the average performance of Chinese firms. They find that trade liberalisation increases exit and raises productivity among private-sector firms, but these effects are muted for SOEs. They suggest that the margin of adjustment comes through CEO turnover, with private-sector firms experiencing more changes in management relative to SOEs in sectors more exposed to trade reforms. Baccini et al. (2019) analyse Vietnam’s entry into the WTO in 2007 and essentially find the same differential response as Brandt et al. (2017) did in China. They conclude that aggregate productivity gains from Vietnam’s WTO entry would have been substantially higher without the presence of SOEs. Both papers appeal to preferential access to capital and soft-budget constraints as the explanation for why the impacts of trade reforms are muted for SOEs.

A handful of papers explore how political connections that do not operate through state ownership but through other routes distort the gains from trade reforms in the developing world. Jävervall and Khoban (Forthcoming) show that connections to politicians in India became substantially less valuable when tariffs on inputs were dramatically reduced in the 1990s, particularly in the most corrupt states. Naidu et al. (2021) show that networks of elites in Haiti held exclusive import licences that generated substantial rents. These elites supported the 1991 military coup to overthrow the democratically-elected Aristide government which threatened these rents. Mobarak and Purbasari (2006) show that Indonesian firms connected to the Suharto family were three times more likely to receive import licences. Rijkers et al. (2017b) uncover a substantial market share and profitability premium among Tunisian companies connected to the Ben Ali regime (prior to the 2011 Jasmine Revolution). These connected firms were also more likely to operate in highly-regulated sectors, including those with restrictions on FDI, which suggests that they influenced the allocation of FDI inflows. Ruckteschler et al. (2022) argue that politically-connected sectors in Morocco—sectors with firms that have members of the royal family and/or former ministers as owners or large shareholders—saw a relative increase in non-tariff measures following the Morocco-EU trade agreement. 

While firms have substantial influence over economic policy in developed countries, our sense is that international trade is generally an area where political connections are relatively less important compared to other economic domains. Access to foreign exchange is typically not restricted by government and entry barriers to access foreign markets or restrict foreign imports are usually part of trade agreement negotiations that are infrequent. However, many developing countries have currency controls and trade policies subject to far more discretion than in developed countries, making the value of political connections more substantial. One further ramification is that if political connections drive the selection of firms into international trade, as the papers above suggest, this may substantially alter the distribution of the benefits from trade through mechanisms such as learning-by-exporting (see Section 3.7 for references). Finally, we note that while there has been work exploring the connections of state-owned firms and those owned by the elite, other connections may be equally important, particularly the ownership of business by the military as is common in many countries such as Egypt and Myanmar, or by political parties themselves as in Ethiopia.

Business groups and family firms

Business groups and family firms are another important feature of the industrial landscape in developing countries. These groups or conglomerates are often (but not always) family-run and family-owned and hold a portfolio of horizontally, and vertically, integrated businesses. Khanna and Yafeh (2007) argue that business groups can be an optimal organisational structure for firms in countries with imperfect capital markets as they can rely on internal capital markets for finance. They may also serve to mitigate contracting issues between suppliers (see Section 2), or to leverage good reputations built in another sector in settings where firms may try to cheat, and reputation is hard to build.

At the same time, business groups have been found to have weak governance structures, for example, expropriating minority shareholders through tunnelling (Bertrand et al. 2002). Feenstra et al. (1999) is an early attempt to examine how business groups affect country trade patterns. Compared to Taiwan, they find that South Korea (an economy dominated by business groups) exports fewer varieties but those they do are higher quality, consistent with the view that business groups serve to reduce product cannibalisation and to invest in quality that can raise overall group reputation. We are unaware of more recent efforts to examine how group organisational structures may affect trade performance.

Family firms present a related but distinct challenge in a trade setting. Caliendo and Rossi-Hansberg (2012) theorise that trade liberalisation causes productive firms to expand and this leads them to increase the number of layers of management.[4]4. Although Guadalupe and Wulf (2010) find (empirically) that trade flattens hierarchies (as a result of increased competition in their context).  However, family firms in developing countries typically rely only on family members at upper levels of management in their firms, severely restricting the scope to add layers of management. For example, Ilias (2006) reveals a strong relationship between firm size and the number of brothers of the firm’s founder using tailored surveys conducted in Pakistan’s surgical goods sector. Bloom and Van Reenen (2007) argue that this (potential) distortion in the allocation of management talent arises because of weak rule of law: without the ability to punish outsiders who steal from the firm, owners must delegate management decisions to family who can be trusted (or sanctioned). Akcigit et al. (2021a) show using a calibrated model that such limits to delegation can distort the firm size distribution because they mainly constrain the size of large firms. While the authors do not explicitly model international trade, the fact that large and productive firms typically export suggest that delegation constraints may particularly impact international trade relative to domestic sales.

