Gains from Trade When Firms Matter

Journal of Economic Perspectives—Volume 26, Number 2—Spring 2012—Pages 91–118

Gains from Trade when Firms Matter

Marc J. Melitz and Daniel Trefl er

hhee ggainsains ffromrom llong-distanceong-distance iinternationalnternational ttraderade hhaveave bbeeneen uunderstoodnderstood aandnd eexploitedxploited sincesince prehistoricprehistoric times.times. OurOur ppre-urbanre-urban ancestorsancestors werewere bbenefienefi t-t- T ttinging ffromrom llong-distanceong-distance tradetrade inin obsidianobsidian somesome 10,00010,000 yearsyears ago;ago; Plato’sPlato’s AAcademycademy wwasas bbuiltuilt oonn tthehe pprofirofi tsts ofof AthenianAthenian silversilver exports;exports; andand RomeRome waswas notnot builtbuilt iinn a ddayay ppartlyartly bbecauseecause ggoodsoods mmovedoved ttoooo sslowlylowly iinn tthehe vvastast RRomanoman ttraderade nnetwork.etwork. BButut whereaswhereas tradetrade waswas onceonce dominateddominated byby thethe movementmovement ofof goodsgoods thatthat couldcould oonlynly bbee pproduced,roduced, harvested,harvested, oror minedmined regionally,regionally, thethe internationalinternational tradetrade landscapelandscape iiss nownow dominateddominated byby twotwo strikingstriking facts.facts. TheThe fi rstrst isis thethe riserise ofof intra-industryintra-industry trade—trade— tthathat iis,s, ttwo-waywo-way ttraderade iinn ssimilarimilar pproducts.roducts. CChinesehinese cconsumersonsumers ccanan nnowow bbuyuy a mmidsizeidsize ccarar fromfrom ToyotaToyota (Japan),(Japan), KiaKia (Korea),(Korea), GeneralGeneral MotorsMotors (United(United States),States), andand CheryChery ((China).China). DittoDitto forfor consumersconsumers inin Japan,Japan, Korea,Korea, andand thethe UnitedUnited States.States. TheThe secondsecond sstrikingtriking factfact isis thatthat worldworld tradetrade isis dominateddominated byby huge,huge, innovative,innovative, andand extraordi-extraordi- nnarilyarily productiveproductive fi rms.rms. ForFor example,example, IntelIntel isis soso largelarge thatthat itit isis tthehe llargestargest industrialindustrial eemployermployer inin bothboth OregonOregon andand NewNew MexicoMexico andand accountsaccounts forfor 2020 percentpercent ofof CostaCosta RRica’sica’s exports.exports. China’sChina’s FoxconnFoxconn infamouslyinfamously employsemploys 450,000450,000 workersworkers inin a single oneone ooff iitsts mmanyany eexport-orientedxport-oriented eelectronicslectronics factories.factories. TheseThese areare bigbig companiescompanies . . . andand iiff yyouou aarere rreadingeading tthishis ddocumentocument oonn aann AApplepple computercomputer youyou knowknow thatthat therethere areare ootherther llargearge ccompanies,ompanies, ttoo.oo. TThehe risingrising prominenceprominence ofof intra-industryintra-industry tradetrade andand hugehuge multinationalsmultinationals hashas ttransformedransformed thethe wayway economistseconomists thinkthink aboutabout thethe gainsgains fromfrom trade.trade. InIn thethe past,past, wewe ffocusedocused onon gainsgains thatthat stemmedstemmed eithereither fromfrom endowmentendowment differencesdifferences (wheat(wheat forfor

■ Marc J. Melitz is the David A. Wells Professor of Political Economy, Harvard University, Cambridge, Massachusetts. Daniel Trefl er 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 92 Journal of Economic Perspectives

iironron ore)ore) oror inter-industryinter-industry comparativecomparative advantageadvantage (David(David Ricardo’sRicardo’s classicclassic exampleexample ooff clothcloth forfor port).port). Today,Today, wewe focusfocus onon threethree sourcessources ofof gainsgains fromfrom trade:trade: 1)1) love-love- oof-varietyf-variety gainsgains associatedassociated withwith intra-industryintra-industry trade;trade; 2)2) allocativeallocative effieffi ciencyciency gainsgains aassociatedssociated withwith shiftingshifting laborlabor andand capitalcapital outout ofof small,small, less-productiveless-productive fi rmsrms andand iintonto llarge,arge, mmore-productiveore-productive fi rms;rms; andand 3)3) productiveproductive effieffi ciencyciency gainsgains associatedassociated withwith ttrade-inducedrade-induced iinnovation.nnovation. BBackack inin thethe 1980s,1980s, a “New“New TradeTrade Theory”Theory” waswas developeddeveloped thatthat focusedfocused onon intra-intra- iindustryndustry tradetrade inin differentiateddifferentiated goodsgoods producedproduced subjectsubject toto increasingincreasing returnsreturns toto sscale.cale. ThisThis theorytheory centeredcentered onon anan elegantelegant tension:tension: consumersconsumers lovelove varietyvariety andand areare wwillingilling toto paypay a premiumpremium forfor a desireddesired product,product, butbut asas thethe marketmarket fragmentsfragments intointo nnicheiche pproducts,roducts, producersproducers strugglestruggle toto attainattain thethe volumesvolumes neededneeded toto recouprecoup theirtheir pproductroduct ddevelopmentevelopment ccosts.osts. IInternationalnternational ttraderade ccreatesreates a llargerarger mmarketplace,arketplace, wwhichhich mmeanseans tthathat eeachach fi rmrm cancan operateoperate atat a llargerarger sscalecale aandnd hhenceence moremore fi rmsrms cancan survive.survive. TThehe resultresult readsreads likelike anan advertisementadvertisement forfor freefree trade:trade: lowerlower prices,prices, moremore varieties.varieties. PPaulaul KKrugmanrugman eearnedarned tthehe NNobelobel PPrizerize iinn 22008008 iinn llargearge ppartart fforor hhisis wworkork hhighlightingighlighting hhowow eeconomiesconomies ooff sscalecale aandnd pproductroduct ddifferentiationifferentiation lleadead ttoo iintra-industryntra-industry ttrade,rade, jjustust aass inin ourour exampleexample aboveabove ofof midsizemidsize cars.cars. SeeSee KrugmanKrugman (1979,(1979, 1980),1980), HelpmanHelpman andand KKrugmanrugman (1985),(1985), andand HelpmanHelpman (2011,(2011, chap.chap. 4)4) forfor a reviewreview ofof love-of-varietylove-of-variety gainsgains ffromrom ttrade.rade. MMoreore rrecently,ecently, a ssecondecond ssourceource ofof gainsgains fromfrom tradetrade hashas emergedemerged fromfrom thethe rresearchesearch ofof MelitzMelitz ((2003)2003) aandnd BBernard,ernard, EEaton,aton, JJensen,ensen, andand KKortumortum ((2003).2003). TThishis iiss tthehe fi rm-levelrm-level “reallocation”“reallocation” effecteffect thatthat arisesarises whenwhen therethere isis fi rmrm heterogeneity.heterogeneity. BByy fi rrmm hheterogeneityeterogeneity wwee mmeanean tthathat eevenven withinwithin narrowlynarrowly defidefi nneded industriesindustries somesome fi rrmsms aarere muchmuch largerlarger andand moremore profiprofi tabletable thanthan othersothers because,because, forfor example,example, ttheyhey areare muchmuch moremore productive.productive. GlobalizationGlobalization generatesgenerates bothboth winnerswinners andand loserslosers aamongmong fi rrmsms wwithinithin aann iindustryndustry aandnd tthesehese eeffectsffects aarere mmagnifiagnifi eded byby heterogeneity.heterogeneity. BBetter-performingetter-performing fi rmsrms thrivethrive andand expandexpand intointo foreignforeign markets,markets, whilewhile worse-worse- pperformingerforming fi rmsrms contractcontract andand eveneven shutshut downdown inin thethe faceface ofof foreignforeign competition.competition. TThishis generatesgenerates a newnew sourcesource ofof gainsgains fromfrom trade:trade: asas productionproduction isis concentratedconcentrated ttowardsowards better-performingbetter-performing fi rms,rms, thethe overalloverall effieffi ciencyciency ofof thethe industryindustry improves.improves. IInn tthishis way,way, gglobalizationlobalization raisesraises averageaverage effieffi ciencyciency within an industry. WWhyhy iiss iitt tthathat oonlynly thethe better-performingbetter-performing fi rmsrms grow?grow? GlobalizationGlobalization expandsexpands marketsmarkets butbut alsoalso iincreasesncreases competitioncompetition inin thosethose markets.markets. ThisThis competitioncompetition effecteffect dominatesdominates forfor thethe wworse-performingorse-performing fi rmsrms wwhilehile tthehe iincreasedncreased mmarketarket aaccessccess ddominatesominates fforor tthehe bbetter-etter- pperformingerforming fi rms.rms. Also,Also, a fi rm’srm’s internationalinternational expansion—whetherexpansion—whether byby exporting,exporting, bbyy ooffshoreffshore outsourcingoutsourcing ofof intermediateintermediate componentscomponents andand assembly,assembly, oror byby buildingbuilding pplantslants abroadabroad (multinationals)—entails(multinationals)—entails somesome up-frontup-front fi xedxed costs;costs; andand onlyonly thethe bbest-performingest-performing fi rmsrms havehave thethe salessales volumesvolumes neededneeded toto justifyjustify thesethese fi xedxed costs.costs. OOurur tthirdhird ssourceource ooff ggainsains ffromrom ttraderade ccomesomes ffromrom tthehe ppositiveositive iimpactsmpacts ooff llargerarger mmarketsarkets oonn innovation. NewNew productivity-enhancingproductivity-enhancing productsproducts andand processesprocesses requirerequire uup-frontp-front developmentdevelopment costs.costs. TradeTrade iintegration,ntegration, byby expandingexpanding thethe sizesize ofof thethe market,market, eencouragesncourages fi rmsrms toto ponypony upup thesethese developmentdevelopment dollars,dollars, andand thisthis inin turnturn raisesraises pproductivity.roductivity. TTheoriesheories ofof innovation-basedinnovation-based gainsgains fromfrom tradetrade withwith homogeneoushomogeneous fi rrmsms wwereere developeddeveloped byby GrossmanGrossman andand HelpmanHelpman (1991)(1991) andand areare supportedsupported byby Marc J. Melitz and Daniel Trefl er 93

