Journal of Economic Perspectives—Volume 26, Number 2—Spring 2012—Pages 91–118
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he gains from long-distance international trade have been understood andhe gains from long-distance international trade have been understood and
exploited since prehistoric times. Our pre-urban ancestors were benefit-exploited since prehistoric times. Our pre-urban ancestors were benefitting
from long-distance trade in obsidian some 10,000 years ago; Plato’sting from long-distance trade in obsidian some 10,000 years ago; Plato’s
Academy was built on the profits of Athenian silver exports; and Rome was not builtAcademy was built on the profits of Athenian silver exports; and Rome was not built
in a day partly because goods moved too slowly in the vast Roman trade network.in a day partly because goods moved too slowly in the vast Roman trade network.
But whereas trade was once dominated by the movement of goods that couldBut whereas trade was once dominated by the movement of goods that could
only be produced, harvested, or mined regionally, the international trade landscapeonly be produced, harvested, or mined regionally, the international trade landscape
is now dominated by two striking facts. The first is the rise of intra-industry trade—is now dominated by two striking facts. The first is the rise of intra-industry trade—
that is, two-way trade in similar products. Chinese consumers can now buy a midsizethat is, two-way trade in similar products. Chinese consumers can now buy a midsize
car from Toyota (Japan), Kia (Korea), General Motors (United States), and Cherycar from Toyota (Japan), Kia (Korea), General Motors (United States), and Chery
(China). Ditto for consumers in Japan, Korea, and the United States. The second(China). Ditto for consumers in Japan, Korea, and the United States. The second
striking fact is that world trade is dominated by huge, innovative, and extraordi-striking fact is that world trade is dominated by huge, innovative, and extraordinarily
productive firms. For example, Intel is so large that it is the largest industrialnarily productive firms. For example, Intel is so large that it is the largest industrial
employer in both Oregon and New Mexico and accounts for 20 percent of Costaemployer in both Oregon and New Mexico and accounts for 20 percent of Costa
Rica’s exports. China’s Foxconn infamously employs 450,000 workers in aRica’s exports. China’s Foxconn infamously employs 450,000 workers in a single oneone
of its many export-oriented electronics factories. These are big companies . . . andof its many export-oriented electronics factories. These are big companies . . . and
if you are reading this document on an Apple computer you know that there areif you are reading this document on an Apple computer you know that there are
other large companies, too.other large companies, too.
The rising prominence of intra-industry trade and huge multinationals hasThe rising prominence of intra-industry trade and huge multinationals has
transformed the way economists think about the gains from trade. In the past, wetransformed the way economists think about the gains from trade. In the past, we
focused on gains that stemmed either from endowment differences (wheat forfocused on gains that stemmed either from endowment differences (wheat for
Gains from Trade when Firms Matter
■■ Marc J. Melitz is the David A. Wells Professor of Political Economy, Harvard University,
Cambridge, Massachusetts. Daniel Trefler is the J. Douglas and Ruth Grant Canada Research
Chair in Competitiveness and Prosperity, Rotman School of Management, University of
Toronto, Toronto, Ontario, Canada.
http://dx.doi.org/10.1257/jep.26.2.91. doi=10.1257/jep.26.2.91
Marc J. Melitz and Daniel Trefler
92 Journal of Economic Perspectives
iron ore) or inter-industry comparative advantage (David Ricardo’s classic exampleiron ore) or inter-industry comparative advantage (David Ricardo’s classic example
of cloth for port). Today, we focus on three sources of gains from trade: 1) love-of cloth for port). Today, we focus on three sources of gains from trade: 1) loveof-variety
gains associated with intra-industry trade; 2) allocative efficiency gainsof-variety gains associated with intra-industry trade; 2) allocative efficiency gains
associated with shifting labor and capital out of small, less-productive firms andassociated with shifting labor and capital out of small, less-productive firms and
into large, more-productive firms; and 3) productive efficiency gains associated withinto large, more-productive firms; and 3) productive efficiency gains associated with
trade-induced innovation.trade-induced innovation.
Back in the 1980s, a “New Trade Theory” was developed that focused on intra-Back in the 1980s, a “New Trade Theory” was developed that focused on intraindustry
trade in differentiated goods produced subject to increasing returns toindustry trade in differentiated goods produced subject to increasing returns to
scale. This theory centered on an elegant tension: consumers love variety and arescale. This theory centered on an elegant tension: consumers love variety and are
willing to pay a premium for a desired product, but as the market fragments intowilling to pay a premium for a desired product, but as the market fragments into
niche products, producers struggle to attain the volumes needed to recoup theirniche products, producers struggle to attain the volumes needed to recoup their
product development costs. International trade creates a larger marketplace, whichproduct development costs. International trade creates a larger marketplace, which
means that each firm can operate at a larger scale and hence more firms can survive.means that each firm can operate at a larger scale and hence more firms can survive.
The result reads like an advertisement for free trade: lower prices, more varieties.The result reads like an advertisement for free trade: lower prices, more varieties.
Paul Krugman earned the Nobel Prize in 2008 in large part for his work highlightingPaul Krugman earned the Nobel Prize in 2008 in large part for his work highlighting
how economies of scale and product differentiation lead to intra-industry trade, justhow economies of scale and product differentiation lead to intra-industry trade, just
as in our example above of midsize cars. See Krugman (1979, 1980), Helpman andas in our example above of midsize cars. See Krugman (1979, 1980), Helpman and
Krugman (1985), and Helpman (2011, chap. 4) for a review of love-of-variety gainsKrugman (1985), and Helpman (2011, chap. 4) for a review of love-of-variety gains
from trade.from trade.
More recently, a second source of gains from trade has emerged from theMore recently, a second source of gains from trade has emerged from the
research of Melitz (2003) and Bernard, Eaton, Jensen, and Kortum (2003). Thisresearch of Melitz (2003) and Bernard, Eaton, Jensen, and Kortum (2003). This
is the firm-level “reallocation” effect that arises when there is firm heterogeneity.is the firm-level “reallocation” effect that arises when there is firm heterogeneity.
By firm heterogeneity we mean that even within narrowly defined industries someBy firm heterogeneity we mean that even within narrowly defined industries some
firms are much larger and more profitable than others because, for example,firms are much larger and more profitable than others because, for example,
they are much more productive. Globalization generates both winners and losersthey are much more productive. Globalization generates both winners and losers
among firms within an industry and these effects are magnified by heterogeneity.among firms within an industry and these effects are magnified by heterogeneity.
Better-performing firms thrive and expand into foreign markets, while worse-Better-performing firms thrive and expand into foreign markets, while worseperforming
firms contract and even shut down in the face of foreign competition.performing firms contract and even shut down in the face of foreign competition.
This generates a new source of gains from trade: as production is concentratedThis generates a new source of gains from trade: as production is concentrated
towards better-performing firms, the overall efficiency of the industry improves.towards better-performing firms, the overall efficiency of the industry improves.
In this way, globalization raises average efficiencyIn this way, globalization raises average efficiency within an industry. Why is it that. Why is it that
only the better-performing firms grow? Globalization expands markets but alsoonly the better-performing firms grow? Globalization expands markets but also
increases competition in those markets. This competition effect dominates for theincreases competition in those markets. This competition effect dominates for the
worse-performing firms while the increased market access dominates for the better-worse-performing firms while the increased market access dominates for the betterperforming
firms. Also, a firm’s international expansion—whether by exporting,performing firms. Also, a firm’s international expansion—whether by exporting,
by offshore outsourcing of intermediate components and assembly, or by buildingby offshore outsourcing of intermediate components and assembly, or by building
plants abroad (multinationals)—entails some up-front fixed costs; and only theplants abroad (multinationals)—entails some up-front fixed costs; and only the
best-performing firms have the sales volumes needed to justify these fixed costs.best-performing firms have the sales volumes needed to justify these fixed costs.
Our third source of gains from trade comes from the positive impacts of largerOur third source of gains from trade comes from the positive impacts of larger
markets onmarkets on innovation. New productivity-enhancing products and processes require. New productivity-enhancing products and processes require
up-front development costs. Trade integration, by expanding the size of the market,up-front development costs. Trade integration, by expanding the size of the market,
encourages firms to pony up these development dollars, and this in turn raisesencourages firms to pony up these development dollars, and this in turn raises
productivity. Theories of innovation-based gains from trade with homogeneousproductivity. Theories of innovation-based gains from trade with homogeneous
firms were developed by Grossman and Helpman (1991) and are supported byfirms were developed by Grossman and Helpman (1991) and are supported by
Marc J. Melitz and Daniel Trefler 93
country-level evidence (Helpman 2004, chap. 5.6). At the firm level, there is a strongcountry-level evidence (Helpman 2004, chap. 5.6). At the firm level, there is a strong
relationship between exporting and innovation. For example, Intel and Apple arerelationship between exporting and innovation. For example, Intel and Apple are
major patent holders, and Foxconn holds 40 percent of all Chinese patents filed inmajor patent holders, and Foxconn holds 40 percent of all Chinese patents filed in
the United States (Eberhardt, Helmers, and Yu 2011). Of course, this correlationthe United States (Eberhardt, Helmers, and Yu 2011). Of course, this correlation
between exporting and innovation does not provide evidence for causality and lacksbetween exporting and innovation does not provide evidence for causality and lacks
a framing theory featuring heterogeneous firms. Recently, however, there has beena framing theory featuring heterogeneous firms. Recently, however, there has been
a great deal of theoretical and empirical progress. Lileeva and Trefler (2010) showa great deal of theoretical and empirical progress. Lileeva and Trefler (2010) show
theoretically and empirically how the market-expanding effects of internationaltheoretically and empirically how the market-expanding effects of international
integration causally encourage firms to innovate. Verhoogen (2008), Bustos (2011a,integration causally encourage firms to innovate. Verhoogen (2008), Bustos (2011a,
b), and Aw, Roberts, and Xu (2011) assess other interesting channels through whichb), and Aw, Roberts, and Xu (2011) assess other interesting channels through which
trade promotes firm-level innovation. Note that this third source of gains dealstrade promotes firm-level innovation. Note that this third source of gains deals
withwith within-firm efficiency; in contrast, the second source of gains above deals withefficiency; in contrast, the second source of gains above deals with
between-firm or allocative efficiency.or allocative efficiency.
This paper reviews these three sources of gains from trade both theoreticallyThis paper reviews these three sources of gains from trade both theoretically
and empirically. Our empirical evidence will be centered on the experience ofand empirically. Our empirical evidence will be centered on the experience of
Canada following its closer economic integration in 1989 with the United States—Canada following its closer economic integration in 1989 with the United States—
the largest example of bilateral intra-industry trade in the world—but we will alsothe largest example of bilateral intra-industry trade in the world—but we will also
describe evidence for other countries.describe evidence for other countries.
The related literature is huge. Here we focus on firms that expand interna-The related literature is huge. Here we focus on firms that expand internationally
via exporting as in Melitz (2003) and Bernard, Eaton, Jensen, and Kortumtionally via exporting as in Melitz (2003) and Bernard, Eaton, Jensen, and Kortum
(2003). Another related research topic analyzes how firm boundaries evolve across(2003). Another related research topic analyzes how firm boundaries evolve across
borders as multinational firms look abroad to “outsource” key parts of their produc-borders as multinational firms look abroad to “outsource” key parts of their production
chain. The interested reader is directed to surveys by Antràs and Rossi-Hansbergtion chain. The interested reader is directed to surveys by Antràs and Rossi-Hansberg
(2009) and Helpman (2011, chap. 6).(2009) and Helpman (2011, chap. 6).
Gains from Love of Variety (Economies of Scale and Product Variety)
Our first source of gains from trade is intimately related to intra-industry trade.Our first source of gains from trade is intimately related to intra-industry trade.
To measure intra-industry trade, one needs to start with a classification system thatTo measure intra-industry trade, one needs to start with a classification system that
assigns trade flows to a particular “industry.” One can then categorize trade flows asassigns trade flows to a particular “industry.” One can then categorize trade flows as
either intra-industry (two-way trade within the same industry classification code) oreither intra-industry (two-way trade within the same industry classification code) or
inter-industry (imports and exports in separate industry codes). The United Nationsinter-industry (imports and exports in separate industry codes). The United Nations
uses the Standard International Trade Classification, or SITC, to categorize worlduses the Standard International Trade Classification, or SITC, to categorize world
trade flows. In its most detailed form, the SITC contains 1,161 separate industrytrade flows. In its most detailed form, the SITC contains 1,161 separate industry
codes (that can be consistently traced back over time), but these industries are oftencodes (that can be consistently traced back over time), but these industries are often
aggregated into a smaller subset of industries.aggregated into a smaller subset of industries.
