International Trade

Lecture 4: the Melitz model of trade

Thomas Chaney

Sciences Po

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Empirical challenge to Krugman

There is a lot of heterogeneity across firms, within any sector.

Very few firms export (import, engage in FDI).
Exporters are very different from non exporters.
There is a lot of reallocation between firms within sectors.

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Intensive and extensive margins of trade

One can decompose aggregate trade flows into two margins,

Intensive margin (exports per firm)
Extensive margin (number of exporters)
Xij
Xij = lij Xj with lij ⌘ Xj
Xij = Nij x̄ij with x̄ij = N1ij  xij (w )

ln Nij = aN + b N ln lij + gN ln Xj + # ij
ln x̄ij = ax̄ + b x̄ ln lij + gx̄ ln Xj + hij

Eaton, Kortum and Kramarz (2004) find,

bN = 1 b x̄ = .875
gN = 1 gx̄ = .617

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Melitz model: assumptions

Heterogeneity assumptions
Firms differ in labor productivity
Productivity is random, unobserved before firm starts.
Trade barrier assuptions
Firms face iceberg (variable) trade costs.
Firms face fixed export costs.
Simplifying assuption
Symmetric countries, so that w = w ⇤ = 1.

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Preferences (as in Krugman)

✓ˆ ◆ ss1
s 1
max U ⌘ q (w ) dw s
q (w ) W
ˆ
s.t. p (w ) q (w ) d w = R
W

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Demand (as in Krugman)

✓ ◆ s
p (w ) R
q (w ) =
P P
✓ˆ ◆ 11s
with P = p ( w )1 s d w
W

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Technology and pricing (almost as in Krugman)

Increasing returns to scale technology:

q
l (q, j) = f +
j

Note: firm level productivity j will differ across firms.

Iso-elastic demand ) constant mark-up over marginal cost:
s 1
p ( j) = , 8w s.t. j (w ) = j
s 1j

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Profits

Profits increase with productivity,

✓ ◆s 1
s 1 R
p ( j) = jP f
s s

Note: low productivity ( j ! 0) firms exit to avoid negative profits.

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Aggregation

Endogenous mass of firms, M.

Endogenous distribution of productivities, µ ( j) d j.
Convenient "aggregate" productivity,
✓ˆ • ◆ s11
s 1
j̃ = j µ ( j) d j
0

Aggregate variables (prices, revenue, profits),

1
P = M 1 s p ( j̃)
R = Mr ( j̃)
P = Mp ( j̃)

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Entry and exit

Free entry: fixed entry cost f E , then draw productivity j from p.d.f.
g (·) over R + .
Exogenous exit from Poisson death shock with probability d.
Endogenous exit if negative profits. All firms j < j̄ exit,

p ( j⇤ ) = 0

Endogenous productivity distribution

(
g ( j)
1 G ( j⇤ )
if j j⇤
µ ( j) =
0 otherwise,

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"Zero cutoff profits" condition

"Average" productivity,
! s11
•
1
ˆ
1
j̃ ( j⇤ ) = js g ( j) d j
1 G ( j⇤ ) j⇤

Average profits are profits of the "average" firm, p̄ = p ( j̃ ( j⇤ )).

Profits of the marginal firm directly related to average profits,
"✓ #
j̃ ( j ⇤ ) ◆s 1
p ( j⇤ ) = 0 , p̄ = f 1 (ZCP)
j⇤

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Endogenous entry

Value of entering is expected stream of profits minus entry cost,

" #
•
1 G ( j⇤ )
v E = E Â (1 d ) p ( j ) f E =
t
p̄ f E
t =0 d

Free entry drives down expected profits to zero,

vE  0 (FE )

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General equilibrium

Firms below j⇤ exit (ZCP ).

Free entry drives down (expected) profits to zero (FE ).
Labor markets clear (LMC ).
8 ⇣ ⌘
8 >
> j̃( j⇤ ) s 1
⇤
< p (j ) = 0 (Zero Cutoff Profits) >
< p̄ = f j⇤ 1
vE = 0 (Free Entry) , p̄ = 1 df
E
: >
> G ( j⇤ )
R=L (Labor Market Clearing) >
: M = s(p̄L+f )

(ZCP ) and (FE ) solve for j⇤ and p̄; (LMC ) and p̄ solve for M.

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Ownership structure

dM
Stationary equilibrium: exit mass = entry mass: M E = 1 G ( j̄)
.
Expected profits of firm owners cover the financing of entrants:
f E M E = P.
All firms owned by a continuum of competitive mutual funds that hold
diversified portfolios of firms.
Note: no financing frictions.

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Variable and fixed trade costs

Iceberg trade cost: t.

Fixed export cost: F X = Ât•=0 (1 d)t f X = f X /d.

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Selection into exporting

s 1j s 1 R
Export profits: p X ( j) = s tP s f X.
Note: low productivity firms ( j ! 0) do not export to avoid negative
profits.
⇤ export,
Only firms with productivity above jX
✓ ◆ s11
fX
p X
( jX⇤ ) =0, ⇤
jX =t j̄ (ZCP X )
f

Empirically motivated restriction:

✓ ◆ s11
fX
t > 1 ) jX⇤ > j⇤
f

so that not all firms export.

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Trade equilibrium

Profits derived from domestic and export sales,

1 ⇤)
G ( jX
p̄ = p D ( j⇤ ) + prob X p X ( jX
⇤
) , with prob X =
1 G ( j⇤ )

Equilibrium determined by,

8 ⇣ ⌘ 1
>
> ⇤ = t f X s 1 j⇤
> jX
> ZCP X
>
> ✓h f i ◆ ✓h i ◆
>
< j̃( j⇤ ) s 1 j̃( jX⇤) s 1
p̄ = f 1 + X X 1
j ⇤ prob f j ⇤ (ZCP )
>
> df E
>
> p̄ = 1 G ( j⇤ ) (FE )
>
>
>
: M = s(p̄ +f +LprobX f X ) (LMC )

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Trade and aggregate productivity

Opening up to trade induces reallocation towards more productive

firms.
Aggregate productivity goes up.

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