ccountry-levelountry-level evidenceevidence (Helpman(Helpman 22004,004, cchap.hap. 55.6)..6). AAtt tthehe fi rmrm level,level, therethere isis a strongstrong rrelationshipelationship betweenbetween exportingexporting andand innovation.innovation. ForFor example,example, IntelIntel andand AppleApple areare mmajorajor patentpatent holders,holders, andand FoxconnFoxconn holdsholds 4040 percentpercent ofof allall ChineseChinese patentspatents fi ledled inin tthehe UUnitednited StatesStates (Eberhardt,(Eberhardt, Helmers,Helmers, andand YuYu 2011).2011). OfOf course,course, thisthis correlationcorrelation bbetweenetween exportingexporting andand innovationinnovation doesdoes nnotot pproviderovide eevidencevidence fforor ccausalityausality aandnd llacksacks a framingframing theorytheory featuringfeaturing heterogeneousheterogeneous fi rms.rms. Recently,Recently, however,however, therethere hashas beenbeen a ggreatreat dealdeal ofof theoreticaltheoretical andand empiricalempirical progress.progress. LileevaLileeva andand TreflTrefl erer (2010)(2010) showshow ttheoreticallyheoretically andand eempiricallympirically hhowow tthehe mmarket-expandingarket-expanding eeffectsffects ooff iinternationalnternational iintegrationntegration ccausallyausally eencouragencourage fi rmsrms toto innovate.innovate. VerhoogenVerhoogen (2008),(2008), BustosBustos (2011a,(2011a, bb),), andand Aw,Aw, RRoberts,oberts, aandnd XXuu ((2011)2011) assessassess otherother interestinginteresting channelschannels throughthrough whichwhich ttraderade ppromotesromotes fi rm-levelrm-level innovation.innovation. NoteNote thatthat thisthis thirdthird sourcesource ofof gainsgains dealsdeals wwithith within-fi rm eeffiffi cciency;iency; iinn ccontrast,ontrast, tthehe ssecondecond ssourceource ooff ggainsains aboveabove dealsdeals withwith between-fi rm oorr aallocativellocative eeffiffi ciency.ciency. TThishis ppaperaper reviewsreviews thesethese threethree sourcessources ofof gainsgains fromfrom tradetrade bothboth theoreticallytheoretically aandnd empirically.empirically. OOurur eempiricalmpirical eevidencevidence willwill bebe centeredcentered onon thethe experienceexperience ofof CCanadaanada ffollowingollowing iitsts ccloserloser eeconomicconomic iintegrationntegration inin 19891989 wwithith tthehe UUnitednited SStates—tates— tthehe largestlargest exampleexample ofof bilateralbilateral intra-industryintra-industry tradetrade inin thethe world—butworld—but wewe willwill alsoalso ddescribeescribe eevidencevidence fforor ootherther ccountries.ountries. TThehe rrelatedelated literatureliterature isis huge.huge. HereHere wewe focusfocus onon fi rmsrms thatthat expandexpand interna-interna- ttionallyionally viavia exportingexporting asas inin MMelitzelitz ((2003)2003) aandnd BBernard,ernard, EEaton,aton, JJensen,ensen, aandnd KKortumortum ((2003).2003). AnotherAnother relatedrelated researchresearch topictopic analyzesanalyzes howhow fi rmrm boundariesboundaries evolveevolve acrossacross bbordersorders asas mmultinationalultinational fi rmsrms looklook abroadabroad toto “outsource”“outsource” keykey partsparts ofof theirtheir produc-produc- ttionion cchain.hain. TThehe iinterestednterested rreadereader iiss ddirectedirected ttoo ssurveysurveys bbyy AAntràsntràs aandnd RRossi-Hansbergossi-Hansberg ((2009)2009) andand HHelpmanelpman ((2011,2011, cchap.hap. 66).).

