Trade liberalization, heterogeneous firms and the soft budget constraint

► Segal’s model of soft budget constraint (SBC) is expanded to monopolistically competitive firms. ► SBC model is imbedded in Melitz-type model of international trade. ► Under trade liberalization some firms that would export in the absence of SBC choose not to export. ► Overall, trade liberalization reduces aggregate inefficiencies generated by SBC. We analyze the interaction between the soft budget constraint (SBC) and international trade by placing Segal’s (1998) SBC model within Melitz’s (2003) framework of international trade with heterogeneous monopolistically competitive firms. As in Segal’s model, SBC may result in moral hazard. The opening to international trade adds another sort of inefficiency. Some firms that would have become exporters in the absence of SBC choose to apply low effort and not export in order to extract a subsidy from the government. This effect takes place when the trade costs are sufficiently low. Overall, however, trade liberalization reduces inefficiencies generated by SBC. The number of firms subject to moral hazard SBC decreases, aggregate effort level increases and aggregate profits lost due to SBC-induced sub-optimal effort decline as trade costs decrease.