In summary, despite the emergent literature that studies organisations and international trade, we are aware of little work that explores how the pervasiveness of conglomerates and family ownership structures in developing countries alter the impacts of trade.

Externalities and spillovers from trade and FDI

Externalities from trade and foreign direct investment (FDI) play a crucial role in explaining empirical regularities about growth and development (Klenow and Rodriguez-Clare 2005). These externalities can arise from the accumulation and diffusion of knowledge among firms and workers, or from the introduction of new products that are valued by consumers and producers. Trade, FDI, and migration (Burstein and Monge-Naranjo 2009) enable low and middle-income countries (LMICs) to access the know-how and products developed in high-income countries. The existence of externalities often justifies government intervention through trade, FDI, and broader industrial policies that favour certain firms, industries, or locations (see reviews by Harrison and Rodriguez-Clare 2010, and Juhász et al. 2023). Determining the presence and magnitude of these externalities is essential for evaluating whether such policies are not only effective but, more importantly, efficient.

Here we review the theoretical and empirical literature on externalities from trade and FDI as they relate to firm-level and aggregate growth and development. From the outset, it is crucial to recognise that providing definitive evidence of the existence and magnitude of externalities is challenging. Measuring the benefits (or costs) associated with these externalities requires accounting for any monetary or non-monetary compensation, which often remains unrecorded. Given this challenge, we expand our review beyond LMICs, emphasising the factors that may explain differing outcomes in these countries, and referencing studies where the evidence is consistent with (but not exclusive to) externalities.

Knowledge externalities

Trade and FDI may facilitate knowledge flows across and within borders generating both firm-level and aggregate gains. While these knowledge flows feature heavily in the theoretical literature and policy discussions, direct empirical evidence on such flows is scarce.[5]5. Theoretical contributions by Sampson (2016), Hsieh et al. (2019), Buera and Oberfield (2020), Perla et al. (2021), Akcigit et al. (2021b) and Atkin et al. (2024) formalise how knowledge flows through trade and scale economies may impact growth and development.   One avenue for knowledge flows is importing knowledge-intensive inputs, then reverse-engineering and building upon the knowledge. Aghion et al. (2019) find that when French firms start exporting to a new country, they receive more patent citations from that country, suggestive of knowledge flowing to the new export market. Ayerst et al. (2023) use cross-country inter-sectoral citation and trade data to show that increases in embodied technology imports from the US—assumed to be the technology leader—result in greater innovation, as measured by forward citations, and enhanced knowledge diffusion, indicated by backward citations.[6]6. De Souza et al. (2024) show that Brazil's import tariff increases led to more technology transfer contracts (such as technology licensing and technical assistance agreements). While Brazilian firms paid for these technology transfers (hence, they did not experience externalities), the paper then shows increases in citations to the foreign firms selling technology to Brazil among Brazilian firms who did not purchase the technology but were located near those who did.  Further research on this topic, especially in the context of LMICs, is needed, as it remains unclear whether importers in these countries have the capacity to absorb and build upon the knowledge embedded in their imports.

An alternative avenue for knowledge flows through trade is exporting to high-income countries. The experiment by Atkin et al. (2017b) provides a clean identification of productivity improvements caused by exporting. In addition to learning by producing higher standard rugs, Egyptian exporters of rugs seem to have also benefited from knowledge transfers from foreign buyers (mediated by local intermediaries). Several open questions remain. First, may there have been any form of compensation from the exporter or local intermediary to the foreign buyer for the transferred knowledge? Knowledge transfers can be costly, and foreign buyers may have sought to extract the surplus from their transfers. Second, would exporters in other manufacturing industries (particularly more capital-intensive ones) or services have experienced similar productivity gains? Third, can firms in LMICs achieve similar productivity gains without a well-resourced intermediary?

