DP4635 | Trade Liberalization with Heterogenous Firms

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This Paper details the positive and normative effects of reciprocal trade liberalization when firms have endogenously determined, heterogeneous productivity levels. We show that trade liberalization leads to: (i) an anti-variety effect (the number of varieties consumed drops) in contrast to the well-known Krugman variety effect; and (ii) a Stolper-Samuelson like result on factor rewards. We decompose the welfare impact into four partial effects. Three of these are unique to the model, namely, the Melitz anti-variety effect, the Melitz productivity effect, and the MacDonalisation effect. We show that the first effect tends to lower welfare while the other two tend to raise it. Overall, the four effects imply that the representative gains from trade liberalization. If we identify factor ownership with particular classes of consumers, we can say that freer trade implies unambiguous welfare gains for labourers and export-firm owners. Other firm owners gain if and only if spending on manufactured varieties is sufficiently high.