Estimating the gains from trade in frictional local labor markets

Abstract We develop a theory and an empirical strategy to estimate the welfare gains from trade in economies with frictional local labor markets. Our welfare formula nests standard market structures and adds an adjustment margin via the employment rate. To identify two key parameters – the trade elasticity and the elasticity of substitution in consumption – we use a theoretically consistent identification strategy that exploits variation in industrial composition across local labor markets. Examining Germany's recent trade integration with China and Eastern Europe, we find that under monopolistic competition with free entry and firm heterogeneity, the welfare gains are 5.5 percent higher than in frictionless settings.