Gains from Love of Variety (Economies of Scale and Product Variety)

OOurur fi rstrst ssourceource ofof gainsgains fromfrom ttraderade iiss iintimatelyntimately rrelatedelated ttoo iintra-industryntra-industry ttrade.rade. TToo mmeasureeasure intra-industryintra-industry trade,trade, oneone needsneeds toto startstart withwith a classificlassifi cationcation systemsystem thatthat aassignsssigns ttraderade fl owsows toto a particularparticular “industry.”“industry.” OneOne cancan thenthen categorizecategorize tradetrade fl owsows asas eeitherither intra-industryintra-industry (two-way(two-way tradetrade withinwithin thethe samesame industryindustry classificlassifi cationcation code)code) oror iinter-industrynter-industry ((importsimports aandnd eexportsxports inin separateseparate industryindustry codes).codes). TheThe UnitedUnited NationsNations uusesses thethe StandardStandard InternationalInternational TradeTrade ClassifiClassifi cation,cation, oror SITC,SITC, toto categorizecategorize worldworld ttraderade fl ows.ows. InIn itsits mostmost detaileddetailed form,form, thethe SITCSITC containscontains 1,1611,161 separateseparate industryindustry ccodesodes ((thatthat ccanan bbee cconsistentlyonsistently ttracedraced bbackack ooverver ttime),ime), bbutut tthesehese iindustriesndustries aarere ooftenften aaggregatedggregated iintonto a smallersmaller ssubsetubset ooff iindustries.ndustries. FFigureigure 1 sshowshows thethe timetime ttrendrend fforor tthehe ssharehare ooff iintra-industryntra-industry tradetrade accordingaccording toto tthishis mmostost ddetailedetailed cclassifilassifi cation,cation, andand a moremore aggregatedaggregated versionversion withwith onlyonly 5959 industryindustry ccodes.odes. Mechanically,Mechanically, tthehe ssharehare ooff iintra-industryntra-industry ttraderade rrisesises wwithith tthehe llevelevel ooff aaggrega-ggrega- ttionion fforor tthehe iindustrialndustrial cclassifilassifi cationcation systemsystem (after(after all,all, withwith a singlesingle aggregateaggregate industryindustry ccode,ode, aallll ttraderade wwouldould bebe “intra”“intra” toto thisthis aggregatedaggregated industry).industry). However,However, thethe timetime ttrendsrends forfor thethe twotwo seriesseries areare veryvery similar:similar: intra-industryintra-industry tradetrade grewgrew rapidlyrapidly fromfrom 11962962 ttoo tthehe mmidid 11990s,990s, bbeforeefore sstabilizingtabilizing atat a ssubstantiallyubstantially higherhigher level.level. AsAs countriescountries 94 Journal of Economic Perspectives

Figure 1 World Share of Intra-Industry Trade 1962–2006

.2 Aggregated industry classification Detailed industry classification

.1 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 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 Classifi cation (1,161 separate industry codes) and a more aggregated version with only 59 industry codes.

iindustrialize,ndustrialize, theythey tendtend toto experienceexperience a higherhigher shareshare ofof intra-industryintra-industry tradetrade becausebecause ttheyhey ttendend ttoo pproduceroduce aandnd eexportxport ddifferentiatedifferentiated mmanufacturedanufactured goodsgoods thatthat aarere ssimilarimilar ttoo otherother brandsbrands ofof goodsgoods thatthat areare imported.imported. However,However, somesome ofof thethe countriescountries withwith tthehe highesthighest sharesshares ofof intra-industryintra-industry tradetrade inin 20002000 werewere newlynewly industrializingindustrializing nations,nations, ssuchuch aass tthehe CCzechzech RRepublicepublic ((7777 ppercent),ercent), tthehe SSlovaklovak RRepublicepublic ((7676 ppercent),ercent), MMexicoexico ((7373 ppercent),ercent), andand HungaryHungary (72(72 percent);percent); forfor comparison,comparison, thethe UnitedUnited StatesStates hadhad a 6969 percentpercent shareshare ofof intra-industryintra-industry tradetrade inin 20002000 (OECD Economic Outlook 2002,2002, cchap.hap. 66;; basedbased onon thethe 59-industry59-industry levellevel ofof aggregation).aggregation). MostMost recently,recently, China’sChina’s shareshare ooff iintra-industryntra-industry ttraderade hhasas rrisenisen aabovebove tthehe 5500 percentpercent mark.mark. WWhyhy mightmight a countrycountry bothboth exportexport andand importimport goodsgoods thatthat areare similar?similar? AsAs a sstartingtarting point,point, considerconsider worldworld tradetrade inin automobiles.automobiles. ConsumersConsumers inin a car-producingcar-producing ccountryountry areare notnot limitedlimited toto buyingbuying thethe carcar modelsmodels thatthat areare producedproduced domestically:domestically: mmanyany ooff tthosehose cconsumersonsumers cchoosehoose toto buybuy modelsmodels thatthat areare producedproduced elsewhereelsewhere andand iimported.mported. TheThe extentextent ofof thisthis productproduct differentiationdifferentiation isis thenthen limitedlimited byby highhigh fi xedxed sstart-uptart-up ccostsosts fforor a nnewew bbrandrand aandnd bbyy tthehe rrelatedelated economieseconomies ooff sscale.cale. WWee nownow highlighthighlight howhow thethe combinationcombination ofof productproduct differentiationdifferentiation andand econo-econo- mmiesies ooff sscalecale ggeneratesenerates iintra-industryntra-industry ttraderade uusingsing a ttheoreticalheoretical eexample.xample. NNoticeotice tthathat tthishis ssourceource ooff gainsgains fromfrom tradetrade providesprovides a rationalerationale forfor tradetrade betweenbetween twotwo identicalidentical ccountries,ountries, whichwhich providesprovides a starkstark contrastcontrast withwith thethe gainsgains fromfrom inter-industryinter-industry tradetrade Gains from Trade when Firms Matter 95