Knowledge flows through FDI are typically associated with firm-to-firm linkages between multinational corporation (MNC) affiliates and domestic firms.[7]7. A VoxDevLit (2024) review on “Foreign Direct Investment and Development” presents a comprehensive literature review on the effects of FDI on Development, specifically highlighting spillover channels in Section 3.  Until recently, a common empirical specification in this literature regressed changes in proxies of domestic firm productivity against changes in own industry and cross-industry exposure to FDI, finding strong positive associations for changes in downstream FDI—so-called “backward spillovers” to domestic firms in industries upstream from industries with increasing FDI (e.g. Javorcik 2004, Blalock and Gertler 2004). Reviews and meta-analyses suggest that linkages between domestic suppliers and foreign affiliates are the most plausible vehicle for knowledge spillovers to domestic firms (Havranek and Irsova 2011, Alfaro 2017).[8]8.Abebe et al. (2022) find revenue-based TFP gains among Ethiopian firms when comparing districts where a large foreign plant opened relative to others where foreign openings were licensed but had not yet occurred. Surveys of domestic firms reveal that most of the TPPR gains of these firms stem from competition with foreign firms in both input and output markets, with knowledge externalities appearing to play a relatively minor role.

A significant constraint in this literature has been data availability, forcing researchers to use industry-level input-output tables for proxies of firm-level linkages to MNCs. This practice has raised concerns about the causal interpretation of positive correlations between downstream-industry FDI and productivity improvements, while also leaving the mechanisms behind any causal effects unclear. Antràs (2020) makes a compelling case for the importance of measuring and conceptualizing global value chain (GVC) participation at the firm level. With MNCs as lead actors in GVCs, starting to supply MNCs serves as a “front-door” entry point into GVCs. Antràs argues that GVCs, especially the knowledge-intensive ones associated with MNCs, are effective vehicles for knowledge diffusion due to their relational nature. However, without firm-level GVC data, we lack insight into which domestic firms join the value chains of MNCs and whether they experience the (uncompensated) knowledge transfers discussed in the theoretical literature and policy circles.

Alfaro-Ureña et al. (2022) use a panel of firm-level balance sheets and all formal firm-to-firm transactions in Costa Rica to estimate the effects of first-time linkages between domestic suppliers and MNC affiliate buyers on supplier performance. They find that first-time suppliers to MNCs experience large and persistent improvements in revenue-based total factor productivity (TFPR). Additionally, these suppliers increase their sales to buyers other than the first MNC buyer. Most of this sales growth stems from acquiring new buyers, which are typically “better buyers” (e.g. larger and with more stable supplier linkages). These effects are unlikely to be driven by the demand shocks only, as similar-sized demand shocks from large Costa Rican buyers do not replicate the effects seen with MNCs. Finally, surveys with both domestic suppliers and MNCs indicate that repeated interactions between the two are essential for the observed improvements in supplier performance. Amiti et al. (2024) and Carballo et al. (2024) further confirm the positive effects on firm performance of becoming a first-time supplier to an MNC for domestic firms in Belgium and Uruguay, respectively.

There are several open questions about the knowledge transfer gains from FDI (through supplier linkages and beyond). First, as in the case of learning from exporting, it is not definitive that the estimated TFP gains capture an externality.[9]9. Bai et al. (2024) make significant progress in measuring FDI knowledge spillovers in China's car industry.  Second, the available data typically cannot definitively establish that the estimated TFPR gains do not reflect markup increases or other unmeasured changes noted in the productivity literature (De Loecker and Goldberg 2014). Third, we need to better understand the factors that influence knowledge transfers. Guillouet et al. (2024) show that language barriers are a significant obstacle to transferring knowledge from foreign to domestic managers at MNCs. Other factors suggested in the theoretical literature include incomplete contracts and imperfectly excludable input production technologies (Sampson 2024). Fourth and last, we need more evidence on other channels through which FDI can trigger externalities. MNCs tend to be better managed and provide more training, improving worker productivity and potentially leading to knowledge transfers through worker mobility (Poole 2013). One concern is that in most LMICs, MNCs pay higher wages and provide better amenities than domestic employers (Alfaro-Ureña et al. 2021), making worker transitions to domestic firms less likely or negatively selected.

Love-of-variety effects

Trade and FDI can create production and consumption externalities by increasing the availability of new input and final good varieties. Goldberg et al. (2010) and Halpern et al. (2015) argue that firms with a “taste for variety” in their production technology improve their performance by accessing a wider range of imported inputs. The improvement is even larger when the new inputs are of higher quality. FDI can also benefit the host economy through its impact on the (nontradable) input varieties available to domestic producers. Rodriguez-Clare (1996) formalises this channel. Under full employment and a love-of-variety production technology, the key welfare statistic is the demand for domestic inputs per worker, a concept Rodriguez-Clare calls the “linkage coefficient.” If MNCs have a higher linkage coefficient than domestic firms, they boost input variety, host-country productivity, and welfare. Alfaro and Rodriguez-Clare (2004) show that although MNCs source a smaller share of their inputs locally compared to domestic firms in several Latin American countries, they generally have a higher linkage coefficient.

