Abstract
This paper presents a model of North-South trade with firm-level productivity differences and R&D driven growth. Compared to manufacturing, R&D activities are intensive in skilled labor and the two regions differ in the relative endowment of skilled and unskilled workers. The relative market size, via its effect on firm selection, magnifies the North’s factor-based cost advantage in variety introduction with respect to good production. Trade liberalization causes reallocation of resources from the least to the most productive firms but the long run welfare effects can be ambiguous. The Southern region is more likely to gain from a reduction in trade costs and the model thus predicts welfare convergence following trade liberalization.