tthathat arisearise fromfrom eexploitingxploiting differencesdifferences acrossacross countries,countries, suchsuch asas differencesdifferences inin tech-tech- nnologyology ((Ricardo)Ricardo) oorr ddifferencesifferences iinn ffactoractor ssuppliesupplies (Heckscher–Ohlin).(Heckscher–Ohlin). IInn oourur ttheoreticalheoretical eexample,xample, ttwowo iidenticaldentical ccountriesountries pproduceroduce ddifferentiatedifferentiated wwidgetidget varietiesvarieties subjectsubject toto thethe samesame cconstant-returns-to-scaleonstant-returns-to-scale technology.technology. AssumeAssume tthathat oneone workerworker cancan produceproduce oneone widget,widget, butbut thatthat productionproduction ofof anyany newnew varietyvariety ofof wwidgetsidgets requiresrequires fourfour workersworkers toto ccoverover fi xedxed overheadoverhead costs:costs: thisthis impliesimplies decreasingdecreasing aaverageverage costscosts ofof pproductionroduction asas tthehe fi xedxed costcost isis spreadspread overover anan increasingincreasing numbernumber ofof ooutpututput uunitsnits ((hencehence tthehe eeconomiesconomies ooff sscale).cale). AAlso,lso, ttoo bbee sspecifipecifi c,c, supposesuppose thatthat bothboth ccountriesountries havehave a fi xedxed supplysupply ofof 1212 wworkers.orkers. IfIf ttheyhey ddoo nnotot ttrade,rade, tthenhen eeachach ccountryountry ccanan pproduce:roduce: AA)) 8 uunitsnits ooff oonene vvariety,ariety, oorr BB)) 2 uunitsnits eeachach ofof twotwo differentdifferent varieties.varieties. AAllowingllowing countriescountries toto tradetrade leadsleads toto a newnew possibilitypossibility thatthat isis betterbetter thanthan whatwhat eeitherither countrycountry ccanan achieveachieve onon itsits own.own. SupposeSuppose thatthat eacheach countrycountry producesproduces 8 unitsunits ooff oneone varietyvariety andand exportsexports 4 ofof thesethese unitsunits toto thethe otherother country.country. ConsumersConsumers areare nownow cconsumingonsuming 4 unitsunits ofof thethe homehome varietyvariety andand 4 unitsunits ofof thethe foreignforeign variety.variety. ThisThis isis ppreferredreferred toto eeitherither ooff tthehe nno-tradeo-trade pproductionroduction pplanslans aabove.bove. CComparedompared ttoo cchoicehoice BB,, ttherehere iiss tthehe ssameame nnumberumber ooff vvarietiesarieties ((22 vvarieties),arieties), butbut moremore ooff eeachach vvarietyariety (four(four vversusersus ttwo).wo). CComparedompared ttoo cchoicehoice AA,, ttherehere iiss tthehe ssameame nnumberumber ooff uunitsnits ((88 uunits),nits), bbutut mmoreore vvarietiesarieties (two(two versusversus one).one). Thus,Thus, tradetrade expandsexpands thethe setset ofof consumerconsumer choiceschoices aandnd eeasesases tthehe tradeofftradeoff betweenbetween consumptionconsumption unitsunits andand productproduct variety.variety. EconomicEconomic iintegrationntegration allowsallows productionproduction ofof eacheach individualindividual varietyvariety toto bebe consolidatedconsolidated forfor thethe wwholehole integratedintegrated market;market; givengiven increasingincreasing returnsreturns toto scale,scale, thisthis reducesreduces averageaverage pproductionroduction costs.costs. AtAt thethe samesame time,time, productproduct varietyvariety increasesincreases becausebecause consumersconsumers ccanan bbuyuy vvarietiesarieties pproducedroduced anywhereanywhere inin thethe integratedintegrated market.market. OOnene ooff tthehe mostmost ssalientalient real-worldreal-world examplesexamples ofof economiceconomic integrationintegration betweenbetween ssimilarimilar ccountriesountries ooccurredccurred bbetweenetween tthehe UUnitednited SStatestates aandnd CCanada.anada. TThishis iintegrationntegration sstartedtarted wwithith tthehe ssigningigning ooff tthehe NNorthorth AAmericanmerican AAutouto PPactact iinn 11964.964. BBeforeefore tthen,hen, mmostost ccarar mmodelsodels wwereere pproducedroduced inin thethe UnitedUnited StatesStates forfor U.S.U.S. consumersconsumers andand inin CanadaCanada fforor CCanadiananadian cconsumers.onsumers. HHighigh ttariffsariffs oonn aautouto ttraderade mmadeade iitt uuneconomicalneconomical ttoo eexportxport mmostost ccarar modelsmodels acrossacross thethe border.border. BecauseBecause thethe CanadianCanadian autoauto marketmarket waswas roughlyroughly oone-tenthne-tenth thethe sizesize ooff tthehe UU.S..S. mmarket,arket, tthishis iimpliedmplied ssubstantialubstantial sscalecale ddisadvantagesisadvantages fforor pproductionroduction inin thethe CanadianCanadian market:market: laborlabor productivityproductivity therethere waswas aboutabout 3030 percentpercent bbelowelow tthehe UU.S..S. llevel.evel. TThehe UU.S..S. mmarketarket wwasas llargearge eenoughnough tthathat aassemblyssembly llinesines ccouldould bbee ddedicatededicated toto oonene pparticulararticular ccarar mmodel,odel, wwhilehile CCanadiananadian aassemblyssembly llinesines hhadad ttoo sswitchwitch aacrosscross mmodels,odels, iinvolvingnvolving ccostlyostly ddowntimeowntime aandnd rreconfieconfi gurationguration costs,costs, andand alsoalso hadhad toto hholdold ssubstantiallyubstantially hhigherigher iinventorynventory llevels.evels. TThehe 19641964 PactPact establishedestablished a freefree tradetrade areaarea forfor autosautos thatthat allowedallowed manufac-manufac- tturersurers ttoo cconsolidateonsolidate thethe pproductionroduction ofof particularparticular carcar modelsmodels inin oneone ccountryountry aandnd eexportxport thatthat modelmodel toto cconsumersonsumers iinn tthehe ootherther ccountry.ountry. FForor eexample,xample, GGeneraleneral MMotorsotors ccutut iinn hhalfalf tthehe nnumberumber ooff mmodelsodels aassembledssembled iinn CCanada.anada. HHowever,owever, ttotalotal pproduc-roduc- ttionion ofof aautosutos iinn CanadaCanada increasedincreased asas thethe remainingremaining modelsmodels producedproduced inin CanadaCanada ssuppliedupplied thethe U.S.U.S. mmarketarket aass wwellell aass tthehe CCanadiananadian oone.ne. CCanadiananadian aautomotiveutomotive eexportsxports ttoo tthehe UUnitednited SStatestates iincreasedncreased ffromrom $$1616 mmillionillion iinn 11962962 ttoo $$2.42.4 bbillionillion iinn 11968.968. TThathat ssameame year,year, UU.S..S. automotiveautomotive exportsexports toto CanadaCanada werewere valuedvalued atat $2.9$2.9 billion:billion: intra-intra- iindustryndustry tradetrade inin action.action. Today,Today, $85$85 billionbillion worthworth ofof automotiveautomotive productsproducts crosscross thethe 96 Journal of Economic Perspectives