Figure 1 shows the time trend for the share of intra-industry trade according toFigure 1 shows the time trend for the share of intra-industry trade according to
this most detailed classification, and a more aggregated version with only 59 industrythis most detailed classification, and a more aggregated version with only 59 industry
codes. Mechanically, the share of intra-industry trade rises with the level of aggrega-codes. Mechanically, the share of intra-industry trade rises with the level of aggregation
for the industrial classification system (after all, with a single aggregate industrytion for the industrial classification system (after all, with a single aggregate industry
code, all trade would be “intra” to this aggregated industry). However, the timecode, all trade would be “intra” to this aggregated industry). However, the time
trends for the two series are very similar: intra-industry trade grew rapidly fromtrends for the two series are very similar: intra-industry trade grew rapidly from
1962 to the mid 1990s, before stabilizing at a substantially higher level. As countries1962 to the mid 1990s, before stabilizing at a substantially higher level. As countries
94 Journal of Economic Perspectives
industrialize, they tend to experience a higher share of intra-industry trade becauseindustrialize, they tend to experience a higher share of intra-industry trade because
they tend to produce and export differentiated manufactured goods that are similarthey tend to produce and export differentiated manufactured goods that are similar
to other brands of goods that are imported. However, some of the countries withto other brands of goods that are imported. However, some of the countries with
the highest shares of intra-industry trade in 2000 were newly industrializing nations,the highest shares of intra-industry trade in 2000 were newly industrializing nations,
such as the Czech Republic (77 percent), the Slovak Republic (76 percent), Mexicosuch as the Czech Republic (77 percent), the Slovak Republic (76 percent), Mexico
(73 percent), and Hungary (72 percent); for comparison, the United States had(73 percent), and Hungary (72 percent); for comparison, the United States had
a 69 percent share of intra-industry trade in 2000 (a 69 percent share of intra-industry trade in 2000 (OECD Economic Outlook 2002,2002,
chap. 6; based on the 59-industry level of aggregation). Most recently, China’s sharechap. 6; based on the 59-industry level of aggregation). Most recently, China’s share
of intra-industry trade has risen above the 50 percent mark.of intra-industry trade has risen above the 50 percent mark.
Why might a country both export and import goods that are similar? As aWhy might a country both export and import goods that are similar? As a
starting point, consider world trade in automobiles. Consumers in a car-producingstarting point, consider world trade in automobiles. Consumers in a car-producing
country are not limited to buying the car models that are produced domestically:country are not limited to buying the car models that are produced domestically:
many of those consumers choose to buy models that are produced elsewhere andmany of those consumers choose to buy models that are produced elsewhere and
imported. The extent of this product differentiation is then limited by high fixedimported. The extent of this product differentiation is then limited by high fixed
start-up costs for a new brand and by the related economies of scale.start-up costs for a new brand and by the related economies of scale.
We now highlight how the combination of product differentiation and econo-We now highlight how the combination of product differentiation and economies
of scale generates intra-industry trade using a theoretical example. Notice thatmies of scale generates intra-industry trade using a theoretical example. Notice that
this source of gains from trade provides a rationale for trade between two identicalthis source of gains from trade provides a rationale for trade between two identical
countries, which provides a stark contrast with the gains from inter-industry tradecountries, which provides a stark contrast with the gains from inter-industry trade
Figure 1
World Share of Intra-Industry Trade 1962–2006
Source: Data from Brühlhart (2009). We thank Marius Brülhart for generously sharing his data.
Notes: Figure 1 shows the time trend for the share of intra-industry trade according to the most detailed
Standard International Trade Classification (1,161 separate industry codes) and a more aggregated
version with only 59 industry codes.
.6
.5
.4
.3
.2
.1
Aggregated industry classification
Detailed industry classification
200620021998199419901986198219781974197019661962
Gains from Trade when Firms Matter 95
that arise from exploiting differences across countries, such as differences in tech-that arise from exploiting differences across countries, such as differences in technology
(Ricardo) or differences in factor supplies (Heckscher–Ohlin).nology (Ricardo) or differences in factor supplies (Heckscher–Ohlin).
In our theoretical example, two identical countries produce differentiatedIn our theoretical example, two identical countries produce differentiated
widget varieties subject to the same constant-returns-to-scale technology. Assumewidget varieties subject to the same constant-returns-to-scale technology. Assume
that one worker can produce one widget, but that production of any new variety ofthat one worker can produce one widget, but that production of any new variety of
widgets requires four workers to cover fixed overhead costs: this implies decreasingwidgets requires four workers to cover fixed overhead costs: this implies decreasing
average costs of production as the fixed cost is spread over an increasing number ofaverage costs of production as the fixed cost is spread over an increasing number of
output units (hence the economies of scale). Also, to be specific, suppose that bothoutput units (hence the economies of scale). Also, to be specific, suppose that both
countries have a fixed supply of 12 workers. If they do not trade, then each countrycountries have a fixed supply of 12 workers. If they do not trade, then each country
can produce: A) 8 units of one variety, or B) 2 units each of two different varieties.can produce: A) 8 units of one variety, or B) 2 units each of two different varieties.
Allowing countries to trade leads to a new possibility that is better than whatAllowing countries to trade leads to a new possibility that is better than what
either country can achieve on its own. Suppose that each country produces 8 unitseither country can achieve on its own. Suppose that each country produces 8 units
of one variety and exports 4 of these units to the other country. Consumers are nowof one variety and exports 4 of these units to the other country. Consumers are now
consuming 4 units of the home variety and 4 units of the foreign variety. This isconsuming 4 units of the home variety and 4 units of the foreign variety. This is
preferred to either of the no-trade production plans above. Compared to choice B,preferred to either of the no-trade production plans above. Compared to choice B,
there is the same number of varieties (2 varieties), but more of each variety (fourthere is the same number of varieties (2 varieties), but more of each variety (four
versus two). Compared to choice A, there is the same number of units (8 units), butversus two). Compared to choice A, there is the same number of units (8 units), but
more varieties (two versus one). Thus, trade expands the set of consumer choicesmore varieties (two versus one). Thus, trade expands the set of consumer choices
and eases the tradeoff between consumption units and product variety. Economicand eases the tradeoff between consumption units and product variety. Economic
integration allows production of each individual variety to be consolidated for theintegration allows production of each individual variety to be consolidated for the
whole integrated market; given increasing returns to scale, this reduces averagewhole integrated market; given increasing returns to scale, this reduces average
production costs. At the same time, product variety increases because consumersproduction costs. At the same time, product variety increases because consumers
can buy varieties produced anywhere in the integrated market.can buy varieties produced anywhere in the integrated market.
One of the most salient real-world examples of economic integration betweenOne of the most salient real-world examples of economic integration between
similar countries occurred between the United States and Canada. This integrationsimilar countries occurred between the United States and Canada. This integration
started with the signing of the North American Auto Pact in 1964. Before then, moststarted with the signing of the North American Auto Pact in 1964. Before then, most
car models were produced in the United States for U.S. consumers and in Canadacar models were produced in the United States for U.S. consumers and in Canada
for Canadian consumers. High tariffs on auto trade made it uneconomical to exportfor Canadian consumers. High tariffs on auto trade made it uneconomical to export
most car models across the border. Because the Canadian auto market was roughlymost car models across the border. Because the Canadian auto market was roughly
one-tenth the size of the U.S. market, this implied substantial scale disadvantages forone-tenth the size of the U.S. market, this implied substantial scale disadvantages for
production in the Canadian market: labor productivity there was about 30 percentproduction in the Canadian market: labor productivity there was about 30 percent
below the U.S. level. The U.S. market was large enough that assembly lines could bebelow the U.S. level. The U.S. market was large enough that assembly lines could be
dedicated to one particular car model, while Canadian assembly lines had to switchdedicated to one particular car model, while Canadian assembly lines had to switch
across models, involving costly downtime and reconfiguration costs, and also had toacross models, involving costly downtime and reconfiguration costs, and also had to
hold substantially higher inventory levels.hold substantially higher inventory levels.
The 1964 Pact established a free trade area for autos that allowed manufac-The 1964 Pact established a free trade area for autos that allowed manufacturers
to consolidate the production of particular car models in one country andturers to consolidate the production of particular car models in one country and
export that model to consumers in the other country. For example, General Motorsexport that model to consumers in the other country. For example, General Motors
cut in half the number of models assembled in Canada. However, total produc-cut in half the number of models assembled in Canada. However, total production
of autos in Canada increased as the remaining models produced in Canadation of autos in Canada increased as the remaining models produced in Canada
supplied the U.S. market as well as the Canadian one. Canadian automotive exportssupplied the U.S. market as well as the Canadian one. Canadian automotive exports
to the United States increased from $16 million in 1962 to $2.4 billion in 1968. Thatto the United States increased from $16 million in 1962 to $2.4 billion in 1968. That
same year, U.S. automotive exports to Canada were valued at $2.9 billion: intra-same year, U.S. automotive exports to Canada were valued at $2.9 billion: intraindustry
trade in action. Today, $85 billion worth of automotive products cross theindustry trade in action. Today, $85 billion worth of automotive products cross the
96 Journal of Economic Perspectives
U.S.–Canada border each year—roughly half in each direction. The productivityU.S.–Canada border each year—roughly half in each direction. The productivity
gains associated with this consolidation were also substantial: by the early 1970s, thegains associated with this consolidation were also substantial: by the early 1970s, the
Canadian auto industry’s 30 percent labor productivity shortfall relative to its U.S.Canadian auto industry’s 30 percent labor productivity shortfall relative to its U.S.
counterpart had disappeared.counterpart had disappeared.
Later, this transformation of the automotive industry was extended to includeLater, this transformation of the automotive industry was extended to include
Mexico. In 1989, Volkswagen consolidated its North American operations inMexico. In 1989, Volkswagen consolidated its North American operations in
Mexico, shutting down its plant in Pennsylvania. This process continued with theMexico, shutting down its plant in Pennsylvania. This process continued with the
implementation of the North American Free Trade Agreement between the Unitedimplementation of the North American Free Trade Agreement between the United
States, Canada, and Mexico. In 1994, Volkswagen started producing the new BeetleStates, Canada, and Mexico. In 1994, Volkswagen started producing the new Beetle
for the entire North American market in that same Mexican plant.for the entire North American market in that same Mexican plant.
This consolidation in response to closer economic integration with the UnitedThis consolidation in response to closer economic integration with the United
States was not limited to the auto industry. Following the implementation of theStates was not limited to the auto industry. Following the implementation of the
Canada–U.S. Free Trade Agreement in 1989, each Canadian manufacturing industryCanada–U.S. Free Trade Agreement in 1989, each Canadian manufacturing industry
experienced a dramatic reduction in its product offerings, concentrating on a smallerexperienced a dramatic reduction in its product offerings, concentrating on a smaller
number of products (Baldwin, Beckstead, and Caves 2002; Baldwin, Caves, and Gunumber of products (Baldwin, Beckstead, and Caves 2002; Baldwin, Caves, and Gu
2005; Baldwin and Gu 2009; Bernard, Redding, and Schott 2011). Baldwin, Caves,2005; Baldwin and Gu 2009; Bernard, Redding, and Schott 2011). Baldwin, Caves,
and Gu (2005) also report that the decrease in product offerings was accompaniedand Gu (2005) also report that the decrease in product offerings was accompanied
by substantial increases in production runs for individual products. This process isby substantial increases in production runs for individual products. This process is
even evident in the Canadian wine industry, an industry that exclusively producedeven evident in the Canadian wine industry, an industry that exclusively produced
low-end wines that could not possibly compete with Californian giants such as Gallo.low-end wines that could not possibly compete with Californian giants such as Gallo.
In response to the Agreement, Canadian manufactures dramatically reduced theIn response to the Agreement, Canadian manufactures dramatically reduced the
number of varietals produced and focused on the varietals used to produce ice wine.number of varietals produced and focused on the varietals used to produce ice wine.
The industry is now healthier than ever (Beamish and Celly 2003).The industry is now healthier than ever (Beamish and Celly 2003).
