Trade Costs and Endogenous Nontradability in a Model with Sectoral and Firm-Level Heterogeneity

The paper takes a first step in the direction of simultaneously incorporating sectoral and firm-level heterogeneity in the models of international trade and macroeconomics in a tractable manner: without increasing the complexity of numerical computations compared to the existing models with heterogeneity in one dimension. In a model with sectoral heterogeneity in trade costs and firm-level heterogeneity in productivity, introducing one source of heterogeneity at a time and piecing together the results implies that, on reduction in trade costs, more goods and more varieties of every tradable good become traded. In contrast, in the correctly specified model with simultaneous heterogeneity in both dimensions, while more goods do indeed become tradable, but for more than 50% of the previously traded goods, the number of traded varieties falls. The model also reconciles apparently contrasting predictions for the differences in the deviation of domestic price from the world price for the traded and nontraded goods when heterogeneity is introduced, one dimension at a time.