Trade and Domestic Policies under Monopolistic Competition

Should trade agreements also constrain domestic policies? We analyze this question from the perspective of models with monopolistic competition, potentially heterogeneous firms, and multiple sectors. We propose a welfare decomposition based on principles from welfare economics to show that, in a broad class of models, welfare changes induced by trade and domestic policies can be exactly decomposed into consumption-efficiency, production-efficiency and terms-of-trade effects. Using this decomposition, we compare trade agreements with different degrees of integration and show how their performance is affected by the interaction between firm heterogeneity and the relative importance of production efficiency versus terms-of-trade effects. We consider several forms of shallow trade agreements, modeled according to GATT-WTO rules, and show that they are not sufficient to achieve the full benefits of globalization that can be obtained with a deep trade agreement coordinating both trade and domestic policies. Moreover, the distortions arising from uncoordinated domestic policies under shallow free trade agreements increase when physical trade costs fall, thus raising the benefits of deep trade integration.