Another prominent example of economic integration began in 1957, when theAnother prominent example of economic integration began in 1957, when the
major countries of Western Europe established a free trade area in manufacturedmajor countries of Western Europe established a free trade area in manufactured
goods: the European Economic Community, or EEC. Many politicians offered angoods: the European Economic Community, or EEC. Many politicians offered an
old-fashioned Ricardian prediction that German manufacturers would eradicateold-fashioned Ricardian prediction that German manufacturers would eradicate
their European competitors. The facts did not treat such predictions kindly: tradetheir European competitors. The facts did not treat such predictions kindly: trade
within the EEC grew twice as fast as world trade during the 1960s, and intra-industrywithin the EEC grew twice as fast as world trade during the 1960s, and intra-industry
trade as a share of EEC trade more than doubled from 1960 to 1990. The benefitstrade as a share of EEC trade more than doubled from 1960 to 1990. The benefits
of the original European Community agreement were about 1 percent of GDP forof the original European Community agreement were about 1 percent of GDP for
the largest economies and about 3 percent of GDP for mid-sized economies suchthe largest economies and about 3 percent of GDP for mid-sized economies such
as Belgium (Harrison, Rutherford, and Wooton 1989). (These numbers captureas Belgium (Harrison, Rutherford, and Wooton 1989). (These numbers capture
more than just pure love-of-variety gains.) Economic integration has continued inmore than just pure love-of-variety gains.) Economic integration has continued in
Europe as more countries have joined the free trade area that is today called theEurope as more countries have joined the free trade area that is today called the
European Union and as a subset of EU countries adopted the euro as a commonEuropean Union and as a subset of EU countries adopted the euro as a common
currency in 1999. Euro-zone members have experienced strong trade growth, espe-currency in 1999. Euro-zone members have experienced strong trade growth, especially
intra-industry trade growth, relative to non-EU countries and even relative tocially intra-industry trade growth, relative to non-EU countries and even relative to
EU countries that have not adopted the euro.EU countries that have not adopted the euro.
A substantial portion of the increased trade that comes with economic integra-A substantial portion of the increased trade that comes with economic integration
also delivers increased product variety to consumers. Balistreri, Hilberrry, andtion also delivers increased product variety to consumers. Balistreri, Hilberrry, and
Rutherford (2011) show that the worldwide elimination of all trade barriers wouldRutherford (2011) show that the worldwide elimination of all trade barriers would
raise the number of varieties available by about 3 percent, lower manufacturingraise the number of varieties available by about 3 percent, lower manufacturing
prices by a similar amount, and raise world welfare by 2 percent. Most of theseprices by a similar amount, and raise world welfare by 2 percent. Most of these
Marc J. Melitz and Daniel Trefler 97
gains would accrue to developing countries such as China. Broda and Weinsteingains would accrue to developing countries such as China. Broda and Weinstein
(2006) estimate that the number of products available to U.S. consumers through(2006) estimate that the number of products available to U.S. consumers through
imports tripled between 1972 and 2001, resulting in welfare gains to U.S. consumersimports tripled between 1972 and 2001, resulting in welfare gains to U.S. consumers
equivalent to a 2.6 percent rise in U.S. GDP. Feenstra (2010, table 2.1) examinesequivalent to a 2.6 percent rise in U.S. GDP. Feenstra (2010, table 2.1) examines
how worldwide welfare would change if all countries went from autarky to theirhow worldwide welfare would change if all countries went from autarky to their
1996 levels of trade. He estimates that the welfare gains from increased varieties1996 levels of trade. He estimates that the welfare gains from increased varieties
are comparable to a 12.5 percent rise in world GDP. While the exact magnitudesare comparable to a 12.5 percent rise in world GDP. While the exact magnitudes
of the gains from increased variety differ across studies due to differences in whatof the gains from increased variety differ across studies due to differences in what
exactly is being modeled, the clear message is that the gains have been very large forexactly is being modeled, the clear message is that the gains have been very large for
developed countries and continue to be large for developing countries.developed countries and continue to be large for developing countries.
Trade expands product variety both in final goods (which benefits consumers)Trade expands product variety both in final goods (which benefits consumers)
as well as in specialized production inputs (which benefits the firms that use thoseas well as in specialized production inputs (which benefits the firms that use those
inputs). Ethier (1982) showed that there is a close parallel between these two. Insteadinputs). Ethier (1982) showed that there is a close parallel between these two. Instead
of the love-of-variety that accrues to consumers, firms benefit from the increasedof the love-of-variety that accrues to consumers, firms benefit from the increased
productivity derived from an increased range of available production inputs. Recentproductivity derived from an increased range of available production inputs. Recent
firm-level research has confirmed this product variety benefit for firms that importfirm-level research has confirmed this product variety benefit for firms that import
intermediate inputs. Using Hungarian data, Halpern, Koren, and Szeidl (2005)intermediate inputs. Using Hungarian data, Halpern, Koren, and Szeidl (2005)
show that importing many varieties of foreign inputs increases firm productivityshow that importing many varieties of foreign inputs increases firm productivity
by 12 percent. Using Indonesian data, Amiti and Konings (2007) show that aby 12 percent. Using Indonesian data, Amiti and Konings (2007) show that a
10 percentage point fall in input tariffs leads to a productivity gain of 12 percent10 percentage point fall in input tariffs leads to a productivity gain of 12 percent
for firms that import their inputs. Kasahara and Rodrigue (2008), Kasahara andfor firms that import their inputs. Kasahara and Rodrigue (2008), Kasahara and
Lapham (2012), Topalova and Khandelwal (2011), and Goldberg, Khandelwal,Lapham (2012), Topalova and Khandelwal (2011), and Goldberg, Khandelwal,
Pavcnik, and Topalova (2010) show similarly large gains for Chile and India. In thePavcnik, and Topalova (2010) show similarly large gains for Chile and India. In the
context of the Canada–U.S. Free Trade Agreement, Lileeva and Trefler (2010) findcontext of the Canada–U.S. Free Trade Agreement, Lileeva and Trefler (2010) find
that the fall in Canadian tariffs on inputs that Canadian firms purchased from thethat the fall in Canadian tariffs on inputs that Canadian firms purchased from the
United States resulted in a 0.5 percent rise in Canadian manufacturing productivity.United States resulted in a 0.5 percent rise in Canadian manufacturing productivity.
The Canadian impacts are not nearly as large as effects from developing countries,The Canadian impacts are not nearly as large as effects from developing countries,
which suggests that access to a variety of inputs is an important ingredient in thewhich suggests that access to a variety of inputs is an important ingredient in the
process of economic development.process of economic development.
More variety means more competition, and more competition forces firmsMore variety means more competition, and more competition forces firms
to lower their markups and prices. We see evidence of this after the Turkish andto lower their markups and prices. We see evidence of this after the Turkish and
Cote d’Ivoire trade liberalizations of 1985 (Levinsohn 1993; Harrison 1994) and inCote d’Ivoire trade liberalizations of 1985 (Levinsohn 1993; Harrison 1994) and in
Belgium during the 1994–2004 period of increased integration (Abraham, Konings,Belgium during the 1994–2004 period of increased integration (Abraham, Konings,
Vanormelingen 2009; De Loecker 2011). On the other hand, there was no evidenceVanormelingen 2009; De Loecker 2011). On the other hand, there was no evidence
of falling markups in Mexico after the trade liberalization of the early 1980s (Tyboutof falling markups in Mexico after the trade liberalization of the early 1980s (Tybout
and Westbrook 1995). We turn next to the gains associated with reallocation ofand Westbrook 1995). We turn next to the gains associated with reallocation of
resources across heterogeneous firms within an industry.resources across heterogeneous firms within an industry.
Gains from Reallocation at the Firm Level
By the mid-1980s, a large body of theoretical work demonstrated thatBy the mid-1980s, a large body of theoretical work demonstrated that
freer trade could affect productivity by forcing firms to move up or down theirfreer trade could affect productivity by forcing firms to move up or down their
average cost curves. Much of the follow-on empirical work assumed that firmsaverage cost curves. Much of the follow-on empirical work assumed that firms
98 Journal of Economic Perspectives
were identical, and it made a variety of assumptions that allowed inferences to bewere identical, and it made a variety of assumptions that allowed inferences to be
drawn from industry-level data (for example, Harris 1984). We now know that thedrawn from industry-level data (for example, Harris 1984). We now know that the
heterogeneity of firms even within narrowly defined industries is a central featureheterogeneity of firms even within narrowly defined industries is a central feature
of the data that cannot be ignored (for example, Bernard, Jensen, Redding, andof the data that cannot be ignored (for example, Bernard, Jensen, Redding, and
Schott 2007).Schott 2007).
Our second source of gains from trade is the result of shifting resources awayOur second source of gains from trade is the result of shifting resources away
from less-productive firms and towards more-productive firms. To analyze gainsfrom less-productive firms and towards more-productive firms. To analyze gains
from reallocation of trade between firms, we need a model of trade with hetero-from reallocation of trade between firms, we need a model of trade with heterogeneous
firms—that is, in which performance varies across different firms. We cangeneous firms—that is, in which performance varies across different firms. We can
then capture how firms with different characteristics respond differently to trade.then capture how firms with different characteristics respond differently to trade.
Consider the case from the previous example where opening to trade leads to aConsider the case from the previous example where opening to trade leads to a
transition from production plan A in which each country produces two varieties totransition from production plan A in which each country produces two varieties to
production plan B in which each country produces one variety. In the real world,production plan B in which each country produces one variety. In the real world,
those varieties are associated with the firms that produce them. Opening up to tradethose varieties are associated with the firms that produce them. Opening up to trade
therefore implies that one of the two firms in each country shuts down, while thetherefore implies that one of the two firms in each country shuts down, while the
remaining firm expands production from 2 units to 8 units. But what are the factorsremaining firm expands production from 2 units to 8 units. But what are the factors
explaining which firms expand and which ones exit?explaining which firms expand and which ones exit?
Monopolistic Competitors with Heterogeneous Costs
Melitz and Ottaviano (2008) develop a model of trade that allows for differ-Melitz and Ottaviano (2008) develop a model of trade that allows for differences
across firms; we use a simplified version of that model for the discussion here.ences across firms; we use a simplified version of that model for the discussion here.
Consider a monopolistically competitive industry in which many firms compete byConsider a monopolistically competitive industry in which many firms compete by
offering different products that are relatively close substitutes for one another—atoffering different products that are relatively close substitutes for one another—at
least as compared to products in other industries. For simplicity, we assume thatleast as compared to products in other industries. For simplicity, we assume that
each firm produces a single product, that demand for all products is symmetric,each firm produces a single product, that demand for all products is symmetric,
and that firms differ only with respect to productivity. Specifically, firms differand that firms differ only with respect to productivity. Specifically, firms differ
only with respect to their marginal costs of productiononly with respect to their marginal costs of production cii, where, where i indexes firms.indexes firms.
(A number of authors have developed related models that allow firms to produce(A number of authors have developed related models that allow firms to produce
multiple products: for example, Eckel and Neary 2010; Bernard, Redding, andmultiple products: for example, Eckel and Neary 2010; Bernard, Redding, and
Schott 2011; and Mayer, Melitz, and Ottaviano 2011. Also, demand need not beSchott 2011; and Mayer, Melitz, and Ottaviano 2011. Also, demand need not be
symmetric: there can be product-quality differences across firms. Such product-symmetric: there can be product-quality differences across firms. Such productquality
differences lead to very similar predictions for firm performance as thequality differences lead to very similar predictions for firm performance as the
ones we now discuss for cost differences.)ones we now discuss for cost differences.)
Panel A of Figure 2 illustrates the price and quantity choices for two monopolisti-Panel A of Figure 2 illustrates the price and quantity choices for two monopolistically
competitive firms. Both firms face the same downward-slopingcally competitive firms. Both firms face the same downward-sloping residual demanddemand
curve: residual demand is demand as perceived by the firm, and thus depends oncurve: residual demand is demand as perceived by the firm, and thus depends on
the behavior of other competing firms in the market.the behavior of other competing firms in the market.11
On the production side,On the production side,
1
The equation for the demand facing a firm that is used in what follows is Q = S[(1/n) − b(
_
p − p)],
where Q is the quantity of output demanded, S is the total output of the industry, n is the number of firms
in the industry, b > 0 is a constant term representing the responsiveness of a firm’s sales to its price, p is
the price charged by the firm itself, and
_
p is the average price charged by its competitors. This demand
equation may be given the following intuitive justification: If all firms charge the same price, each will
have a market share 1/n. A firm charging more than the average of other firms will have a smaller market
share, whereas a firm charging less will have a larger share.
Gains from Trade when Firms Matter 99
Figure 2
Performance Differences across Firms
Source: Authors.
