Firm heterogeneity, misallocation, and trade

While the standard trade models explain observed firm heterogeneity with variance in firms' innate productivity, discriminatory policies and political connections in China may also affect the firm size and generate resource misallocation across firms. In this paper, I show that the productivity heterogeneity alone has difficulty explaining the observed firm-level patterns in Chinese manufacturing sector. I document that larger firms exhibit lower average revenue productivity, revenue productivity variance is high conditional on firm size, and larger exporters exhibit lower export intensity. Introducing firm-level misallocation can help reconcile these facts and doing so matters for estimating the gains from trade. The misallocation model predicts the size of gains from trade that is 45% lower than the standard model predicts when both models are calibrated with the same Chinese manufacturing data. The result suggests that accounting for firm level heterogeneity in the dimensions other than productivity is important when estimating the gains from trade.