Market Structure and the impact of RCEP in The Philippines: What are the Differences between Melitz, Krugman and Armington Models

We develop a full applied heterogeneous firms small open economy CGE model to assess the impact of the Regional Comprehensive Economic Partnership on The. Philippines. We assess how the results differ with three versions of market structure: heterogeneous firms (based on Melitz, but extended to include foreign direct investment); perfect competition (Armington style); and monopolistic competition in the style of Krugman (1980). We have some sectors, like agriculture, that are assumed to be perfectly competitive in all model formulations. Although the work of Arkolakis, Costinot and Rodriguez Clare (2012) initially suggested that the theoretical innovations of Krugman and Melitz did not add to the welfare gains, further developments, especially from Costinot and Rodriguez-Clare (2013) and Melitz and Redding (2015), have shown that, as the models become more realistic and complex, there are potential gains in Krugman over Armington and Melitz over Krugman. Nonetheless, welfare calculations based on the “exact hat” style calculations of Arkolakis et al., (2012) are not available for many real world features, such as the impact of foreign direct investment in services, NTBs, unbalanced trade, import of primary factors and intermediates with real data on input shares. Our models incorporate those features. Following the results of Arkolakis, Costinot and Rodriguez-Clare (2012), we adjust the trade elasticities of our models so that the trade response is consistent across the models. We find that our Krugman and Melitz models both produce significantly larger welfare gains than the Armington structure. The relationship between the welfare gains in the Krugman versus Melitz models is complex and depends on how the heterogeneous firms model is implemented in a small open economy framework as well as the small open economy model itself.