The recession in the 1980s followed by the worldwide decrease in transportation and communication costs has triggered a process of downsizing. The macroeconomic consequences of this process are only weakly understood. The model developed in this paper associates downsizing with trade between countries with similar tastes, which predominantly exchange very similar, substitutable products. Our two-region model is characterized by the endogenous determination of product variety, firm size, R & D intensity, economic growth, relative productivity, relative wages and welfare. Downsizing enlarges profits, causing an increase in product varieties and a reduction in firm size. Smaller firms allocate less labour to research activities, so that growth is depressed and relative productivity of the region engaging in downsizing declines. The welfare effects of downsizing are shown to be ambiguous and crucially dependent on consumer's taste for variety and their intertemporal elasticity of substitution. © 2002 Elsevier Science B.V. All rights reserved.