How do labor market policies interact with trade reforms? Do minimum wage regulation and employment protection legislation hamper the gains from trade? Are these regulations effective in protecting workers from import competition? I answer these questions by studying how labor market institutions at the time of a trade reform determine the dynamic adjustment to trade. I first document that for a large group of developing countries (1) unemployment and income inequality increases on average following a trade reform, (2) there are significant cross-country differences in trade adjustments, and (3) the responses of both unemployment and inequality are stronger when the firing costs are lower and the statutory minimum wage is larger. I interpret this evidence through the lens of a model of international trade, featuring heterogeneous firms, endogenous industry dynamics and search and matching frictions in a dual labor market. I calibrate the model to match the pre-liberalization firm dynamics in Colombia and Mexico, two countries that differed by the labor regulations in place at the time of trade liberalization, and I characterize numerically the full transition path towards the new steady state. I show that lower firing costs and higher minimum wage enhance firm selection following a trade liberalization, fostering short- and long-run gains from trade at the expense of higher job reallocation between and within industries, and higher unemployment. Taken together, these two institutions can explain around 30% of the difference in the short-run unemployment response to a fall in trade costs between countries, and up to 60% of the long-run difference. Finally, I find that a strong efficiency-equity trade-off arises as an economy reduces employment rigidities in favor of stronger downward wage rigidities.

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