A: Cost, Price
B: Profit
Cost,PriceProfit
Quantity
MC2
MC1
DMR
q1q2
c2
p2
c1
p1
c*
Operating profit
Net profit
c1 c2 c
cmaxc*
Marginal Cost (MC)
– f
π1
o
π2
o
100 Journal of Economic Perspectives
marginal costs for firm 1 are shown as lower than those for firm 2. In panel A, firm 1marginal costs for firm 1 are shown as lower than those for firm 2. In panel A, firm 1
has a lower marginal cost (has a lower marginal cost (c11) than firm 2 () than firm 2 (c22). We also assume that economies of). We also assume that economies of
scale exist because of a fixed cost that a firm must incur to develop a product andscale exist because of a fixed cost that a firm must incur to develop a product and
set up its initial production.set up its initial production.
In this setting, each firm maximizes profit by choosing an output levelIn this setting, each firm maximizes profit by choosing an output level q thatthat
equalizes marginal cost and marginal revenue. Firm 1 chooses a higher output levelequalizes marginal cost and marginal revenue. Firm 1 chooses a higher output level
than firm 2 (than firm 2 (q11 >> q22), associated with a lower price (), associated with a lower price (p11 << p22). Firm 1 also sets a). Firm 1 also sets a
higher markup than firm 2:higher markup than firm 2: p11 −− c11 >> p22 −− c22; this is a consequence of the marginal; this is a consequence of the marginal
revenue curve being steeper than the demand curve. Thus, firm 1 earns a higherrevenue curve being steeper than the demand curve. Thus, firm 1 earns a higher
operating profit than firm 2:operating profit than firm 2: ππ11
o
>> ππ22
o
, as represented by the shaded areas in panel A, as represented by the shaded areas in panel A
of Figure 2. We assume that all firms face the same set-up costof Figure 2. We assume that all firms face the same set-up cost f, so firm 1 also earns, so firm 1 also earns
higher net profits (subtracting the fixed costhigher net profits (subtracting the fixed cost f for all firms). Of course, differences infor all firms). Of course, differences in
fixed costs would not affect marginal costs and thus would not affect firm decisionsfixed costs would not affect marginal costs and thus would not affect firm decisions
concerning price and output. We can thus summarize the relevant performanceconcerning price and output. We can thus summarize the relevant performance
differences that result from marginal cost differences across firms in the followingdifferences that result from marginal cost differences across firms in the following
way. Compared to a firm with higher marginal cost, a firm with a lower marginalway. Compared to a firm with higher marginal cost, a firm with a lower marginal
cost will: 1) set a lower price but at a higher markup over marginal cost, 2) producecost will: 1) set a lower price but at a higher markup over marginal cost, 2) produce
more output, and 3) earn higher profits.more output, and 3) earn higher profits.
Panel B in Figure 2 shows how firm profit varies with its marginal costPanel B in Figure 2 shows how firm profit varies with its marginal cost cii. Both. Both
operating and net profit will be decreasing functions of marginal cost, while theoperating and net profit will be decreasing functions of marginal cost, while the
difference between the two is the fixed set-up costdifference between the two is the fixed set-up cost f. Going back to panel A, we see. Going back to panel A, we see
that a firm can earn a positive operating profit so long as its marginal cost is belowthat a firm can earn a positive operating profit so long as its marginal cost is below
the intercept of the demand curve on the vertical axis. Letthe intercept of the demand curve on the vertical axis. Let c** denote this cost cutoff.denote this cost cutoff.
A firm with a marginal costA firm with a marginal cost cii above this cutoff is effectively “priced out” of theabove this cutoff is effectively “priced out” of the
market and would earn negative operating profits if it were to produce any outputmarket and would earn negative operating profits if it were to produce any output
(represented by the dotted segment for operating profit in panel A). Such a firm(represented by the dotted segment for operating profit in panel A). Such a firm
would choose to shut down and not produce (earning zero operating profit butwould choose to shut down and not produce (earning zero operating profit but
incurring a net profit loss –incurring a net profit loss –f due to the fixed cost). Why would such a firm enterdue to the fixed cost). Why would such a firm enter
in the first place? Clearly, it would not if it knew about its high costin the first place? Clearly, it would not if it knew about its high cost cii prior both toprior both to
entry and to paying the fixed costentry and to paying the fixed cost f..
We assume that entrants face some randomness about their future productionWe assume that entrants face some randomness about their future production
costcost cii. This randomness disappears only. This randomness disappears only after the set-up costthe set-up cost f is paid and is sunk.is paid and is sunk.
Thus some firms will regret their entry decision, as their net profit is negative (theyThus some firms will regret their entry decision, as their net profit is negative (they
cannot recover the sunk costcannot recover the sunk cost f ). This is the case for firm 2 in panel B; even though). This is the case for firm 2 in panel B; even though
its operating profit is positive, it does not cover the sunk costits operating profit is positive, it does not cover the sunk cost f. On the other hand,. On the other hand,
some firms discover that their production costsome firms discover that their production cost cii is very low and earn a high (andis very low and earn a high (and
positive) net profit.positive) net profit.
Firms consider all these possible outcomes, captured by the net profit curveFirms consider all these possible outcomes, captured by the net profit curve
in panel B when they make their entry decision. Firms anticipate that there is ain panel B when they make their entry decision. Firms anticipate that there is a
range of lower costs where net profits are positive (shaded area to the left above therange of lower costs where net profits are positive (shaded area to the left above the
horizontal axis), and another range of higher costs where net profits are negativehorizontal axis), and another range of higher costs where net profits are negative
(shaded area to the right below the horizontal axis). In the long-run equilibrium,(shaded area to the right below the horizontal axis). In the long-run equilibrium,
firms enter until theirfirms enter until their expected net profit across all potential cost levelsnet profit across all potential cost levels cii is drivenis driven
to zero. If every cost levelto zero. If every cost level cii from 0 tofrom 0 to cmaxmax is equally likely, then this equilibrium isis equally likely, then this equilibrium is
Marc J. Melitz and Daniel Trefler 101
reached when the two shaded areas are equal.reached when the two shaded areas are equal.22
Panel B of Figure 2 summarizes thePanel B of Figure 2 summarizes the
industry equilibrium for a given market size. It shows which range of firms surviveindustry equilibrium for a given market size. It shows which range of firms survive
and produce (with costand produce (with cost cii belowbelow c**) and how their profits will vary with their cost) and how their profits will vary with their cost
levelslevels cii..
What Changes When Economies Integrate?
How will the situation faced by these heterogeneous firms alter when econo-How will the situation faced by these heterogeneous firms alter when economies
integrate into a single larger market? A larger market can support a largermies integrate into a single larger market? A larger market can support a larger
number of firms than a smaller market, which implies more competition in thenumber of firms than a smaller market, which implies more competition in the
larger market. Increased competition—absent any increase in market size—leads tolarger market. Increased competition—absent any increase in market size—leads to
an inward shift of each firm’s residual demand curve. On the other hand, holdingan inward shift of each firm’s residual demand curve. On the other hand, holding
competition fixed, a larger market rotates out the residual demand curves forcompetition fixed, a larger market rotates out the residual demand curves for
all firms. Putting these two effects of increased competition and greater marketall firms. Putting these two effects of increased competition and greater market
size together gives us the combined effect of international trade on the residualsize together gives us the combined effect of international trade on the residual
demand curve perceived by firms. This change is depicted in panel A of Figure 3,demand curve perceived by firms. This change is depicted in panel A of Figure 3,
as the shift from demand curveas the shift from demand curve D toto D′′. The residual demand curve shifts in from. The residual demand curve shifts in from
the perspective of the smaller firms with lower output levels that operate on thethe perspective of the smaller firms with lower output levels that operate on the
higher part of the demand curve: here, the effect of tougher competition domi-higher part of the demand curve: here, the effect of tougher competition dominates.
However, from the perspective of the larger firms that operate on the lowernates. However, from the perspective of the larger firms that operate on the lower
part of the demand curve, the residual demand curve has shifted out: here, thepart of the demand curve, the residual demand curve has shifted out: here, the
effect of the larger market size dominates.effect of the larger market size dominates.
Panel B of Figure 3 shows the consequences of this demand change for thePanel B of Figure 3 shows the consequences of this demand change for the
operating profits of firms with different cost levelsoperating profits of firms with different cost levels cii. The decrease in demand for. The decrease in demand for
the smaller firms translates into a new lower cost cutoffthe smaller firms translates into a new lower cost cutoff c**′′: Firms with the highest: Firms with the highest
cost levels (abovecost levels (above c**′′) cannot survive the decrease in demand and are forced to) cannot survive the decrease in demand and are forced to
exit. On the other hand, the flatter demand curve is advantageous to firms withexit. On the other hand, the flatter demand curve is advantageous to firms with
the lowest cost levels: they can adapt to the increased competition by loweringthe lowest cost levels: they can adapt to the increased competition by lowering
their markup (and hence their price) and gaining some additional market share.their markup (and hence their price) and gaining some additional market share.
(Recall that the high-cost firms are already setting low markups, and cannot lower(Recall that the high-cost firms are already setting low markups, and cannot lower
their prices to induce positive demand, as this would mean pricing below theirtheir prices to induce positive demand, as this would mean pricing below their
marginal cost of production.) Thus, the best-performing firms with the lowest costmarginal cost of production.) Thus, the best-performing firms with the lowest cost
levelslevels cii now earn increased operating and net profits. Panel B of Figure 3 illustratesnow earn increased operating and net profits. Panel B of Figure 3 illustrates
how increased market size generates both winners and losers amongst firms in anhow increased market size generates both winners and losers amongst firms in an
industry. Low-cost firms thrive and increase their profits and market shares, high-industry. Low-cost firms thrive and increase their profits and market shares, highcost
firms contract, and the highest cost firms exit.cost firms contract, and the highest cost firms exit.
In this model, economic integration through market expansion does notIn this model, economic integration through market expansion does not
directly affect firm productivity. Nevertheless, it generates an overall increase indirectly affect firm productivity. Nevertheless, it generates an overall increase in
aggregate productivity as market shares are reallocated from the low-productivityaggregate productivity as market shares are reallocated from the low-productivity
firms with high marginal costs to the high-productivity ones with low marginal costs.firms with high marginal costs to the high-productivity ones with low marginal costs.
2
In contrast, when there is no uncertainty about marginal cost because all firms share the same cost c,
then entry drives the realized net profit to zero for all firms. With firm heterogeneity, expected net profit
is zero, but realized profits will vary as shown in panel B of Figure 2.
102 Journal of Economic Perspectives
Figure 3
Winners and Losers from Market Integration
Source: Authors.
A: Shift in a firm’s residual curve with international trade
B: Shift in operating profit with international trade
PriceProfit
Quantity
D
D′
Combined effect of bigger
market size and more competition
More competition
(market size fixed)
Winners Losers
Exit
Marginal Cost (MC)
c*
c*
′
Operating profit
Gains from Trade when Firms Matter 103
Trade Costs, Export Decisions, and Trade Liberalization
The discussion to this point has implicitly modeled economic integration asThe discussion to this point has implicitly modeled economic integration as
a change in market size from a closed economy with no trade all the way to aa change in market size from a closed economy with no trade all the way to a
single combined market with no trade barriers. In reality, initial trade costs aresingle combined market with no trade barriers. In reality, initial trade costs are
rarely so high as to block all trade prior to liberalization, and liberalization reducesrarely so high as to block all trade prior to liberalization, and liberalization reduces
trading costs without fully eliminating them. In a number of ways, this kind oftrading costs without fully eliminating them. In a number of ways, this kind of
partial trade liberalization has a very similar effect to the simpler case of full inte-partial trade liberalization has a very similar effect to the simpler case of full integration.
With partial trade liberalization, the better-performing firms expand, thegration. With partial trade liberalization, the better-performing firms expand, the
worse-performing ones contract, and the worst performing ones exit. This gener-worse-performing ones contract, and the worst performing ones exit. This generates
the same type of reallocation effect previously described and leads to a rise inates the same type of reallocation effect previously described and leads to a rise in
aggregate productivity.aggregate productivity.33
However, adding trade costs also allows us to analyze an additional issue:However, adding trade costs also allows us to analyze an additional issue:
whether firms choose to export. With trade costs, exporting is profitable only forwhether firms choose to export. With trade costs, exporting is profitable only for
a subset of better-performing firms. Some firms do not export, and instead onlya subset of better-performing firms. Some firms do not export, and instead only
serve domestic consumers. We now extend our theoretical model to incorporateserve domestic consumers. We now extend our theoretical model to incorporate
trade costs and firms’ export decisions. For this purpose, we can no longer analyze atrade costs and firms’ export decisions. For this purpose, we can no longer analyze a
single market: instead, we need to look at firms’ decisions in both the domestic andsingle market: instead, we need to look at firms’ decisions in both the domestic and
export markets jointly. For simplicity, we consider a special case where both coun-export markets jointly. For simplicity, we consider a special case where both countries
are symmetric, so that demand conditions in both the domestic and exporttries are symmetric, so that demand conditions in both the domestic and export
markets will be identical.markets will be identical.
