We study the welfare implications of a bilateral free trade agreement (FTA). The model is based on the recent trade literature that considers search and matching frictions in the labor market. We extend the model by incorporating country-level heterogeneity in terms of production technology, population, and productivity endowment. By calibrating the model to Japanese and Korean data in order to assess the expected outcome of the potential Korea–Japan FTA, we find that when the two countries have the same population size, Japan receives greater benefits from the FTA because its relatively more capital-intensive production allows for quicker output adjustment upon trade liberalization. When we take into account that Japan's population is 2.5 times that of Korea, however, the results show that Korea enjoys a greater surplus because of the market size effect.

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