UU.S.–Canada.S.–Canada borderborder eacheach year—roughlyyear—roughly halfhalf inin eacheach direction.direction. TheThe productivityproductivity ggainsains associatedassociated withwith thisthis cconsolidationonsolidation werewere alsoalso substantial:substantial: byby thethe earlyearly 1970s,1970s, thethe CCanadiananadian autoauto industry’sindustry’s 3030 percentpercent laborlabor productivityproductivity shortfallshortfall relativerelative toto itsits U.S.U.S. ccounterpartounterpart hhadad ddisappeared.isappeared. LLater,ater, tthishis transformationtransformation ofof thethe automotiveautomotive industryindustry waswas extendedextended toto includeinclude MMexico.exico. InIn 1989,1989, VolkswagenVolkswagen consolidatedconsolidated itsits NorthNorth AmericanAmerican operationsoperations inin MMexico,exico, sshuttinghutting downdown itsits plantplant inin Pennsylvania.Pennsylvania. ThisThis processprocess continuedcontinued withwith thethe iimplementationmplementation ofof tthehe NNorthorth AAmericanmerican FFreeree TTraderade AAgreementgreement bbetweenetween tthehe UUnitednited SStates,tates, CCanada,anada, andand MMexico.exico. IInn 11994,994, VVolkswagenolkswagen sstartedtarted producingproducing thethe newnew BeetleBeetle fforor tthehe eentirentire NNorthorth AAmericanmerican mmarketarket iinn tthathat ssameame MMexicanexican pplant.lant. TThishis cconsolidationonsolidation iinn rresponseesponse ttoo ccloserloser eeconomicconomic iintegrationntegration wwithith tthehe UUnitednited SStatestates wwasas nnotot llimitedimited ttoo tthehe aautouto iindustry.ndustry. FFollowingollowing tthehe iimplementationmplementation ooff tthehe CCanada–U.S.anada–U.S. FFreeree TTraderade AAgreementgreement iinn 11989,989, eeachach CCanadiananadian mmanufacturinganufacturing iindustryndustry eexperiencedxperienced a ddramaticramatic rreductioneduction iinn iitsts pproductroduct oofferings,fferings, cconcentratingoncentrating oonn a ssmallermaller nnumberumber ooff pproductsroducts ((Baldwin,Baldwin, BBeckstead,eckstead, aandnd CCavesaves 22002;002; BBaldwin,aldwin, CCaves,aves, aandnd GGuu 22005;005; BBaldwinaldwin aandnd GGuu 22009;009; BBernard,ernard, RRedding,edding, aandnd SSchottchott 22011).011). BBaldwin,aldwin, CCaves,aves, aandnd GGuu ((2005)2005) aalsolso rreporteport tthathat tthehe ddecreaseecrease iinn pproductroduct oofferingsfferings wwasas aaccompaniedccompanied bbyy ssubstantialubstantial iincreasesncreases iinn pproductionroduction rrunsuns fforor iindividualndividual pproducts.roducts. TThishis pprocessrocess iiss eevenven eevidentvident iinn tthehe CCanadiananadian wwineine iindustry,ndustry, aann iindustryndustry tthathat eexclusivelyxclusively pproducedroduced llow-endow-end wwinesines tthathat ccouldould nnotot ppossiblyossibly ccompeteompete wwithith CCalifornianalifornian ggiantsiants ssuchuch aass GGallo.allo. IInn rresponseesponse ttoo tthehe AAgreement,greement, CCanadiananadian mmanufacturesanufactures ddramaticallyramatically rreducededuced tthehe nnumberumber ooff vvarietalsarietals pproducedroduced aandnd ffocusedocused oonn tthehe vvarietalsarietals uusedsed ttoo pproduceroduce iicece wwine.ine. TThehe iindustryndustry iiss nnowow hhealthierealthier tthanhan eeverver ((BeamishBeamish aandnd CCellyelly 22003).003). AAnothernother prominentprominent exampleexample ooff eeconomicconomic iintegrationntegration bbeganegan iinn 11957,957, wwhenhen tthehe mmajorajor countriescountries ofof WesternWestern EuropeEurope establishedestablished a freefree tradetrade areaarea inin manufacturedmanufactured ggoods:oods: thethe EuropeanEuropean EconomicEconomic Community,Community, oror EEC.EEC. ManyMany politicianspoliticians offeredoffered anan oold-fashionedld-fashioned RicardianRicardian predictionprediction thatthat GermanGerman manufacturersmanufacturers wouldwould eradicateeradicate ttheirheir EEuropeanuropean competitors.competitors. TheThe ffactsacts ddidid nnotot ttreatreat ssuchuch ppredictionsredictions kkindly:indly: ttraderade wwithinithin tthehe EEECEC ggrewrew ttwicewice aass ffastast aass wworldorld ttraderade dduringuring tthehe 11960s,960s, aandnd iintra-industryntra-industry ttraderade asas a shareshare ofof EECEEC tradetrade moremore thanthan doubleddoubled fromfrom 19601960 toto 1990.1990. TheThe benefibenefi tsts ooff tthehe ooriginalriginal EEuropeanuropean CommunityCommunity aagreementgreement werewere aaboutbout 1 ppercentercent ofof GGDPDP fforor tthehe largestlargest economieseconomies andand aboutabout 3 percentpercent ofof GDPGDP forfor mid-sizedmid-sized economieseconomies suchsuch aass BBelgiumelgium (Harrison,(Harrison, Rutherford,Rutherford, andand WootonWooton 1989).1989). (These(These numbersnumbers capturecapture mmoreore tthanhan jjustust ppureure llove-of-varietyove-of-variety ggains.)ains.) EEconomicconomic iintegrationntegration hhasas ccontinuedontinued iinn EEuropeurope asas moremore countriescountries havehave joinedjoined thethe freefree tradetrade areaarea thatthat isis todaytoday calledcalled thethe EEuropeanuropean UnionUnion andand asas a subsetsubset ofof EUEU countriescountries adoptedadopted thethe euroeuro asas a commoncommon ccurrencyurrency inin 11999.999. EEuro-zoneuro-zone mmembersembers hhaveave eexperiencedxperienced sstrongtrong ttraderade ggrowth,rowth, eespe-spe- cciallyially intra-industryintra-industry tradetrade growth,growth, relativerelative toto non-EUnon-EU countriescountries andand eveneven relativerelative toto EEUU ccountriesountries tthathat hhaveave nnotot aadopteddopted tthehe eeuro.uro. A ssubstantialubstantial portionportion ofof thethe increasedincreased tradetrade thatthat comescomes withwith economiceconomic integra-integra- ttionion alsoalso deliversdelivers increasedincreased productproduct varietyvariety toto consumers.consumers. Balistreri,Balistreri, Hilberrry,Hilberrry, andand RRutherfordutherford ((2011)2011) showshow thatthat thethe worldwideworldwide eliminationelimination ofof allall tradetrade barriersbarriers wouldwould rraiseaise tthehe nnumberumber ooff vvarietiesarieties availableavailable byby aboutabout 3 percent,percent, lowerlower manufacturingmanufacturing ppricesrices byby a similarsimilar amount,amount, andand raiseraise worldworld welfarewelfare byby 2 percent.percent. MostMost ofof thesethese Marc J. Melitz and Daniel Trefl er 97

