Modeling Firm Heterogeneity in International Trade: Do General Equilibrium Effects Matter?

The aim of this work is analyzing the practical relevance, from a qualitative perspective, of a new methodology which is intended to include firm heterogeneity, as modeled by Melitz (2003), in computable general equilibrium effects. We assess to what extent the inclusion of industries with heterogeneous firms in a CGE framework does not simply make the Melitz model “operational”, but allows accounting for structural effects that may significantly affect the nature, meaning and implications of the model results.We develop two applied models, which are calibrated with the same data set. A first "simple" model is based on the original Melitz specification, with one sector, one primary factor, and two regions. A second model includes a full fledged general equilibrium structure, with two industries and two primary factors. Furthermore, fixed costs in heterogenous industries are related to demand for services. We carry out the same simulation exercise, a classic lowering of trade costs, with the two models. We contrast the models results, highlighting any possible qualitative difference. Finally, we trace back any divergence in terms of differences in the structure of the two models.The typical experiment of lowering trade barriers, leading to firm selection and aggregate productivity gains in Melitz (2003), now also triggers a reallocation of production among industries and a change in relative returns of primary factors, as it is typical in multi-sectoral general equilibrium models. An increase in the number of exporting firms, for instance, generates an additional demand for services in both the origin and destination countries, because of variable and fixed trade costs.