Collaborative Research: Trade Liberalization in a World of Heterogeneous Firms: Theoretical and Quantitative Results

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Trade Liberalization in a World of Heterogeneous Firms: Theoretical and Quantitative Results Intellectual Merit The applied general equilibrium models used to predict the impact of the North American Free Trade Agreement on trade flows failed to capture the explosion of trade that occurred subsequently and the accompanying redistribution of trade across industrial sectors. The analysis of disaggregated trade flows between Canada, Mexico, and the United States shows that much of the increase in trade has been trade in goods not previously exported or exported very little - what is known as the extensive margin of trade. This proposal shows that mechanically incorporating this insight into crude projections of North American trade patterns would have produced significantly better predictions of the pattern of trade following the enactment of NAFTA than did multisectoral applied GE models. The data suggest that capturing the extensive margin of trade is important for understanding the impacts of trade policy, which implies that models that generate extensive margin growth are needed. The proposed research will use advances in the firm-level theory of trade to build models that are suitable for policy analysis. The initial aim of the project is to evaluate the properties of models based on two types of industrial structures: monopolistic competition with entry costs, as in Melitz (2003) and perfect competition, as in Eaton and Kortum (2002). Constructing models flexible enough to be estimated for policy analysis requires generalizing the standard theories. Based on Kehoe and Ruhl (2009b), the models are extended to include multiple dimensions of firm heterogeneity and generalized distributions over underlying productivity. A mapping scheme is developed to match the firm-level decisions in the model to the product-level and industry-level aggregates in the data. Broader Impact To inform the policy debate over free trade and protectionism, economists need to better understand the impact of trade on different industries. The proposed research develops models that transform the firm-level trade models popular in current research into models useful for policy analysis. Methodologically, these sorts of models will allow economists to analyze the impact of policy on the structures of industries. Currently, the United States is negotiating free trade agreements with several Latin American countries, and a free trade agreement with South Korea waits to be approved by the legislatures in each country. Successful trade negotiations require careful evaluation of the impact of trade policy on individual industrial sectors. Without an accurate understanding of the distributional impacts of trade policy, it is difficult to advise policy makers and to inform the public on the merits of such liberalization policies