ggainsains wwouldould accrueaccrue toto developingdeveloping countriescountries suchsuch asas China.China. BrodaBroda andand WeinsteinWeinstein ((2006)2006) eestimatestimate tthathat tthehe nnumberumber ooff pproductsroducts aavailablevailable ttoo UU.S..S. cconsumersonsumers tthroughhrough iimportsmports ttripledripled bbetweenetween 11972972 aandnd 22001,001, rresultingesulting iinn wwelfareelfare ggainsains ttoo UU.S..S. cconsumersonsumers eequivalentquivalent toto a 2.62.6 percentpercent riserise inin U.S.U.S. GDP.GDP. FeenstraFeenstra (2010,(2010, tabletable 2.1)2.1) examinesexamines hhowow wworldwideorldwide welfarewelfare wouldwould changechange ifif allall countriescountries wentwent fromfrom autarkyautarky toto theirtheir 11996996 llevelsevels ooff ttrade.rade. HHee eestimatesstimates tthathat tthehe wwelfareelfare ggainsains ffromrom iincreasedncreased vvarietiesarieties aarere comparablecomparable toto a 12.512.5 percentpercent riserise inin worldworld GDP.GDP. WhileWhile thethe exactexact magnitudesmagnitudes ooff tthehe gainsgains fromfrom iincreasedncreased varietyvariety differdiffer acrossacross studiesstudies duedue toto differencesdifferences inin whatwhat eexactlyxactly isis bbeingeing mmodeled,odeled, thethe cclearlear mmessageessage iiss tthathat tthehe ggainsains hhaveave bbeeneen vveryery llargearge fforor ddevelopedeveloped ccountriesountries aandnd continuecontinue toto bebe largelarge forfor developingdeveloping countries.countries. TTraderade expandsexpands productproduct varietyvariety bothboth inin fi nalnal goodsgoods (which(which benefibenefi tsts consumers)consumers) aass wwellell aass iinn sspecializedpecialized productionproduction inputsinputs (which(which benefibenefi tsts thethe fi rmsrms thatthat useuse thosethose iinputs).nputs). EthierEthier (1982)(1982) showedshowed thatthat therethere isis a closeclose parallelparallel betweenbetween thesethese two.two. InsteadInstead ooff tthehe love-of-varietylove-of-variety thatthat accruesaccrues toto consumers,consumers, fi rmsrms benefibenefi t fromfrom thethe increasedincreased pproductivityroductivity derivedderived fromfrom aann iincreasedncreased rrangeange ooff aavailablevailable pproductionroduction inputs.inputs. RRecentecent fi rrm-levelm-level researchresearch hashas conficonfi rmedrmed thisthis productproduct varietyvariety benefibenefi t forfor fi rmsrms thatthat importimport iintermediatentermediate inputs.inputs. UsingUsing HungarianHungarian data,data, Halpern,Halpern, Koren,Koren, andand SzeidlSzeidl (2005)(2005) sshowhow thatthat importingimporting manymany varietiesvarieties ofof foreignforeign inputsinputs increasesincreases fi rmrm productivityproductivity bbyy 1212 percent.percent. UsingUsing IndonesianIndonesian data,data, AmitiAmiti andand KoningsKonings (2007)(2007) showshow thatthat a 1100 ppercentageercentage pointpoint fallfall inin inputinput tariffstariffs leadsleads toto a productivityproductivity gaingain ofof 1212 percentpercent fforor fi rmsrms thatthat importimport theirtheir inputs.inputs. KasaharaKasahara andand RodrigueRodrigue (2008),(2008), KasaharaKasahara andand LLaphamapham (2012),(2012), TopalovaTopalova andand KhandelwalKhandelwal (2011),(2011), andand Goldberg,Goldberg, Khandelwal,Khandelwal, PPavcnik,avcnik, andand TopalovaTopalova (2010)(2010) showshow similarlysimilarly largelarge gainsgains forfor ChileChile andand India.India. InIn thethe ccontextontext ofof thethe Canada–U.S.Canada–U.S. FreeFree TradeTrade Agreement,Agreement, LileevaLileeva andand TreflTrefl erer (2010)(2010) fi ndnd tthathat tthehe fallfall inin CanadianCanadian tariffstariffs onon inputsinputs thatthat CanadianCanadian fi rmsrms purchasedpurchased fromfrom thethe UUnitednited StatesStates resultedresulted inin a 00.5.5 ppercentercent rriseise iinn CCanadiananadian mmanufacturinganufacturing pproductivity.roductivity. TThehe CCanadiananadian impactsimpacts areare notnot nearlynearly asas largelarge asas effectseffects fromfrom developingdeveloping countries,countries, wwhichhich suggestssuggests thatthat accessaccess toto a varietyvariety ofof inputsinputs isis anan importantimportant ingredientingredient inin thethe pprocessrocess ooff eeconomicconomic ddevelopment.evelopment. MMoreore vvarietyariety mmeanseans mmoreore ccompetition,ompetition, aandnd mmoreore ccompetitionompetition fforcesorces fi rmsrms ttoo lowerlower theirtheir markupsmarkups andand prices.prices. WeWe seesee evidenceevidence ofof thisthis afterafter thethe TurkishTurkish andand CCoteote dd’Ivoire’Ivoire tradetrade lliberalizationsiberalizations ofof 19851985 (Levinsohn(Levinsohn 1993;1993; HarrisonHarrison 1994)1994) andand inin BBelgiumelgium dduringuring tthehe 11994–2004994–2004 pperioderiod ooff iincreasedncreased iintegrationntegration ((Abraham,Abraham, KKonings,onings, VVanormelingenanormelingen 2009;2009; DeDe LoeckerLoecker 2011).2011). OnOn thethe otherother hand,hand, therethere waswas nono evidenceevidence ooff ffallingalling mmarkupsarkups iinn MMexicoexico aafterfter tthehe ttraderade lliberalizationiberalization ooff tthehe eearlyarly 11980s980s ((TyboutTybout aandnd WWestbrookestbrook 1995).1995). WeWe turnturn nextnext toto thethe gainsgains associatedassociated withwith reallocationreallocation ofof rresourcesesources aacrosscross hheterogeneouseterogeneous fi rmsrms withinwithin anan industry.industry.

Gains from Reallocation at the Firm Level

BByy tthehe mid-1980s,mid-1980s, a llargearge bbodyody ofof theoreticaltheoretical workwork demonstrateddemonstrated tthathat ffreerreer tradetrade couldcould affectaffect productivityproductivity byby forcingforcing fi rmsrms toto movemove upup oror downdown theirtheir aaverageverage ccostost ccurves.urves. MMuchuch ooff tthehe ffollow-onollow-on eempiricalmpirical wworkork aassumedssumed tthathat fi rmsrms 98 Journal of Economic Perspectives

