This paper builds a dynamic industry model with heterogeneous firms that explains why international trade induces reallocations of resources among firms in an industry. The paper shows how the exposure to trade will induce only the more productive firms to enter the export market (while some less productive firms continue to produce only for the domestic market) and will simultaneously force the least productive firms to exit. It then shows how further increases in the industry's exposure to trade lead to additional inter-firm reallocations towards more productive firms. These phenomena have been empirically documented but can not be explained by current general equilibrium trade models, because they rely on a representative firm framework. The paper also shows how the aggregate industry productivity growth generated by the reallocations contributes to a welfare gain, thus highlighting a benefit from trade that has not been examined theoretically before. The paper adapts Hopenhayn's (1992a) dynamic industry model to monopolistic competition in a general equilibrium setting. In so doing, the paper provides an extension of Krugman's (1980) trade model that incorporates firm level productivity differences. Firms with different productivity levels coexist in an industry because each firm faces initial uncertainty concerning its productivity before making an irreversible investment to enter the industry.

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Multinational sales have grown at high rates over the last two decades, outpacing the remark-able expansion of trade in manufactures. Con-sequently, the trade literature has sought to incorporate the mode of foreign market access into the “new ” trade theory. This literature rec-ognizes that firms can serve foreign buyers through a variety of channels: they can export their products to foreign customers, serve them through foreign subsidiaries, or license foreign firms to produce their products. Our work focuses on the firm’s choice be-tween exports and “horizontal ” foreign direct investment (FDI). Horizontal FDI refers to an investment in a foreign production facility that