This article examines how final product trade with China shapes and interacts with labor market imperfections that create market power in labor markets and prevent an efficient market outcome. I develop a framework for measuring such labor market power distortions in monetary terms and document large degrees of these distortions in Germany’s manufacturing sector. Import competition only exerts labor market disciplining effects if firms, rather than employees, possess labor market power. Otherwise, increasing export demand and import competition both fortify existing distortions, which decreases labor market efficiency. This widens the gap between potential and realized output and thus diminishes classical gains from trade.

Introduction

The rapid and ongoing process of globalization creates profound challenges for firms operating in the market economy. Global integration has increased the size of firms’ product markets and the amount of their competitors, while global production networks and dramatically falling transportation costs redefine the nature of production activities. How firms respond to these new market conditions has fundamental implications for domestic workers, productivity levels, and living standards.Traditionally, most research studying firm responses to trade exposure relies on perfectly functioning labor markets. By design, this limits the analyses to scenarios where wages are always on competitive levels and where firms do fully pass gains and losses from trade exposure through to labor expenditure adjustments. Recent work, however, has raised awareness to the role of imperfect functioning labor markets for understanding firms’ responses to trade exposure: By affecting how firms adjust to changes in product and input market conditions, labor market imperfections may alter distributional outcomes from trade and may change aggregate trade gains compared to a baseline scenario with competitive labor markets (e.g. Egger and Kreickemeier, 2009; Kambourov, 2009; Dix-Carneiro, 2014). Therefore, understanding how international trade interacts with labor market imperfections has a first order priority in evaluating welfare effects and distributional impacts from trade.