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Introducing adjustment costs into an otherwise frictionless model of capital allocation preserves the prediction that trade reforms have an impact on capital allocation, however these effects take place gradually over time. In contrast, the industry dynamics model with irreversible investment that lies at the core of our analysis implies naturally that there is substantial inertia in the response of an economy to trade reforms. Firms that have previously been protected may not exit, even when trade reforms are permanent. And certain reforms-both temporary and permanent~~may fail to elicit changes in industrial configuration. Ours is an economy in which the industrial structure is difficult to change and. in which the changes that do occur tend to be persistent.
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Our emphasis on the role of fixed costs and investment irreversabilities in determining the outcome of trade reforms accords with the recent investment literature which stresses the importance of these features for understanding the episodic nature of investment dynamics (see, for example, Doms and Dunne (1993), Caballero, Engel and Haltiwanger (1995), and Eberly (1997)).
We use our model to address a set of questions that always emerges every time a reform plan is implemented:
(i) should the reform be sudden or preannounced?;
(ii) are there advantages to gradual reforms?;
(iii) if several policy measures are being considered is the sequence of implementation relevant?:
(iv) do failed reforms condition the success of future reforms?;
(v) what is the role of initial conditions in determining the reform outcome?;
and (vi) is there a relation between the size of the reform and its outcome?