wwereere identical,identical, andand itit mademade a varietyvariety ofof assumptionsassumptions thatthat allowedallowed inferencesinferences toto bebe ddrawnrawn fromfrom industry-levelindustry-level ddataata ((forfor eexample,xample, HHarrisarris 11984).984). WWee nnowow kknownow tthathat tthehe hheterogeneityeterogeneity ooff fi rmsrms eevenven wwithinithin nnarrowlyarrowly ddefiefi nneded iindustriesndustries iiss a ccentralentral ffeatureeature ooff tthehe datadata thatthat ccannotannot bbee iignoredgnored ((forfor eexample,xample, BBernard,ernard, JJensen,ensen, RRedding,edding, aandnd SSchottchott 2007).2007). OOurur ssecondecond ssourceource ofof gainsgains fromfrom ttraderade iiss tthehe rresultesult ooff sshiftinghifting rresourcesesources aawayway ffromrom lless-productiveess-productive fi rmsrms andand towardstowards more-productivemore-productive fi rms.rms. ToTo analyzeanalyze gainsgains ffromrom rreallocationeallocation ofof ttraderade bbetweenetween fi rms,rms, wewe needneed a modelmodel ofof tradetrade withwith hetero-hetero- ggeneouseneous fi rms—thatrms—that is,is, inin whichwhich performanceperformance variesvaries acrossacross differentdifferent fi rms.rms. WeWe cancan tthenhen ccaptureapture howhow fi rmsrms withwith differentdifferent characteristicscharacteristics respondrespond differentlydifferently toto trade.trade. CConsideronsider thethe casecase fromfrom thethe previousprevious exampleexample wherewhere openingopening toto tradetrade leadsleads toto a ttransitionransition fromfrom productionproduction planplan A inin whichwhich eacheach countrycountry producesproduces twotwo varietiesvarieties toto pproductionroduction planplan B inin whichwhich eacheach countrycountry producesproduces oneone variety.variety. InIn thethe realreal world,world, tthosehose vvarietiesarieties aarere aassociatedssociated wwithith tthehe fi rmsrms thatthat produceproduce them.them. OpeningOpening upup toto tradetrade tthereforeherefore impliesimplies thatthat oneone ofof thethe twotwo fi rmsrms inin eacheach countrycountry shutsshuts down,down, whilewhile thethe rremainingemaining fi rmrm expandsexpands productionproduction fromfrom 2 unitsunits toto 8 units.units. ButBut whatwhat areare thethe factorsfactors eexplainingxplaining wwhichhich fi rmsrms expandexpand andand whichwhich onesones exit?exit?

Monopolistic Competitors with Heterogeneous Costs MMelitzelitz andand OttavianoOttaviano (2008)(2008) developdevelop a modelmodel ofof tradetrade thatthat allowsallows forfor differ-differ- eencesnces acrossacross fi rrms;ms; wwee uusese a ssimplifiimplifi eedd vversionersion ooff tthathat mmodelodel fforor tthehe ddiscussioniscussion hhere.ere. CConsideronsider a monopolisticallymonopolistically competitivecompetitive industryindustry iinn whichwhich manymany fi rrmsms competecompete byby oofferingffering differentdifferent productsproducts thatthat areare relativelyrelatively closeclose substitutessubstitutes forfor oneone another—atanother—at lleasteast asas comparedcompared toto productsproducts inin otherother industries.industries. ForFor simplicity,simplicity, wewe assumeassume thatthat eeachach fi rmrm producesproduces a singlesingle product,product, thatthat demanddemand forfor allall productsproducts isis symmetric,symmetric, aandnd thatthat fi rmsrms differdiffer onlyonly withwith respectrespect toto productivity.productivity. SpecifiSpecifi cally,cally, fi rmsrms differdiffer oonlynly withwith respectrespect ttoo ttheirheir mmarginalarginal ccostsosts ooff pproductionroduction ci , w wherehere i iindexesndexes fi rrms.ms. ((AA numbernumber ooff aauthorsuthors hhaveave ddevelopedeveloped rrelatedelated mmodelsodels tthathat aallowllow fi rmsrms toto produceproduce mmultipleultiple products:products: forfor example,example, EckelEckel andand NearyNeary 2010;2010; Bernard,Bernard, Redding,Redding, andand SSchottchott 2011;2011; andand Mayer,Mayer, Melitz,Melitz, andand OttavianoOttaviano 2011.2011. Also,Also, demanddemand needneed notnot bebe ssymmetric:ymmetric: therethere cancan bebe product-qualityproduct-quality differencesdifferences acrossacross fi rms.rms. SuchSuch product-product- qqualityuality differencesdifferences leadlead toto veryvery similarsimilar predictionspredictions forfor fi rrmm performanceperformance asas thethe oonesnes wewe nownow discussdiscuss forfor costcost differences.)differences.) PPanelanel A ooff FFigureigure 2 iillustratesllustrates tthehe ppricerice aandnd qquantityuantity cchoiceshoices fforor ttwowo mmonopolisti-onopolisti- ccallyally ccompetitiveompetitive fi rms.rms. BothBoth fi rmsrms faceface thethe samesame downward-slopingdownward-sloping residual demanddemand ccurve:urve: rresidualesidual demanddemand isis ddemandemand aass pperceivederceived byby thethe fi rm,rm, andand thusthus dependsdepends onon tthehe behaviorbehavior ofof otherother competingcompeting fi rmsrms inin thethe market.market.1 OnOn thethe productionproduction side,side,

_ 1 The equation for the demand facing a fi rm 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 fi rms > in the industry, b 0 is a constant term representing_ the responsiveness of a fi rm’s sales to its price, p is the price charged by the fi rm itself, and p is the average price charged by its competitors. This demand equation may be given the following intuitive justifi cation: If all fi rms charge the same price, each will have a market share 1/n. A fi rm charging more than the average of other fi rms will have a smaller market share, whereas a fi rm charging less will have a larger share. Gains from Trade when Firms Matter 99

Figure 2 Performance Differences across Firms

A: Cost, Price

c *

c2 MC2 Cost, Price

c1 MC1

MR D

q2 q1 Quantity B: Profit

Operating profit

o π1 Profit

o π2 * c cmax

c1 c2 c

Net profit –f

Marginal Cost (MC)

Source: Authors. 100 Journal of Economic Perspectives

mmarginalarginal ccostsosts fforor fi rmrm 1 areare shownshown asas lowerlower thanthan thosethose forfor fi rmrm 2.2. InIn panelpanel A,A, fi rmrm 1 hhasas a lowerlower marginalmarginal costcost (c1) tthanhan fi rmrm 2 (c2)).. WeWe alsoalso assumeassume thatthat economieseconomies ofof sscalecale existexist becausebecause ofof a fi xxeded ccostost thatthat a fi rrmm mustmust incurincur toto developdevelop a productproduct andand ssetet uupp iitsts iinitialnitial pproduction.roduction. IInn tthishis setting,setting, eacheach fi rmrm maximizesmaximizes profiprofi t byby choosingchoosing anan outputoutput levellevel q thatthat eequalizesqualizes marginalmarginal costcost andand marginalmarginal revenue.revenue. FirmFirm 1 chooseschooses a higherhigher outputoutput levellevel tthanhan fi rmrm 2 (q1 > q2)),, associatedassociated withwith a lowerlower priceprice (p1 < p2)).. FirmFirm 1 alsoalso setssets a hhigherigher markupmarkup tthanhan fi rrmm 2:2: p1 − c1 > p2 − c2 ; tthishis isis a cconsequenceonsequence ofof thethe marginalmarginal rrevenueevenue curvecurve beingbeing steepersteeper thanthan thethe demanddemand curve.curve. Thus,Thus, fi rmrm 1 earnsearns a higherhigher o o ooperatingperating profiprofi t thanthan fi rmrm 2:2: π 1 > π 2 , aass rrepresentedepresented byby thethe shadedshaded areasareas inin panelpanel A ooff FFigureigure 22.. WWee aassumessume tthathat aallll fi rmsrms faceface thethe samesame set-upset-up costcost f, soso fi rmrm 1 alsoalso earnsearns hhigherigher nnetet pprofirofi tsts (subtracting(subtracting thethe fi xedxed costcost f f foror allall fi rms).rms). OfOf course,course, differencesdifferences inin fi xxeded costscosts wouldwould notnot affectaffect marginalmarginal costscosts andand thusthus wouldwould notnot affectaffect fi rmrm decisionsdecisions cconcerningoncerning priceprice andand output.output. WeWe cancan thusthus summarizesummarize thethe relevantrelevant performanceperformance ddifferencesifferences thatthat resultresult fromfrom mmarginalarginal ccostost ddifferencesifferences acrossacross fi rmsrms inin thethe followingfollowing wway.ay. CComparedompared toto a fi rmrm withwith higherhigher marginalmarginal cost,cost, a fi rmrm withwith a lowerlower marginalmarginal ccostost wwill:ill: 11)) ssetet a llowerower ppricerice bbutut aatt a hhigherigher mmarkuparkup ooverver mmarginalarginal ccost,ost, 22)) pproduceroduce mmoreore ooutput,utput, aandnd 33)) eearnarn hhigherigher pprofirofi ts.ts.