Assume that a firm must incur an additional trade costAssume that a firm must incur an additional trade cost t for each unit of outputfor each unit of output
that it sells to customers across the border. As a result of this trade cost, each firmthat it sells to customers across the border. As a result of this trade cost, each firm
will set a different price in its export market relative to its domestic market, whichwill set a different price in its export market relative to its domestic market, which
will lead to different quantities sold in each market, and ultimately to different profitwill lead to different quantities sold in each market, and ultimately to different profit
levels earned in each market. Because we are assuming that each firm’s marginallevels earned in each market. Because we are assuming that each firm’s marginal
cost is constant and does not vary with production levels, the decisions regardingcost is constant and does not vary with production levels, the decisions regarding
pricing and quantity sold in each market can be separated: a decision regarding thepricing and quantity sold in each market can be separated: a decision regarding the
domestic market will have no effect on the profitability of different decisions fordomestic market will have no effect on the profitability of different decisions for
the export market.the export market.
Consider the case of firms located in Home. Their situation regarding theirConsider the case of firms located in Home. Their situation regarding their
domestic (Home) market is exactly as was illustrated in Figure 2, except that all thedomestic (Home) market is exactly as was illustrated in Figure 2, except that all the
outcomes such as price, output, and profit relate to the domestic market only. Nowoutcomes such as price, output, and profit relate to the domestic market only. Now
consider the export (Foreign) market. The firms face the same demand curve inconsider the export (Foreign) market. The firms face the same demand curve in
Foreign as they do in Home (the two countries are identical). The only differenceForeign as they do in Home (the two countries are identical). The only difference
is that each firm’s marginal cost in the export market is shifted up by the tradeis that each firm’s marginal cost in the export market is shifted up by the trade
costcost t. What are the effects of the trade cost on the firms’ decisions regarding the. What are the effects of the trade cost on the firms’ decisions regarding the
export market? A higher marginal cost induces a firm to raise its price, which leadsexport market? A higher marginal cost induces a firm to raise its price, which leads
to a lower output quantity sold and to lower profits (as highlighted in Figure 2).to a lower output quantity sold and to lower profits (as highlighted in Figure 2).
3
The more general version of this model analyzed by Melitz and Ottaviano (2008) allows for multiple
countries of different sizes and for arbitrary trade costs between any country pair (though the trade costs
are proportional to production costs instead of per output unit as in the current version). That paper
shows more formally that the effects of multilateral liberalization (all countries proportionally reduce
trade costs) are very similar to the case of full economic integration that leads to a single larger market.
104 Journal of Economic Perspectives
We also know that if marginal cost is raised above a threshold levelWe also know that if marginal cost is raised above a threshold level c**, then a firm, then a firm
cannot profitably operate in that market. Thus, when there are trade costs, somecannot profitably operate in that market. Thus, when there are trade costs, some
firms will find it profitable to operate in the domestic market but not in the exportfirms will find it profitable to operate in the domestic market but not in the export
market because the trade cost pushes their marginal cost for that market above themarket because the trade cost pushes their marginal cost for that market above the
thresholdthreshold c**..
Figure 4 helps to visualize the production and export decisions for all firmsFigure 4 helps to visualize the production and export decisions for all firms
based on their marginal costbased on their marginal cost cii. Panel A of Figure 4 separates a firm’s operating profit. Panel A of Figure 4 separates a firm’s operating profit
into a portion earned from domestic sales, and a portion earned from export sales.into a portion earned from domestic sales, and a portion earned from export sales.
(Both portions are functions of a firm’s marginal cost(Both portions are functions of a firm’s marginal cost cii as in Figure 2.) Because theas in Figure 2.) Because the
only difference between the domestic and export markets is the additional per-unitonly difference between the domestic and export markets is the additional per-unit
trade costtrade cost t,, the horizontal distance between the two curves is equal to the tradethe horizontal distance between the two curves is equal to the trade
costcost t. Firm 1 earns positive operating profits from sales in both the domestic and. Firm 1 earns positive operating profits from sales in both the domestic and
export markets: it will export and reach consumers in both markets. This will beexport markets: it will export and reach consumers in both markets. This will be
the case for all firms with cost belowthe case for all firms with cost below c** –– t. On the other hand, firm 2 only earns. On the other hand, firm 2 only earns
positive operating profits from sales in the domestic market—and thus chooses notpositive operating profits from sales in the domestic market—and thus chooses not
to export. Any firm with cost aboveto export. Any firm with cost above c** –– t will be in this same situation and thereforewill be in this same situation and therefore
will not export: those firms only serve their domestic market. As before, the worstwill not export: those firms only serve their domestic market. As before, the worst
performing firms with cost aboveperforming firms with cost above c** cannot profitably operate at all (even in theircannot profitably operate at all (even in their
domestic market) and therefore exit.domestic market) and therefore exit.
Panel B of Figure 4 summarizes the effects of trade liberalization—a reductionPanel B of Figure 4 summarizes the effects of trade liberalization—a reduction
in the trade costin the trade cost t—for those firm decisions. The figure shows the same two operatingfor those firm decisions. The figure shows the same two operating
profit curves from panel A both before and after (dashed curves) trade liberaliza-profit curves from panel A both before and after (dashed curves) trade liberalization.
The operating profit for the domestic market shifts down due to the increasetion. The operating profit for the domestic market shifts down due to the increase
in competition (which shifts the residual demand curve for the domestic marketin competition (which shifts the residual demand curve for the domestic market
inward as explained earlier). Some of the higher-cost firms that used to produce forinward as explained earlier). Some of the higher-cost firms that used to produce for
domestic consumption no longer earn a positive operating profit after trade liberal-domestic consumption no longer earn a positive operating profit after trade liberalization
and exit. On the other hand, the operating profit for the export market shiftsization and exit. On the other hand, the operating profit for the export market shifts
up due to the lower trade cost. (Increased competition in the export market tends toup due to the lower trade cost. (Increased competition in the export market tends to
reduce operating profits there, but this effect is dominated by the direct effect of thereduce operating profits there, but this effect is dominated by the direct effect of the
trade cost reduction.) A key empirical prediction is that some firms start exporting.trade cost reduction.) A key empirical prediction is that some firms start exporting.
Specifically, among the firms that did not export prior to trade liberalization, onlySpecifically, among the firms that did not export prior to trade liberalization, only
the most productive of these start exporting.the most productive of these start exporting.
Evidence on Gains from Inter-Firm Reallocations
In many ways, the Canada–U.S. Free Trade Agreement is a useful naturalIn many ways, the Canada–U.S. Free Trade Agreement is a useful natural
experiment for considering the effects of trade integration. The policy experimentexperiment for considering the effects of trade integration. The policy experiment
is clearly defined: it dealt only with market integration and was not part of a largeris clearly defined: it dealt only with market integration and was not part of a larger
package of macroeconomic reforms that often accompany trade liberalization. Thepackage of macroeconomic reforms that often accompany trade liberalization. The
enactment of the agreement was largely unanticipated: a Canadian general electionenactment of the agreement was largely unanticipated: a Canadian general election
was fought on the issue one month before the agreement was to be signed into lawwas fought on the issue one month before the agreement was to be signed into law
and pollsters unanimously predicted that Canada’s ruling party—along with theand pollsters unanimously predicted that Canada’s ruling party—along with the
free trade agreement—would be defeated (Brander 1991; Thompson 1993). Thus,free trade agreement—would be defeated (Brander 1991; Thompson 1993). Thus,
evidence about the extent of aggregate productivity changes as a result of realloca-evidence about the extent of aggregate productivity changes as a result of reallocations
among heterogeneous firms can be sought by looking at the distribution oftions among heterogeneous firms can be sought by looking at the distribution of
Marc J. Melitz and Daniel Trefler 105
Figure 4
Export Decision and Trade Liberalization
Source: Authors.
A: Operating profits from domestic and export sales
B: Effects of trade liberalization on firm decisions
Operating profit (domestic)
ExitNonexportersExporters
c2c1
c*
c
Operating profit
(export)
Marginal Cost (MC)
Marginal Cost (MC)
Operating profit (domestic)
Operating
profit (export)
New
exit
New
exporters
c
c*
c* – t
PriceProfit
106 Journal of Economic Perspectives
productivity across Canadian manufacturing plants before and after the agreement,productivity across Canadian manufacturing plants before and after the agreement,
at entrants before and after the agreement, and at the productivity distribution ofat entrants before and after the agreement, and at the productivity distribution of
exporters and nonexporters.exporters and nonexporters.
The agreement came into effect on January 1, 1989. Panel A of Figure 5 showsThe agreement came into effect on January 1, 1989. Panel A of Figure 5 shows
the distribution of labor productivity as measured by value-added per employeethe distribution of labor productivity as measured by value-added per employee
across Canadian manufacturing plants both before the agreement in 1988 and inacross Canadian manufacturing plants both before the agreement in 1988 and in
1996, when there had been time for firm adjustments to occur. For example, the1996, when there had been time for firm adjustments to occur. For example, the
1996 curve summarizes the productivity distribution of all 35,000 Canadian manu-1996 curve summarizes the productivity distribution of all 35,000 Canadian manufacturing
plants in that year. Clearly, the distribution of firms shifted rightward:facturing plants in that year. Clearly, the distribution of firms shifted rightward:
between 1988 and 1996, the share of low-productivity plants in manufacturingbetween 1988 and 1996, the share of low-productivity plants in manufacturing
declined and the share of high-productivity plants rose.declined and the share of high-productivity plants rose.
The horizontal axis is based on a measure of the log of labor productivity.The horizontal axis is based on a measure of the log of labor productivity.
However, to ensure that dispersion is driven by within-industry rather than between-However, to ensure that dispersion is driven by within-industry rather than betweenindustry
differences in labor productivity, we scale each plant’s log productivity byindustry differences in labor productivity, we scale each plant’s log productivity by
subtracting from it the median log productivity of the plant’s four-digit SIC industry.subtracting from it the median log productivity of the plant’s four-digit SIC industry.
Thus, the median plant in each industry has a score of zero on the horizontal axis.Thus, the median plant in each industry has a score of zero on the horizontal axis.
The vertical axis shows the share of plants with the indicated level of productivity.The vertical axis shows the share of plants with the indicated level of productivity.
These frequencies are weighted by plant employment; otherwise, tiny plants thatThese frequencies are weighted by plant employment; otherwise, tiny plants that
account for only a tiny fraction of total employment would dominate the figure.account for only a tiny fraction of total employment would dominate the figure.
To get a sense of the degree of productivity dispersion, consider the horizontalTo get a sense of the degree of productivity dispersion, consider the horizontal
axis of Figure 5 and suppose that log productivity at plant A is one unit higher than ataxis of Figure 5 and suppose that log productivity at plant A is one unit higher than at
plant B. This is equivalent to saying that plant A is three times more productive thanplant B. This is equivalent to saying that plant A is three times more productive than
plant B. If A is four units higher than B, then A is 50 times more productive than B.plant B. If A is four units higher than B, then A is 50 times more productive than B.44
Obviously, labor productivity as shown in Figure 5 is not an identical conceptObviously, labor productivity as shown in Figure 5 is not an identical concept
to the horizontal lines showing levels of marginal cost in the theoretical discussion.to the horizontal lines showing levels of marginal cost in the theoretical discussion.
When marginal costs are low, we typically expect productivity to be high. Therefore,When marginal costs are low, we typically expect productivity to be high. Therefore,
the inverse of marginal costs (1/the inverse of marginal costs (1/c) is often proxied in empirical work by productivity.) is often proxied in empirical work by productivity.
