Introducing Melitz-Style Firm Heterogeneity in CGE Models: Technical Aspects and Implications

This paper discusses which changes in the architecture of a standard CGE model are needed in order to introduce effects of trade and firm heterogeneity a la Melitz. Starting from a simple specification with partial equilibrium, one primary production factor and one industry, the framework is progressively enriched by including multiple factors, intermediate inputs, multiple industries (with a mixture of differentiated and non- differentiated products), and a real general equilibrium closure. Therefore, the model structure is gradually made similar to a full-fledged CGE. Calibration techniques are discussed, and a number of changes from the original Melitz’s assumptions are also proposed. It is argued that the inclusion of industries with heterogeneous firms in a CGE framework does not simply make the Melitz model “operational”, but allows accounting for structural effects that may significantly affect the nature, meaning and implications of the model results. For example, the typical experiment of lowering trade barriers, leading to firm selection and aggregate productivity gains in Melitz (2003), now also triggers a reallocation of production among industries and a change in relative returns of primary factors, as it is typical in multi-sectoral general equilibrium models. An increase in the number of exporting firms, for instance, generates an additional demand for services in both the origin and destination countries, because of variable and fixed trade costs. Arkolakis, Costinot and Rodriguez-Clare (2012) obtain an equivalence result according to which, despite the fact that new theories have identified additional sources of trade gains, from an empirical perspective and conditional on observed trade data, the total size of the gains from trade may turn out to be the same as that predicted by old-style models. Balistreri, Hillberry and Rutherford (2011) argue that this equivalence may hold in one-good one-factor environments, but does not hold anymo...