How do firm-level responses to trade affect industry productivity and the gains from trade?

Marc J. Melitz, Stephen Redding 30 May 2013

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The size of the welfare gains from trade and the mechanisms through which these occur are central to policy debates about trade liberalisation. These include both multilateral trade negotiations such as the WTO Doha Round and regional integration decisions such as the Transatlantic Trade and Investment Partnership. Over the last 20 years, trade economists have uncovered heterogeneous firm-level responses to trade liberalisation, which in turn inspired the development of new theories of international trade.

Evidence of these heterogeneous firm-level responses comes from numerous empirical studies of disaggregated (firm- or plant-level) datasets following Bernard and Jensen (1995):

  • A minority of firms participate in international markets, whether through exports, imports or multinational activity. Often 10% of a nation’s firms account for over 80% of all exports.
  • These firms are larger, more productive, more capital intensive, more skill intensive and pay higher wages than domestic firms within the same industry.
  • While most firms that trade supply few products to a handful of destination markets, a small number of traders account for the vast majority of the value of exports and imports.

Trade liberalisation reforms are found to induce intra-industry reallocations of resources, as low productivity firms exit and more productive firms expand to serve export markets. In turn, these reallocations towards more productive firms generate an increase in average industry productivity.

A new survey of the new new trade theory

In our recent handbook chapter, we review the theories developed to capture these features of the data (Melitz and Redding 2013a). The basic elements of these models are simple:

  • New entrants in an industry face uncertainty about their future productivity (or product quality appeal).
  • Productivity/quality is revealed after a sunk entry cost is incurred.
  • At this point, some firms realise that they cannot earn positive operating profits and exit the industry.
  • The remaining firms continue to produce and those with high productivity or quality attain larger market shares and earn higher profits.
  • The firms that select into exporting as well as selling locally are naturally the most productive since exporting involves additional costs.

When trade costs fall, export profits rise and a new logic leads to changes that raise average industry productivity:

  • Some new firms become exporters (the most productive among those that did not previously export), while existing exporters increase their export sales (and hence their overall production levels).
  • The higher export profits also induce additional entry into the domestic industry (as the returns to high productivity/quality increase).
  • Non-exporters lose market share because of both increased import competition and the additional entry and hence shrink.
  • This forces some of the least productive firms to exit, while some more productive firms expand.

These within-industry reallocations in response to trade liberalisation generate higher industry productivity – and represent a new potential source of gains from trade.

Do these heterogeneous firm responses matter for aggregate welfare?

While these new theories of heterogeneous firms in differentiated product markets have been extremely successful in accounting for features of disaggregated trade data, Arkolakis, Costinot and Rodriguez-Clare (2012) ask whether these new insights for micro-level data have altered our understanding of the aggregate welfare gains from trade.

They show that there exists a class of trade models (with and without firm-level differences across producers) in which a country’s domestic trade share (expenditure on its own goods relative to GDP) and the elasticity of trade with respect to trade costs (the percentage increase in trade from a 1% decrease in trade cost) are sufficient statistics for the aggregate welfare gains from trade. Under these circumstances, calculating the welfare gains from trade does not require knowledge of disaggregated features of international trade data. All one requires is aggregate data on trade shares and the trade elasticity (the sensitivity of aggregate trade to changes in trade costs). If two different models within this class are calibrated to deliver the same trade share and trade elasticity, then they also deliver the same welfare gains from trade – regardless of their different implications for the firm-level responses to trade.

Based on this result, the authors summarise the contribution of new theories of heterogeneous firms to our understanding of the aggregate welfare implications of trade as “So far, not much.”

A new source of gains from trade

In Melitz and Redding (2013b), we show that firm-level responses to trade that generate higher productivity do in fact represent a new source of gains from trade.

  • We start with a model with heterogeneous firms, then compare it to a variant where we eliminate firm differences in productivity while keeping overall industry productivity constant.

We also keep all other model parameters (such as those governing trade costs and demand conditions) constant.

  • This 'straw man' model has no reallocations across firms as a result of trade and hence features no productivity response to trade.

Yet it is constructed so as to deliver the same welfare prior to trade liberalisation. We then show that, for any given reduction in trade costs, the model with firm heterogeneity generates higher aggregate welfare gains from trade because it features an additional adjustment margin (the productivity response to trade via reallocations). We also show that these differences are quantitatively substantial, representing up to a few percentage points of GDP. We thus conclude that firm-level responses to trade and the associated productivity changes have important consequences for the aggregate welfare gains from trade.

Reconciling these findings

How can these findings be reconciled with the results obtained by Arkolakis, Costinot, and Rodriguez-Clare (2012)? Their approach compares models that are calibrated to deliver the same domestic trade share and trade elasticity (the sensitivity of aggregate trade to changes in trade costs). In so doing, this approach implicitly makes different assumptions about demand and trade costs conditions across the models that are under comparison (Simonovska and Waugh 2012). By assuming different levels of product differentiation across the models, and assuming different levels of trade costs, it is possible to have the different models predict the same gains from trade – even though they feature different firm-level responses. In contrast, our approach keeps all these 'structural' demand and cost conditions constant, and changes only the degree of firm heterogeneity (Melitz and Redding 2013b). This leads to different predictions for the welfare gains from trade.

One potential criticism of our approach is that one can estimate the trade elasticity (the sensitivity of aggregate trade to changes in trade costs) using aggregate trade data only – without requiring any specific assumptions about the firm-level responses to trade. Whatever assumptions are made about those firm-level responses (and the demand and trade-cost conditions), they should then be constructed so as to match that estimated aggregate elasticity. However, recent empirical work has shown that those underlying assumptions radically affect the measurement of the aggregate trade elasticity, and that this trade elasticity varies widely across sectors, countries, and the nature of the change in trade costs (see for example Helpman et al. 2008, Ossa 2012, and Simonovska and Waugh 2012). There is thus no single empirical trade-elasticity parameter that can be held constant across those different models.

Given the lack of a touchstone set of elasticities, we favour our approach to measuring the gains from trade arising from different models; one that maintains the same assumptions about demand and trade costs conditions across those models.

References

Arkolakis, C, A Costinot and A Rodriguez-Clare (2012) “New Trade Models, Same Old Gains,” The American Economic Review, 102(1), 94-130.

Bernard, A and J Bradford Jensen (1995) “Exporters, Jobs, and Wages in US Manufacturing: 1976-87,” Brookings Papers on Economic Activity: Microeconomics, 67-112.

Helpman, E, Melitz, M and Y Rubinstein (2008) “Estimating Trade Flows: Trading Partners and Trading Volumes,” Quarterly Journal of Economics, 123(2), 441-87.

Melitz, M and S Redding (2013a) “Heterogeneous Firms and Trade,” Handbook of International Economics, Volume 4, Elsevier: North Holland, forthcoming, 2013. NBER Working Paper, 18652.

Melitz, M and S Redding (2013b) “Firm Heterogeneity and Aggregate Welfare,” NBER Working Paper, 18919.

Ossa, Ralph (2012) “Why Trade Matters After All,” NBER Working Paper, 18113.

Simonovska, I and M Waugh (2012) “Different Trade Models, Different Trade Elasticities,” New York University, mimeograph.

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Topics:  International trade

Tags:  gains from trade, trade theory

David A. Wells Professor of Political Economy, Harvard University

Harold T. Shapiro Professor in Economics, Economics Department and Woodrow Wilson School, Princeton University; CEPR Research Fellow