Trade Policy Under Firm-Level Heterogeneity in a Small Economy

33 Pages Posted: 21 Dec 2007 Last revised: 27 Nov 2022

See all articles by Svetlana A. Demidova

Svetlana A. Demidova

Department of Economics, McMaster University

Andrés Rodríguez-Clare

University of California, Berkeley - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: December 2007

Abstract

In this paper we explore the effect of trade policy on productivity and welfare in the now standard model of firm-level heterogeneity and product differentiation with monopolistic competition. To obtain sharp results, we restrict attention to an economy that takes as given the price of imports and the demand schedules for its exports (a "small economy"). We first establish that welfare can be decomposed into four terms: productivity, terms of trade, variety and curvature, where the latter is a term that captures heterogeneity across varieties. We then show how a consumption subsidy, an export tax, or an import tariff allow our small economy to deal with two distortions that we identify and thereby reach its first best allocation. We also show that an export subsidy generates an increase in productivity, but given the negative joint effect on the other three terms (terms of trade, variety and curvature), welfare falls. In contrast, an import tariff improves welfare in spite of the fact that productivity falls.

Suggested Citation

Demidova, Svetlana A. and Rodríguez-Clare, Andrés, Trade Policy Under Firm-Level Heterogeneity in a Small Economy (December 2007). NBER Working Paper No. w13688, Available at SSRN: https://ssrn.com/abstract=1077814

Svetlana A. Demidova

Department of Economics, McMaster University ( email )

1280 Main Street West
Hamilton, Ontario L8S 4M4
Canada

Andrés Rodríguez-Clare (Contact Author)

University of California, Berkeley - Department of Economics ( email )

579 Evans Hall
Berkeley, CA 94709
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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