There are several unsettled issues in this second strand of the literature. First, direct evidence on the benefits of trade and FDI for final consumers is much scarcer in LMICs than in more advanced economies (Beck and Jaravel 2020, Borusyak and Jaravel 2021); see Section 5.6.[10]10. One exception is Atkin et al. (2018) who look at the consumer welfare impacts of FDI in Mexico's supermarket retail sector.  Second, while the theoretical channel in Rodriguez-Clare (1996) is appealing, it does not align with reduced-form evidence that finds on average, no horizontal spillovers (i.e. no improvements in domestic firms' TFP in the same industry as MNCs). In their meta-analysis, Irsova and Havranek (2013) show that while the average horizontal spillovers are null, in host countries where the technology gap between MNCs and domestic firms is not too large, the latter tend to benefit more from MNCs in their industry. This finding aligns with theoretical work showing that technological incompatibilities between MNCs and domestic firms reduce the welfare gains from FDI (Carluccio and Fally 2013), as well as studies in industries such as apparel where technological incompatibilities are less likely (Kee 2015). This literature would benefit from a revival through new empirical tests using the rich administrative and commercial datasets now available in LMICs. Third and last, any empirical study on varieties must address the challenge of measuring them credibly. Traditionally, varieties in international trade have been defined as an HS code-country of origin-good. However, recent research highlights the limitations of findings based on this definition (Lo Forte 2024).

Marshallian externalities: The benefits to a sector of geographical agglomeration

Trade and FDI can lead to Marshallian externalities such as those due to industry-level economies of scale. For example, Bartelme et al. (2024) study the gains from trade and industrial policy and the interaction of the two in a model with external economies of scale. Despite finding heterogeneous sector-level scale economies (implying inter-sectoral misallocation), optimal industrial policy leads to only modest gains, and optimal trade and industrial policy are often at odds since high externality sectors tend to have low trade elasticities. Lashkaripour and Lugovskyy (2023) develop an estimation technique that separately identifies the economies of scale elasticity from the trade elasticity, albeit under a strong assumption that scale externalities operate through love of variety. Barwick et al. (2023) study industrial policies in the shipbuilding industry in China and find no evidence of industry-wide Marshallian externalities. Atkin et al. (2024) find dynamic economies of scale in more complex sectors, exploiting changes in the complexity of a country's export mix due to other countries entering the WTO. However, they estimate dynamic losses from trade rather than gains for almost all countries as there tends to be more countries producing in more complex sectors and so trade liberalisation moves countries away from these high-spillover sectors. Finally, Ottonello et al. (2024) examine the role of exchange rates in conjunction with industrial policy in an environment with production externalities. The authors argue that when such externalities are more pronounced in the earlier stages of development, economies converging toward the technological frontier can improve welfare by intervening in foreign exchange markets.

More research is needed to understand when coordinated trade, FDI and industrial policies can be welfare-enhancing under real-world implementation constraints and pervasive distortions, particularly those faced by LMICs. Second, the estimation of Marshallian externalities tends to rely heavily on stylised model assumptions and aggregate empirical moments. More research is also needed to examine the sensitivity of findings to modeling assumptions and to incorporate richer data into model-based estimates of Marshallian externalities of various types. Finally, as workers in LMICs have been moving primarily from agriculture to services (rather than manufacturing), credible estimates of externalities in (tradable) service industries, such as tourism (Faber and Gaubert 2019), are necessary.

In summary, there are three main takeaways. First, the literature has found that interacting with advanced economies through trade and FDI is likely to provide learning opportunities for firms and workers in LMICs. Second, trade and FDI can expose producers and consumers to a wider variety of goods and services. To the extent that producers and consumers love variety and/or the new varieties are higher quality (price adjusted), this exposure increases welfare. Third, economies of scale are likely present in complex sectors, particularly manufacturing. However, whether they lead to (dynamic) gains from trade is still an open question.