The productivity heterogeneity shown for Canadian manufacturing firms inThe productivity heterogeneity shown for Canadian manufacturing firms in
Figure 5 is a pervasive feature of all economies including, for example, the UnitedFigure 5 is a pervasive feature of all economies including, for example, the United
States (Bernard, Eaton, Jensen, and Kortum 2003), many European economiesStates (Bernard, Eaton, Jensen, and Kortum 2003), many European economies
(Mayer and Ottaviano 2008; Bartelsman, Hatiwanger, and Scarpetta 2009), as(Mayer and Ottaviano 2008; Bartelsman, Hatiwanger, and Scarpetta 2009), as
well as China and India (Hsieh and Klenow 2009). Wagner (2007) surveys relatedwell as China and India (Hsieh and Klenow 2009). Wagner (2007) surveys related
studies from countries all around the world, reporting similar patterns regardingstudies from countries all around the world, reporting similar patterns regarding
widespread firm heterogeneity within industries. Thus, the lessons derived from thiswidespread firm heterogeneity within industries. Thus, the lessons derived from this
example are not specific to the Canadian experience.example are not specific to the Canadian experience.
What caused the change from 1988 to 1996 in the productivity distribution ofWhat caused the change from 1988 to 1996 in the productivity distribution of
Canadian manufacturing firms? It was largely due to the reallocation mechanismsCanadian manufacturing firms? It was largely due to the reallocation mechanisms
across plants described above. The first of these mechanisms that we examine isacross plants described above. The first of these mechanisms that we examine is
4
Let φA and φB be productivities of A and B and suppose that they are 1 unit apart i.e., ln(φA) – ln(φB) = 1.
From the property of logs, φA/φB = e1
= 2.7 ≈ 3. For a difference of 4 units, e4
≈ 50. On a more technical
level, the figure is constructed starting with “standardized” log productivities (see the formula in Lileeva
2008, p. 369), which we then multiply by a single scale factor to transform the standardized log productivities
into log productivities that are directly comparable with log productivities reported in studies
from other countries.
Gains from Trade when Firms Matter 107
Figure 5
Distribution of Productivity across Canadian Manufacturing Plants before and
after the Canada–U.S. Free Trade Agreement
Source: Authors’ calculations using data from the Canadian Annual Survey of Manufactures.
Notes: The horizontal axes are based on a measure of the log of labor productivity. However, to ensure
that dispersion is driven by within-industry rather than between-industry differences in labor productivity,
we scale each plant’s log productivity by subtracting from it the median log productivity of the plant’s
four-digit SIC industry. Thus, the median plant in each industry has a score of zero on the horizontal
axis. The vertical axis shows the share of plants with the indicated level of productivity. These frequencies
are weighted by plant employment; otherwise, tiny plants that account for only a tiny fraction of total
employment would dominate the figure.
40%
30%
20%
10%
0%
Pre-FTA: Entrants
during 1980–88
FTA: Entrants
during 1988–96
–2 –1 0 1 2 3 4 5 6
B: Labor productivity distribution of entering Canadian manufacturing plants 1980–1988 and
1988–1996 (employment weighted)
A: Labor productivity distribution of all Canadian manufacturing plants 1988 and 1996
(employment weighted)
40%
30%
20%
10%
0%
1988
1996
–2 –1 0 1 2 3 4 5 6
–2 –1 0 1 2 3 4 5 6
Exporters, 1996
C: Labor productivity distribution of exporters and nonexporters, 1996 (employment weighted)
Nonexporters, 1996
40%
30%
20%
10%
0%
35%
25%
15%
5%
108 Journal of Economic Perspectives
the fall in the survival threshold of marginal cost—that is, the leftward shift ofthe fall in the survival threshold of marginal cost—that is, the leftward shift of c** inin
panel B of Figure 4. The empirical counterpart to a fall inpanel B of Figure 4. The empirical counterpart to a fall in c** is a rise in the break-is a rise in the breakeven
level of productivity. One can examine this mechanism by looking either ateven level of productivity. One can examine this mechanism by looking either at
exit rates or at entry rates. Since a plant may not exit until it has completed theexit rates or at entry rates. Since a plant may not exit until it has completed the
multiyear process of depreciating its fixed capital, it is best to look at entry rates,multiyear process of depreciating its fixed capital, it is best to look at entry rates,
which adjust more quickly to shocks such as a free trade agreement. Panel B ofwhich adjust more quickly to shocks such as a free trade agreement. Panel B of
Figure 5 displays the productivity levels of new entrants to Canadian manufacturingFigure 5 displays the productivity levels of new entrants to Canadian manufacturing
both for the pre-agreement period (1980–1988) and for the period immediatelyboth for the pre-agreement period (1980–1988) and for the period immediately
after the agreement came into force (1988–1996). There was a striking decline inafter the agreement came into force (1988–1996). There was a striking decline in
the entry rates of plants with productivity near or below the median. To use a sportsthe entry rates of plants with productivity near or below the median. To use a sports
analogy, in the earlier period many low-productivity plants made the cut and joinedanalogy, in the earlier period many low-productivity plants made the cut and joined
the team while in the later period a number of such low-productivity plants nothe team while in the later period a number of such low-productivity plants no
longer made the cut.longer made the cut.55
The pattern here is confirmed by more formal econometric analysis (specifi-The pattern here is confirmed by more formal econometric analysis (specifically,
binary-outcome regressions of exit on plant characteristics as well as industrycally, binary-outcome regressions of exit on plant characteristics as well as industry
and time controls). For example, Baggs (2005) and Baldwin and Gu (2006) showand time controls). For example, Baggs (2005) and Baldwin and Gu (2006) show
that the free trade agreement tariff cuts raised exit by a large amount. Lileevathat the free trade agreement tariff cuts raised exit by a large amount. Lileeva
(2008) estimates that the free trade agreement tariff cuts raised exit rates by as(2008) estimates that the free trade agreement tariff cuts raised exit rates by as
much as 16 percent, with all of the increase involving the exit of nonexporters.much as 16 percent, with all of the increase involving the exit of nonexporters.
Bernard, Jensen, and Schott (2006) find similar results for U.S. plants faced withBernard, Jensen, and Schott (2006) find similar results for U.S. plants faced with
U.S. tariff reductions.U.S. tariff reductions.
Trade Costs and the Export Decision
A central prediction of the theory is that in the presence of trade costs, onlyA central prediction of the theory is that in the presence of trade costs, only
low-cost, high-productivity firms export. Panel C of Figure 5 shows the distributionlow-cost, high-productivity firms export. Panel C of Figure 5 shows the distribution
of Canadian plants separately for exporters and nonexporters. Clearly, the distribu-of Canadian plants separately for exporters and nonexporters. Clearly, the distribution
for exporters is to the right of that for nonexporters. On average, Canadiantion for exporters is to the right of that for nonexporters. On average, Canadian
exporters are 40 percent more productive than nonexporters in the same industryexporters are 40 percent more productive than nonexporters in the same industry
(Baldwin and Gu 2003). Since the seminal work of Bernard and Jensen (1995), a(Baldwin and Gu 2003). Since the seminal work of Bernard and Jensen (1995), a
huge body of research covering dozens of countries has found this same pattern ofhuge body of research covering dozens of countries has found this same pattern of
higher productivity for exporters relative to nonexporters.higher productivity for exporters relative to nonexporters.66
5
Bernard and Jensen (1999), Trefler (2004), Lileeva (2008), and Lileeva and Trefler (2010) all point out
that one must look not just at pre-Free Trade Agreement levels (as in Figure 5), but also at pre-FTA trends.
All of the FTA results reported here hold with pre-FTA controls for both levels and trends. For example,
variants of some of the panels in Figure 5 with pre-FTA trend controls appear in Lileeva (2008).
6
In examining panel C of Figure 5, a critical reader may wonder why there are so many highly productive
nonexporters and whether this contradicts the theory. A simple but prominent example may help to
explain. Highly productive auto parts plants often cluster around a giant auto assembly plant—Ford,
General Motors, and Honda all have major auto assembly plants near Toronto, Canada, that are
surrounded by parts suppliers. These parts suppliers are highly productive, but do not directly export.
This pattern is clearly not a challenge to the theory: these highly productive plants are supplying parts
that are assembled into the autos that are ultimately exported to the United States: highly productive
parts suppliers are “indirect” exporters. Of course, there are surely other factors outside the scope of
our model that explain why some very productive firms do not export—and conversely—why some lowproductivity
firms export.
Marc J. Melitz and Daniel Trefler 109
A much more demanding prediction of the theory deals with who willA much more demanding prediction of the theory deals with who will start
exporting in response to falling trade costs. Panel B of Figure 4 shows that those who. Panel B of Figure 4 shows that those who
start exportingstart exporting will be among the most productive of those who never exportedbe among the most productive of those who never exported
before. To test this prediction, Lileeva and Trefler (2010) examined a samplebefore. To test this prediction, Lileeva and Trefler (2010) examined a sample
of over 5,000 Canadian manufacturing plants that had never exported prior toof over 5,000 Canadian manufacturing plants that had never exported prior to
the Canada–U.S. free trade agreement. A very large percentage of these plantsthe Canada–U.S. free trade agreement. A very large percentage of these plants
(40 percent) started exporting after the agreement came into force on January 1,(40 percent) started exporting after the agreement came into force on January 1,
1989. Lileeva and Trefler examine whether these plants started exporting because1989. Lileeva and Trefler examine whether these plants started exporting because
of the U.S. tariff cuts and, more importantly, whether those that started exportingof the U.S. tariff cuts and, more importantly, whether those that started exporting
because of the tariff cuts were more productive than nonexporters. To this end,because of the tariff cuts were more productive than nonexporters. To this end,
Lileeva and Trefler divide up their sample into quartiles of the 1988 distributionLileeva and Trefler divide up their sample into quartiles of the 1988 distribution
of labor productivity (with the quartiles defined separately for each industry to netof labor productivity (with the quartiles defined separately for each industry to net
out industry characteristics). Only 20 percent of the plants in the bottom quar-out industry characteristics). Only 20 percent of the plants in the bottom quartile
of labor productivity started exporting because of the tariff cuts, compared totile of labor productivity started exporting because of the tariff cuts, compared to
nearly 60 percent of the plants from the top quartile of labor productivity. (Thesenearly 60 percent of the plants from the top quartile of labor productivity. (These
estimates are from a probit regression in which the dependent variable is 1 if theestimates are from a probit regression in which the dependent variable is 1 if the
plant started exporting and 0 if the plant remained a nonexporter. The key inde-plant started exporting and 0 if the plant remained a nonexporter. The key independent
variable is a plant-specific measure of the change in the U.S. tariff. Thispendent variable is a plant-specific measure of the change in the U.S. tariff. This
measure is described below.) The key conclusion is that, among firms that did notmeasure is described below.) The key conclusion is that, among firms that did not
export before trade liberalization, the most productive of these were three timesexport before trade liberalization, the most productive of these were three times
more likely to start exporting in response to the U.S. tariff cuts. This is as predictedmore likely to start exporting in response to the U.S. tariff cuts. This is as predicted
in panel B of Figure 4.in panel B of Figure 4.77
Quantifying the Gains from Trade Due to Reallocation across Heterogeneous Plants
In the wake of the Canada–U.S. free trade agreement, Canadian manufacturingIn the wake of the Canada–U.S. free trade agreement, Canadian manufacturing
productivity rose sharply. We have shown that part of this productivity gain was dueproductivity rose sharply. We have shown that part of this productivity gain was due
to the reallocation mechanisms highlighted by the theory. But how important wereto the reallocation mechanisms highlighted by the theory. But how important were
these in quantitative terms for productivity growth and overall welfare?these in quantitative terms for productivity growth and overall welfare?
In the conventional approach to estimating the gains from trade, the focusIn the conventional approach to estimating the gains from trade, the focus
is on measuring welfare, or more specifically, on the income a society would beis on measuring welfare, or more specifically, on the income a society would be
willing to pay for lower tariffs. These “compensating variation” gains are typicallywilling to pay for lower tariffs. These “compensating variation” gains are typically
derived from models that 1) make a large number of parametric assumptionsderived from models that 1) make a large number of parametric assumptions
(assuming very specific functional forms for preferences that determine the(assuming very specific functional forms for preferences that determine the
extent of product differentiation, as well as for the utility derived from love-extent of product differentiation, as well as for the utility derived from loveof-variety),
and 2) make use of parameter estimates about which we are highlyof-variety), and 2) make use of parameter estimates about which we are highly
uncertain. In short, a lot of uncertainty surrounds welfare-gain estimates. In theuncertain. In short, a lot of uncertainty surrounds welfare-gain estimates. In the
heterogeneous-firms literature, the focus has shifted to estimating productivityheterogeneous-firms literature, the focus has shifted to estimating productivity
gains rather than welfare. The last two decades have seen major improvementsgains rather than welfare. The last two decades have seen major improvements
in our ability to estimate productivity gains, both because of the creation ofin our ability to estimate productivity gains, both because of the creation of
7
On a related note, profits play a key role in all the mechanisms of our model. Baggs and Brander (2006)
confirm that profits move in the expected directions. In particular, they find that falling Canadian tariffs
are associated with declining Canadian profits, especially for import-competing firms, while falling U.S.
tariffs are associated with increasing Canadian profits, especially for export-oriented firms.
