Sluggish labor market response to the trade liberalization can reduce the welfare gains from trade by impeding resource reallocation. I estimate sectoral labor switching costs for 30 countries in a dynamic discrete choice problem to derive welfare implications of labor market rigidity through comparative cross-country analysis. On average, workers have to give up approximately 4-years of income to switch to another sector. Compared with labor market flexibility measures, labor switching costs are low when the country has a flexible labor market and vice versa. In addition, I embed the switching cost estimates into a dynamic multi-country, multi-sector Eaton and Kortum model. In a counterfactual trade liberalization simulation with a 20% drop of trade costs, high switching costs lead to a slower response in the labor market, and in turn, negatively affect a country’s ability to achieve welfare gains from trade.
Recent trade liberalization leads to a surge in the trade of intermediate goods. Increased accessibility to the key intermediate goods through trade can create an opportunity to overcome technological bottlenecks and initiate the expansion of capital-intensive industries, which can be referred to as specialization dynamics for developing countries. For this to occur, domestic factors must be reallocated toward high productivity sectors. In this paper, I capture domestic factor market efficiency by sectoral wage differentials and I provide a framework to analyze the relationship between specialization dynamics and resource reallocation. I find that the gain from trade is negatively related to the level of distortions in the skilled labor market. I also find that countries with smaller factor market distortions shift their specialization patterns towards capital-intensive industries.