As should be apparent, there is much we don’t know in this area. Current empirical evidence on learning through international trade and business with multinationals does not conclusively demonstrate the existence of an (unpriced) externality and the need for government intervention. In addition, more evidence, particularly from LMICs, is needed on love-of-variety externalities in consumption and production resulting from trade and FDI. And current research on Marshallian externalities often relies on stylised models and aggregated data. More work is needed to test the robustness of these findings using alternative model assumptions and richer data on economic interactions in LMICs, where patterns may differ from those in more advanced economies.

Climate change and international trade

Concerns about climate change and natural resources have intensified in recent decades and developing countries have been central to the policy debates around these issues. Evidence shows these countries are both more vulnerable to the effects of climate change (IPCC 2022) and the source of much of the recent growth in global greenhouse emissions (Copeland et al. 2022), but implementing environmental regulations in these countries can be challenging due to weak institutions. In this context, two key questions are: how will trade shape the effects of climate change, and how effective are trade policies as mitigating tools? A fast-growing literature in trade and development has sought to address these questions, aided by the growing availability of rich, spatially disaggregated data produced by climate scientists.[11]11. We will focus on studies that are carried in the context of LMICs, or that have direct implications to such countries. See Cherniwchan, Copeland and Taylor (2017), Copeland, Shapiro and Taylor (2022), Desmet and Rossi-Hansberg (2024), and Dominguez-Iino (2023) for recent reviews.

To start, a large body of research studies the idea that stricter environmental regulations in wealthier countries may shift global production of dirty industries to developing countries with laxer regulations—commonly referred to as the Pollution Haven Hypothesis (hereafter, PHH). Recent reviews by Cherniwchan et al. (2017) and Copeland et al. (2022) note that earlier research found that stricter environmental regulations can increase production costs, affecting trade and foreign investment flows through this mechanism. However, this earlier literature argues that these effects are generally not strong enough to outweigh other sources of comparative advantage driving the location of dirty industries (Grossman and Krueger 1995, Antweiler et al. 2001). In line with these results, Duan et al. (2021) and Duan et al. (2023) find limited effects of environmental regulations on the location of industries using quantitative trade models. These reviews also raise the point that trade-induced technological changes might limit the importance of the relocation of dirty industries to poorer countries. Rodrigue et al. (2022), for example, show that WTO-induced exporting reduces firms’ emissions intensity in China by at least 36% across pollutants with changes in product scope, investments in new capital, and importing foreign abatement equipment explaining most of the empirical relationship between exporting and emissions.

Recent research, on the other hand, has found stronger evidence in support of the PHH. Broner et al. (2012) shows that environmental regulations significantly impact the location of dirty industries, with effects comparable to those of human and physical capital. Shapiro (2023) identifies five empirical facts indicating that stronger institutions—e.g. those related to financial, judicial and labour markets—significantly impact on the location of clean industries. Tanaka et al. (2022) show that a tightening of the US air quality standards in 2009 relocated the US battery recycling industry to Mexico, with large implications for infant health there.[12]12. The paper does not assess the potential benefits on infant health in the US, though it argues that based on previous studies these effects are likely small.  Artuc and Sommer (2024) and Farrokhi and Lashkaripour (2024) show how border adjustments—tariffs that ensure imports face similar environmental costs to domestic production—can curb the relocation of pollution from rich to poor countries when stricter environmental regulations are imposed. Overall, further research is needed to better understand how comparative advantage influences the global location of clean versus polluting industries. Existing research has struggled to deal with the possibility that other factors are contributing to the relocation of dirty industries away from richer economies, while at the same time, the increased strictness of environmental regulations may have a more pronounced impact on the global distribution of industries than those previously studied.

Another set of studies evaluates the economic impact of productivity changes due to climate change. Nath (2023) shows that climate change will impact agriculture more severely than non-agricultural sectors. This has particularly harmful effects on poor countries, where a combination of high trade barriers and subsistence consumption means a large fraction of the population work in agriculture—a phenomenon referred to as the “food problem”. Focusing on African countries and introducing the role of migration across countries and sub-regions, Conte (2024) shows that the impact of climate change on agricultural productivity will displace about 22 million individuals in sub-Saharan Africa but reducing migration costs in Africa to the levels observed in Europe cuts welfare losses in the continent by half.