110 Journal of Economic Perspectives
high-quality, firm-level longitudinal data and because of methodological develop-high-quality, firm-level longitudinal data and because of methodological developments
aimed at exploiting these data. Thus, although productivity gains are notments aimed at exploiting these data. Thus, although productivity gains are not
the same as welfare gains, we have much greater confidence in our estimates ofthe same as welfare gains, we have much greater confidence in our estimates of
the productivity gains associated with freer trade.the productivity gains associated with freer trade.
The productivity gains associated with the reallocation of market shares acrossThe productivity gains associated with the reallocation of market shares across
firms following the Canada–U.S. free trade agreement are usefully broken intofirms following the Canada–U.S. free trade agreement are usefully broken into
two components. First,two components. First, the fall in the U.S. tariffs allowed Canadian plants to exportallowed Canadian plants to export
more. This shifted the composition of output towards high-productivity exportersmore. This shifted the composition of output towards high-productivity exporters
and away from low-productivity nonexporters. Lileeva and Trefler (2010) estimateand away from low-productivity nonexporters. Lileeva and Trefler (2010) estimate
that the fall in U.S. tariffs causally raised Canadian manufacturing productivity bythat the fall in U.S. tariffs causally raised Canadian manufacturing productivity by
4.1 percent via this export-composition channel. Second,4.1 percent via this export-composition channel. Second, the fall in the Canadian
tariffs led to a shift in domestic market shares—exporters gained market share atled to a shift in domestic market shares—exporters gained market share at
the expense of nonexporters. In the extreme, many nonexporters simply went outthe expense of nonexporters. In the extreme, many nonexporters simply went out
of business. Trefler (2004) calculates that this selection effect increased overallof business. Trefler (2004) calculates that this selection effect increased overall
Canadian manufacturing productivity by 4.3 percent.Canadian manufacturing productivity by 4.3 percent.88
Putting these numbers together, we see that the reallocation and selectionPutting these numbers together, we see that the reallocation and selection
effects induced by the free trade agreement generated a productivity increase ofeffects induced by the free trade agreement generated a productivity increase of
8.4 percent (4.18.4 percent (4.1 ++ 4.3) for Canadian manufacturing. This represents a massive4.3) for Canadian manufacturing. This represents a massive
productivity increase in just a short time—especially when one considers that thisproductivity increase in just a short time—especially when one considers that this
productivity gain did not come from productivity improvements at the plant level: itproductivity gain did not come from productivity improvements at the plant level: it
only came from the shifting of market shares from less- to more-productive plants.only came from the shifting of market shares from less- to more-productive plants.
Canada is not the only country to have experienced such a substantial produc-Canada is not the only country to have experienced such a substantial productivity
boost from reallocations driven by trade liberalization. Bernard and Jensentivity boost from reallocations driven by trade liberalization. Bernard and Jensen
(2004) find that almost half of all U.S. manufacturing productivity growth during(2004) find that almost half of all U.S. manufacturing productivity growth during
1983–1992 is explained by the reallocation of resources towards exporters. Pavcnik1983–1992 is explained by the reallocation of resources towards exporters. Pavcnik
(2002) studies the response of the Chilean manufacturing sector to a massive trade(2002) studies the response of the Chilean manufacturing sector to a massive trade
liberalization episode that took place from 1979 to 1986. She finds that two-thirdsliberalization episode that took place from 1979 to 1986. She finds that two-thirds
of the ensuing 19 percent increase in productivity (another example of a massiveof the ensuing 19 percent increase in productivity (another example of a massive
increase in aggregate productivity) was generated by composition changes withinincrease in aggregate productivity) was generated by composition changes within
industries due to a reallocation of market shares towards more-efficient producers.industries due to a reallocation of market shares towards more-efficient producers.
Surveys by Greenaway and Kneller (2007) and Wagner (2007) summarize theSurveys by Greenaway and Kneller (2007) and Wagner (2007) summarize the
connections between trade liberalization and aggregate productivity—includingconnections between trade liberalization and aggregate productivity—including
this reallocation effect across heterogeneous firms—for a wide range of studiesthis reallocation effect across heterogeneous firms—for a wide range of studies
and countries.and countries.
8
Specifically, Trefler (2004) regressed labor productivity growth in the period after the free trade
agreement (relative to the pre–agreement period) on U.S. and Canadian tariff cuts mandated by the
agreement. He then showed that the Canadian tariff cuts raised productivity at the industry level, but
not at the plant level. This means that the gains in productivity were coming from selection, rather than
from improvements at the plant level. Using this approach, he finds that the free trade agreement raised
Canadian manufacturing labor productivity by 5.8 percent of which 4.3 percent was due to the exit
associated with the Canadian tariff cuts.
Gains from Trade when Firms Matter 111
Gains from Rising Within-Plant Productivity
In this section, we move from this “between-plant” effect in which productiveIn this section, we move from this “between-plant” effect in which productive
plants expand at the expense of less-productive plants to our third source of gainsplants expand at the expense of less-productive plants to our third source of gains
from trade: a “within-plant” effect in which trade raises productivity of individualfrom trade: a “within-plant” effect in which trade raises productivity of individual
plants by raising the returns to innovation.plants by raising the returns to innovation.
At least as far back as Schmookler (1954), economists have known that the largerAt least as far back as Schmookler (1954), economists have known that the larger
the market, the more profitable it is for firms to invest in productivity-enhancingthe market, the more profitable it is for firms to invest in productivity-enhancing
activities. Firms in large markets have the large sales volumes needed to justify incur-activities. Firms in large markets have the large sales volumes needed to justify incurring
the high fixed costs of innovation. The U.S. tariff cuts that were part of thering the high fixed costs of innovation. The U.S. tariff cuts that were part of the
U.S.–Canada free trade agreement greatly increased the size of the market faced byU.S.–Canada free trade agreement greatly increased the size of the market faced by
Canadian firms. It should therefore have encouraged Canadian firms to increaseCanadian firms. It should therefore have encouraged Canadian firms to increase
their exportingtheir exporting and to increase their investments in productivity-enhancing tech-to increase their investments in productivity-enhancing technologies.
We start here with a short extension to the theoretical model that capturesnologies. We start here with a short extension to the theoretical model that captures
how larger markets generate incentives for some firms to innovate, and then turnhow larger markets generate incentives for some firms to innovate, and then turn
to empirical evidence.to empirical evidence.
A Theory of Market Size and Firm Innovation
Suppose that an innovation process requires an up-front fixed costSuppose that an innovation process requires an up-front fixed cost fII andand
in return generates ain return generates a reduction in marginal costin marginal cost ΔΔcII. That is, innovation reduces. That is, innovation reduces
marginal cost frommarginal cost from c toto c −− ΔΔcII. A firm that produces. A firm that produces q units of output and engagesunits of output and engages
in innovation will lower its production costs byin innovation will lower its production costs by q ×× ΔΔcII. The firm will weigh this cost. The firm will weigh this cost
saving against the fixed innovation costsaving against the fixed innovation cost fII , and innovate if, and innovate if q ×× ΔΔcII >> fII oror
q >
fI_
ΔcI
.
In words, only firms with large volumes q (that is, those with initially lower levels of
marginal cost) will find it profitable to innovate. What happens to this firm-level
innovation decision when trade is liberalized? Lower trade costs increase an exporter’s
sales in the export market, and thus increase the exporter’s overall output level
q. For some exporters, this increase in output will tip the balance in favor of innovating.
For some nonexporters, trade liberalization will tip the balance in favor of
exporting and innovating.
Evidence on Within-Firm Productivity Growth and Trade
For evidence on the link from growth of trade to within-firm productivity,For evidence on the link from growth of trade to within-firm productivity,
we turn again to Canada’s experience with the free trade agreement. Lileeva andwe turn again to Canada’s experience with the free trade agreement. Lileeva and
Trefler (2010) look at their sample of 5,000 Canadian manufacturing plants that didTrefler (2010) look at their sample of 5,000 Canadian manufacturing plants that did
not export prior to 1988 and divide these plants into those that started exportingnot export prior to 1988 and divide these plants into those that started exporting
after the passage of the free trade agreement and those that did not. In the raw data,after the passage of the free trade agreement and those that did not. In the raw data,
the labor productivity of those that started to export rose 29 percent more than forthe labor productivity of those that started to export rose 29 percent more than for
nonexporters; starting to export was highly correlated with within-plant productivitynonexporters; starting to export was highly correlated with within-plant productivity
growth. Of course, this 29 percent number does not take into account a seriousgrowth. Of course, this 29 percent number does not take into account a serious
112 Journal of Economic Perspectives
problem of reverse causality: does exporting lead to increased productivity or doesproblem of reverse causality: does exporting lead to increased productivity or does
increased productivity lead to exporting?increased productivity lead to exporting?
To answer this question, one needs an instrument for exporting: that is, oneTo answer this question, one needs an instrument for exporting: that is, one
needs an event that causes a firm to export but that does not directly affect itsneeds an event that causes a firm to export but that does not directly affect its
productivity growth. As Lileeva and Trefler (2010) show, “plant-specific” tariff cutsproductivity growth. As Lileeva and Trefler (2010) show, “plant-specific” tariff cuts
fit the bill as an instrument. Consider a single Canadian plant called Lumber-fit the bill as an instrument. Consider a single Canadian plant called Lumberjack
and the many products it produces. Empirically, products are defined veryjack and the many products it produces. Empirically, products are defined very
narrowly, at the six-digit level of the Harmonized System product classification, sonarrowly, at the six-digit level of the Harmonized System product classification, so
that there are thousands of products in manufacturing. For each product producedthat there are thousands of products in manufacturing. For each product produced
by Lumberjack, one can calculate the U.S. tariff cut. Averaging these tariff cutsby Lumberjack, one can calculate the U.S. tariff cut. Averaging these tariff cuts
across all of Lumberjack’s products yields a plant-specific tariff cut. This plant-across all of Lumberjack’s products yields a plant-specific tariff cut. This plantspecific
tariff cut has enormous power in predicting whether a Canadian plantspecific tariff cut has enormous power in predicting whether a Canadian plant
starts exporting and how much it exports. The tariff cut also has no direct impactstarts exporting and how much it exports. The tariff cut also has no direct impact
either theoretically or empirically on a plant’s productivity growth. It is thus a noveleither theoretically or empirically on a plant’s productivity growth. It is thus a novel
and valid instrument.and valid instrument.
Lileeva and Trefler (2010) actually do something fancier than instrumentalLileeva and Trefler (2010) actually do something fancier than instrumental
variables—they estimate the local average treatment effect (LATE). This is thevariables—they estimate the local average treatment effect (LATE). This is the
effect on productivity of starting to exporteffect on productivity of starting to export for those plants that started exporting because
of the tariff cuts. Thus, unlike previous studies of the causal impacts of exporting on. Thus, unlike previous studies of the causal impacts of exporting on
productivity, their work only uses information drawn from plants that were likelyproductivity, their work only uses information drawn from plants that were likely
to be affected by the free trade agreement. Using their plant-specific tariff instru-to be affected by the free trade agreement. Using their plant-specific tariff instrument
and the local average treatment effect estimator, they establish that the freement and the local average treatment effect estimator, they establish that the free
trade agreementtrade agreement caused the productivity of new exporters to rise by 15.3 percent.the productivity of new exporters to rise by 15.3 percent.
Since this 15.3 percent rise occurred in plants that accounted for 23 percent ofSince this 15.3 percent rise occurred in plants that accounted for 23 percent of
Canadian manufacturing output, the 15.3 percent rise in labor productivityCanadian manufacturing output, the 15.3 percent rise in labor productivity
of new exporters raisedof new exporters raised overall Canadian manufacturing productivity by 3.5 percentCanadian manufacturing productivity by 3.5 percent
(3.5(3.5 == 15.315.3 ×× 0.23; see Table 2 below).0.23; see Table 2 below).
