Trade competition and reallocations in a small open economy

Abstract

In this chapter, I develop a simple model of firm heterogeneity with endogenous markups. The endogenous markups stem from preferences that feature variable elasticities of substitution (VES) in a monopolistically competitive environment. Although the model is kept general along some key dimensions (both preferences and technology heterogeneity are left un-parametrized), I show how it is still amenable to simple, mostly graphical, comparative statics analyses of asymmetric trade liberalization (for either imports or exports) by applying these to the case of a “small” open economy.1 The comparative statics analyses for trade liberalization are applied to describe both short-run and long-run effects of liberalization – where the latter allows for a response of firm entry to liberalization. These effects are described both in a partial equilibrium setting where wages in a given sector are fixed and trade need not be balanced; as well as in a general equilibrium setting where wages across countries adjust to balance trade. Although the preferences are left unparametrized, they are restricted to a broad class of additively separable preferences that generates predictions for markups under monopolistic competition that are consistent with a large set of established empirical patterns. These patterns include evidence for markup differences across firms (larger firms set larger markups), as well as for changes in markups associated with incomplete pass-through of cost changes into prices.2 A substantial portion of the theoretical trade literature analyzing the response of heterogeneous exporters assumes constant markups – based on the assumptions of constant elasticity of substitution ∗I thank Xiang Ding for superb research assistance, and Gene Grossman and Lili Yan Ing for their comments and feedback. Demidova and Rodríguez-Clare (2013) show how to extend the standard competitive version of a small open economy to the case of product differentiation and imperfect competition with heterogeneous producers. This is the same version that is applied here. See the evidence reviewed in De Loecker and Goldberg (2014), Burstein and Gopinath (2014).