Increasing attention has been given to the impact of trade policies on deforestation—a natural resource with important implications for CO2 emissions due to the high carbon content of forests. Dominguez-Iino (2023) explores how differences in the monopsony power of trading companies over farmers across South American regions shape the impact of tariffs. Because monopsony power is particularly strong in frontier regions near forests, tariff increases have a smaller impact on the price received by farmers in these areas, reducing the effectiveness of tariffs as a tool to curb deforestation. Focusing on the palm oil market in Indonesia and Malaysia, Hsiao (2024) highlights two challenges for trade policy aimed at reducing deforestation. First, there is an international coordination problem: when only a few countries raise their tariffs against Indonesia and Malaysia, exports are diverted to countries that do not adopt the policy. Second, there is a commitment problem with the introduction of production taxes when deforestation represents a sunk cost, because they neither prevent past deforestation, which is already sunk, nor future deforestation, which has not yet produced output and will become sunk once it does.

Focusing on deforestation in the Amazon, several papers assess how migration and trade linkages shape the impact of infrastructure projects, each focusing on different aspects of this issue. Gollin and Wolfersberger (2024) study the impact of new roads on deforestation, by extending the land use frameworks from Sotelo (2020) and Farrokhi and Pellegrina (2023) to incorporate changes in forest area. Araujo et al. (2023) use the “market access” framework from Donaldson and Hornbeck (2016) and find that reduced-form estimates ignore the aggregate effects of infrastructure expansions on deforestation by one quarter. Restrepo and Mariante (2024) develop a dynamic framework to investigate how trade and migration linkages shape the impact of policies in the Amazon across regions and over time. Takasaki et al. (2024) estimate congestion and agglomeration forces in agriculture and analyse their implications for forest conservation.

Complementing the studies above, two papers take a global perspective on comparative advantage and the use of natural resources. Carleton et al. (2023) study the efficiency of the global use of water.[13]13. Two papers studying the role of changes in water levels using spatial economy models, but without directly addressing international trade, are Balboni (2025) and Jedwab et al. (2024).  They build an agricultural trade model in which farmers extract their water from regional aquifers. They show that trade in water embedded in goods production alleviates disparities in water availability across the Earth. The paper also argues that, due to the lack of property rights, farmers over-extract water, failing to internalise the negative externalities from their extraction on other farmers sourcing their water from the same aquifer. Farrokhi et al. (2024) examine how trade costs shape deforestation at a global level. They show that structural change and comparative advantage forces determine the extent, location and timing of deforestation. Global reductions in trade costs relocate deforestation to countries with a comparative advantage in agriculture. The negative impact on the global forest area is nonetheless limited, because the elasticity of the demand for agriculture, which comes from the substitution between agricultural and non-agricultural goods, is low. Both papers model resource extraction similarly to the seminal theoretical work of Brander and Taylor (1997) and Copeland and Taylor (1994), where there are no property rights over the natural resource. In this context, comparative advantage determines the location of exploitation of the natural resource, but trade liberalisation does not necessarily increase aggregate welfare due to inefficient exploitation.

An area that has received less attention is climate risk: climate change is expected to increase the frequency of negative shocks such as floods and extreme temperature days, affecting the risk profile of economies. A recent paper by Castro-Vincenzi et al. (2024) on this topic uses establishment-to-establishment transaction level data from India to document that firms respond to flooding events across the country by diversifying their sourcing decisions. Another paper from Balboni et al. (2024) shows that firms’ that experience flooding relocate to less flood-prone locations. While not focusing on issues related to international trade, these studies indicate that regional trade linkages and firms’ geographic location react to extreme weather events, indicating potential avenues for future work on international trade.

In summary, the research on trade, development and the environment shows that market forces related to institutions, trade costs, and migration frictions are important in shaping the effects of climate change and mitigating policies. Results point towards leakage effects being significant: policies targeted at specific regions have sizable implications for economic activities elsewhere, with these effects being influenced by migration and trade frictions.

We propose several avenues for future research. First, further research on the role of comparative advantage in driving the location of clean versus dirty industries is needed. Second, we still lack studies on the impact of trade liberalisation on the survival of cleaner versus dirtier firms—related to the selection mechanisms in Melitz (2003)—particularly in the context of low- and medium-income countries. Third, while the literature has made progress in incorporating dynamic mechanisms to study climate change, such as anticipatory effects (Bilal and Rossi-Hansberg 2023) and technological innovation (Cruz and Rossi-Hansberg 2024), their interaction with key features of developing economies, such as market failures and firm-level distortions, remains underexplored. Fourth, several topics need further exploration, such as global trade in waste products and water pollution. Lastly, climate change is expected to increase the frequency of negative shocks, affecting the risk profile of economies. There has been some initial work on this topic, but the literature here is still scarce.

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