Lileeva and Trefler (2010) then trace the sources of this productivity gainLileeva and Trefler (2010) then trace the sources of this productivity gain
back to investments in productivity. The authors examine advanced manufacturingback to investments in productivity. The authors examine advanced manufacturing
technologies and rates of innovation at these plants. Table 1 presents the results.technologies and rates of innovation at these plants. Table 1 presents the results.
Consider the first row, which deals with management techniques essentially associ-Consider the first row, which deals with management techniques essentially associated
with lean manufacturing. In the period immediately after implementation ofated with lean manufacturing. In the period immediately after implementation of
the free trade agreement, 16 percent of new exporters adopted such techniques,the free trade agreement, 16 percent of new exporters adopted such techniques,
10 percentage points more than nonexporters did. The final column, which reports10 percentage points more than nonexporters did. The final column, which reports
local average treatment effect (LATE) estimates, shows that 7 of the 10 percentagelocal average treatment effect (LATE) estimates, shows that 7 of the 10 percentage
points was attributable to the effects of increased exporting resulting from the U.S.points was attributable to the effects of increased exporting resulting from the U.S.
tariff cuts. As shown in Table 1, similar results hold for the adoption of other tech-tariff cuts. As shown in Table 1, similar results hold for the adoption of other technologies
and for innovation.nologies and for innovation.
These results break with the discussion of Bernard, Jensen, Redding, and SchottThese results break with the discussion of Bernard, Jensen, Redding, and Schott
(2007) in this journal, who correctly argue that most careful studies show exporting(2007) in this journal, who correctly argue that most careful studies show exporting
does not raise productivity. Over the years, however, a few careful studies have foundraise productivity. Over the years, however, a few careful studies have found
otherwise, as in Canada (Baldwin and Gu 2003, 2004; Lileeva 2008), in nine Africanotherwise, as in Canada (Baldwin and Gu 2003, 2004; Lileeva 2008), in nine African
countries (Van Biesebrock 2005), and in Slovenia (De Loecker 2007). López (2005)countries (Van Biesebrock 2005), and in Slovenia (De Loecker 2007). López (2005)
provides an overall survey.provides an overall survey.
Marc J. Melitz and Daniel Trefler 113
What has recently buttressed the minority view that a rise in exporting canWhat has recently buttressed the minority view that a rise in exporting can
lead to a rise in productivity is a spate of papers isolating the causal mechanismslead to a rise in productivity is a spate of papers isolating the causal mechanisms
through which exporting affects productivity. We have already seen the market-sizethrough which exporting affects productivity. We have already seen the market-size
mechanism of Lileeva and Trefler (2010). Bustos (2011a, b) develops a relatedmechanism of Lileeva and Trefler (2010). Bustos (2011a, b) develops a related
model of scale-biased technology choice, which she takes to Argentinean firm-levelmodel of scale-biased technology choice, which she takes to Argentinean firm-level
data for the 1992–1996 period. Bustos (2011b, table 6) shows that firms that begandata for the 1992–1996 period. Bustos (2011b, table 6) shows that firms that began
exporting between 1992 and 1996 also increased their technology spending. Bustosexporting between 1992 and 1996 also increased their technology spending. Bustos
(2011a) shows that technology spending increased most in sectors that experi-(2011a) shows that technology spending increased most in sectors that experienced
improved access to Brazilian product markets (through the tariff cuts in theenced improved access to Brazilian product markets (through the tariff cuts in the
Mercosur regional trade agreement). In a series of studies of Taiwanese electronicsMercosur regional trade agreement). In a series of studies of Taiwanese electronics
exporters, Aw, Roberts, and Winston (2007) and Aw, Roberts, and Xu (2008, 2011)exporters, Aw, Roberts, and Winston (2007) and Aw, Roberts, and Xu (2008, 2011)
show empirically that there is a complex dynamic interplay between the decisionsshow empirically that there is a complex dynamic interplay between the decisions
to export and conduct research and development, with today’s decisions aboutto export and conduct research and development, with today’s decisions about
one affecting tomorrow’s decisions about the other—and both affecting futureone affecting tomorrow’s decisions about the other—and both affecting future
productivity. Extending this dynamic methodology to general equilibrium, Shenproductivity. Extending this dynamic methodology to general equilibrium, Shen
(2011) also finds strong complementarities between exporting and productivity-(2011) also finds strong complementarities between exporting and productivityenhancing
investments among Spanish firms. Bloom, Draca, and Van Reenenenhancing investments among Spanish firms. Bloom, Draca, and Van Reenen
(2011) show that import competition from China has led to increases in R&D,(2011) show that import competition from China has led to increases in R&D,
patenting, information technology, and total factor productivity among more tech-patenting, information technology, and total factor productivity among more technologically
advanced European firms. Atkeson and Burstein (2010) are the onlynologically advanced European firms. Atkeson and Burstein (2010) are the only
ones to examine exporting and investing in productivity within a full-blown generalones to examine exporting and investing in productivity within a full-blown general
equilibrium analysis. They find the general equilibrium feedbacks are important.equilibrium analysis. They find the general equilibrium feedbacks are important.
A New Dimension of Heterogeneity
In our theoretical model above, firms below a certain productivity thresholdIn our theoretical model above, firms below a certain productivity threshold
should not be exporting. Yet in the empirical work reviewed above, we saw thatshould not be exporting. Yet in the empirical work reviewed above, we saw that
many low-productivity Canadian plants started exporting in response to U.S. tariffmany low-productivity Canadian plants started exporting in response to U.S. tariff
cuts. There is a second puzzle that we have not yet noted: Lileeva and Trefler (2010,cuts. There is a second puzzle that we have not yet noted: Lileeva and Trefler (2010,
table 3) report that the plants that gained most from starting to export (both intable 3) report that the plants that gained most from starting to export (both in
terms of productivity gains and increased innovation) were primarily plants thatterms of productivity gains and increased innovation) were primarily plants that
Table 1
Innovation Response to Free Trade Agreement by New Exporters
Raw adoption and innovation rates LATE
New exporters Nonexporters Difference Difference
Manufacturing information systems 16% 6% 10% 7%
Inspection and communications 18% 10% 8% 8%
Any product or process innovation 30% 20% 10% 8%
Any product innovation 26% 14% 12% 7%
Source: Lileeva and Trefler (2010).
Note: “LATE” is the local average treatment effect.
114 Journal of Economic Perspectives
initially had low productivity. That is, among plants that started to export, theinitially had low productivity. That is, among plants that started to export, the
benefit was greatest for the least-productive plants.benefit was greatest for the least-productive plants.
To see why, consider a firm that is just indifferent between investing and notTo see why, consider a firm that is just indifferent between investing and not
investing. From the earlier equation, indifference means thatinvesting. From the earlier equation, indifference means that q == fII //44cII, where, where
44cII is the reduction in marginal cost or the increase in productivity. Rearrangingis the reduction in marginal cost or the increase in productivity. Rearranging
((44cII == fII //q) and noting that sales) and noting that sales q are increasing in initial productivity, we arriveare increasing in initial productivity, we arrive
at a simple conclusion.at a simple conclusion. Among the set of firms that are just indifferent between innovating
and not innovating, the less-productive, low-, the less-productive, low-q firms must expect larger productivityfirms must expect larger productivity
gainsgains 44cII from innovation. Lileeva and Trefler’s (2010) results strongly confirmfrom innovation. Lileeva and Trefler’s (2010) results strongly confirm
this prediction.this prediction.
Conclusions
Recent research into the welfare gains from intra-industry trade have focusedRecent research into the welfare gains from intra-industry trade have focused
on three sources of gains: 1) gains from increased variety and economies of scale,on three sources of gains: 1) gains from increased variety and economies of scale,
2) productivity gains at the industry level from shifting resources away from low-2) productivity gains at the industry level from shifting resources away from lowproductivity
firms and towards high-productivity firms, and 3) productivity gains atproductivity firms and towards high-productivity firms, and 3) productivity gains at
the firm level from innovating for a larger market. Each of these mechanisms havethe firm level from innovating for a larger market. Each of these mechanisms have
proven to be highly important empirically in the context of the exhaustively studiedproven to be highly important empirically in the context of the exhaustively studied
Canada–U.S. free trade agreement, and also appear important in many other less-Canada–U.S. free trade agreement, and also appear important in many other lessstudied
contexts. Indeed, Balistreri, Hillberry, and Rutherford (2011) show thatstudied contexts. Indeed, Balistreri, Hillberry, and Rutherford (2011) show that
adding firm heterogeneity to standard computable equilibrium models of trade raisesadding firm heterogeneity to standard computable equilibrium models of trade raises
the gains from trade liberalization by a multiple of four. Empirical confirmation ofthe gains from trade liberalization by a multiple of four. Empirical confirmation of
the gains from trade predicted by models with heterogeneous firms represents onethe gains from trade predicted by models with heterogeneous firms represents one
of the truly significant advances in the field of international economics.of the truly significant advances in the field of international economics.
We summarize the causal effects of the free trade agreement on overallWe summarize the causal effects of the free trade agreement on overall
Canadian manufacturing productivity in Table 2. As the last row shows, CanadianCanadian manufacturing productivity in Table 2. As the last row shows, Canadian
manufacturing labor productivity rose by 13.8 percent. The idea that a singlemanufacturing labor productivity rose by 13.8 percent. The idea that a single
government policy could raise productivity by such a large amount and in such agovernment policy could raise productivity by such a large amount and in such a
short time-span is truly remarkable.short time-span is truly remarkable.
In writing this review, we have focused on the net gains from trade. Yet the modelIn writing this review, we have focused on the net gains from trade. Yet the model
we have developed highlights how intra-industry trade will generate both winnerswe have developed highlights how intra-industry trade will generate both winners
and losers. For example, in the context of the Canada–U.S. free trade agreement,and losers. For example, in the context of the Canada–U.S. free trade agreement,
Trefler (2004) shows that 12 percent of the workers in low-productivity firms lostTrefler (2004) shows that 12 percent of the workers in low-productivity firms lost
their jobs. Recent research suggests that American workers are similarly strugglingtheir jobs. Recent research suggests that American workers are similarly struggling
in response to the Chinese import surge (Liu and Trefler 2011; Autor, Dorn, andin response to the Chinese import surge (Liu and Trefler 2011; Autor, Dorn, and
Hanson 2011). Clearly, this suggests an important role for policies that provide anHanson 2011). Clearly, this suggests an important role for policies that provide an
adequate safety net and transitional assistance for those affected workers. The blowadequate safety net and transitional assistance for those affected workers. The blow
to those workers could be cushioned by policies that impede the reallocation processto those workers could be cushioned by policies that impede the reallocation process
across firms. However, such policies—as opposed to policies that provide some formacross firms. However, such policies—as opposed to policies that provide some form
of direct assistance to the affected workers—would also entail a substantial long-runof direct assistance to the affected workers—would also entail a substantial long-run
cost. After all, it is precisely this reallocation process that generates some of thecost. After all, it is precisely this reallocation process that generates some of the
long-run gains that we have described. In addition, policies that seek to impede thelong-run gains that we have described. In addition, policies that seek to impede the
Gains from Trade when Firms Matter 115
reallocation process by making firm contractions and expansions costlier would alsoreallocation process by making firm contractions and expansions costlier would also
reduce the potential gains to firm innovation and hence lead to less innovation andreduce the potential gains to firm innovation and hence lead to less innovation and
further depress the potential long-run gains from trade. Nonetheless, it is importantfurther depress the potential long-run gains from trade. Nonetheless, it is important
to remember that there are winners and losers from trade liberalization not justto remember that there are winners and losers from trade liberalization not just
among firms, but also among their employees.among firms, but also among their employees.
■ Trefler gratefully acknowledges funding from the Social Sciences and Humanities Research
Council of Canada (SSHRC) and the Canadian Institute for Advanced Research (CIFAR).
His research would not have been possible without the tremendous support of John Baldwin
and Alla Lileeva. We thank the editors (David Autor, Chad Jones, John List, and Timothy
Taylor) for their invaluable comments.
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Table 2
Overall Effect of Free Trade Agreement on Canadian
Manufacturing Productivity
Selection/reallocation (between plants)
Growth of exporters (most-productive plants) 4.1%
Contraction and exit of least-productive plants 4.3%
Within-plant growth
New exporters invest in raising productivity 3.5%
Existing exporters invest in raising productivity 1.4%
Improved access to U.S. intermediate inputs 0.5%
Total 13.8%
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