Welfare Effects of Preferential Trade Under Heterogeneity and Imperfections: Theory and Evidence

We study wage and welfare effects of preferential trade under heterogeneous firms and labour market imperfections, both empirically and theoretically. Using data from the Consumer Pyramids Household Survey (CPHS) and the UK-India Generalised System of Preferences (GSP) observed over the period 2014-2019, we show that trade exposure through GSP graduation reduces household wage income but increases business profit income and overall income. We then examine potential welfare effects theoretically in a generalised oligopoly equilibrium model with labour and product market imperfections and heterogeneous firms. We find that trade-induced joint effects of market size and competition do not reduce union wage. However, specialisation arising from heterogeneous productivity distribution across trading partners disincentivises labour-intensive firms and hence unambiguously dampens wages. The drop in union wage reduces price and their volatility, rein-forcing welfare gains. The welfare gain increases with competition and differences in productivity across trading partners.