PPanelanel B inin FigureFigure 2 showsshows howhow fi rmrm profiprofi t variesvaries withwith itsits marginalmarginal costcost ci . B Bothoth ooperatingperating andand netnet profiprofi t willwill bebe decreasingdecreasing functionsfunctions ofof marginalmarginal cost,cost, whilewhile thethe ddifferenceifference betweenbetween thethe twotwo isis thethe fi xedxed set-upset-up costcost f. GoingGoing backback toto panelpanel A,A, wewe seesee tthathat a fi rmrm cancan earnearn a positivepositive operatingoperating profiprofi t soso longlong asas itsits marginalmarginal costcost isis belowbelow tthehe iinterceptntercept ooff tthehe ddemandemand ccurveurve oonn tthehe vverticalertical aaxis.xis. LLetet c* denotedenote thisthis costcost cutoff.cutoff.

A fi rmrm wwithith a mmarginalarginal ccostost ci aabovebove thisthis cutoffcutoff isis effectivelyeffectively “priced“priced out”out” ofof thethe mmarketarket andand wouldwould earnearn negativenegative operatingoperating profiprofi tsts ifif itit werewere toto produceproduce anyany outputoutput ((representedrepresented byby thethe dotteddotted segmentsegment forfor operatingoperating profiprofi t inin panelpanel A).A). SuchSuch a fi rmrm wwouldould choosechoose toto shutshut downdown andand notnot produceproduce (earning(earning zerozero operatingoperating profiprofi t butbut iincurringncurring a netnet profiprofi t lossloss –f ddueue ttoo tthehe fi xedxed cost).cost). WhyWhy wouldwould suchsuch a fi rmrm enterenter iinn tthehe fi rstrst place?place? Clearly,Clearly, itit wouldwould notnot ifif itit knewknew aboutabout itsits highhigh costcost ci ppriorrior bothboth toto eentryntry aandnd ttoo ppayingaying tthehe fi xedxed costcost f. WWee assumeassume thatthat entrantsentrants faceface somesome randomnessrandomness aboutabout theirtheir futurefuture productionproduction ccostost ci . TThishis randomnessrandomness disappearsdisappears onlyonly after tthehe sset-upet-up costcost f isis ppaidaid andand isis sunk.sunk. TThushus ssomeome fi rmsrms wwillill regretregret theirtheir entryentry decision,decision, asas theirtheir netnet profiprofi t isis negativenegative (they(they ccannotannot recoverrecover thethe sunksunk costcost f )).. TThishis isis thethe casecase forfor fi rmrm 2 inin panelpanel B;B; eveneven thoughthough iitsts ooperatingperating pprofirofi t isis positive,positive, itit doesdoes notnot covercover thethe sunksunk costcost f. OnOn thethe otherother hand,hand, ssomeome fi rmsrms ddiscoveriscover tthathat ttheirheir pproductionroduction ccostost ci iiss vveryery llowow aandnd eearnarn a hhighigh ((andand ppositive)ositive) nnetet pprofirofi t.t. FFirmsirms cconsideronsider aallll thesethese ppossibleossible outcomes,outcomes, capturedcaptured byby thethe netnet profiprofi t curvecurve iinn ppanelanel B whenwhen theythey makemake theirtheir entryentry decision.decision. FirmsFirms anticipateanticipate thatthat therethere isis a rrangeange ofof llowerower ccostsosts wwherehere nnetet pprofirofi tsts areare positivepositive (shaded(shaded areaarea toto thethe leftleft aboveabove thethe hhorizontalorizontal axis),axis), andand anotheranother rangerange ofof higherhigher costscosts wherewhere netnet profiprofi tsts areare negativenegative ((shadedshaded aarearea ttoo tthehe rrightight bbelowelow thethe hhorizontalorizontal axis).axis). InIn thethe long-runlong-run equilibrium,equilibrium, fi rmsrms enterenter untiluntil theirtheir expected netnet profiprofi t acrossacross allall potentialpotential costcost levelslevels ci isis drivendriven ttoo zzero.ero. IfIf eeveryvery ccostost llevelevel ci ffromrom 0 ttoo cmmaxax iiss eequallyqually llikely,ikely, thenthen thisthis equilibriumequilibrium isis Marc J. Melitz and Daniel Trefl er 101

rreachedeached whenwhen thethe twotwo shadedshaded areasareas areare equal.equal.2 PanelPanel B ooff FFigureigure 2 ssummarizesummarizes tthehe iindustryndustry equilibriumequilibrium forfor a givengiven marketmarket size.size. ItIt showsshows whichwhich rangerange ofof fi rmsrms survivesurvive * aandnd produceproduce (with(with costcost ci bbelowelow c ) aandnd howhow theirtheir profiprofi tsts willwill varyvary withwith theirtheir costcost llevelsevels ci .

What Changes When Economies Integrate? HHowow willwill thethe situationsituation facedfaced byby thesethese heterogeneousheterogeneous fi rmsrms alteralter whenwhen econo-econo- mmiesies integrateintegrate intointo a singlesingle largerlarger market?market? A largerlarger marketmarket cancan supportsupport a largerlarger nnumberumber ooff fi rmsrms thanthan a smallersmaller market,market, whichwhich impliesimplies moremore competitioncompetition inin thethe llargerarger market.market. IIncreasedncreased ccompetition—absentompetition—absent aanyny iincreasencrease iinn mmarketarket ssize—leadsize—leads ttoo aann iinwardnward shiftshift ofof eacheach fi rm’srm’s residualresidual demanddemand curve.curve. OnOn thethe otherother hand,hand, holdingholding ccompetitionompetition fi xed,xed, a largerlarger marketmarket rotatesrotates outout thethe residualresidual demanddemand curvescurves forfor aallll fi rms.rms. PuttingPutting thesethese twotwo effectseffects ofof increasedincreased competitioncompetition andand greatergreater marketmarket ssizeize togethertogether givesgives usus thethe combinedcombined effecteffect ofof internationalinternational tradetrade onon thethe residualresidual ddemandemand ccurveurve pperceivederceived bbyy fi rms.rms. ThisThis changechange isis depicteddepicted inin panelpanel A ofof FigureFigure 3,3, aass tthehe shiftshift fromfrom demanddemand curvecurve D ttoo D ′. TThehe rresidualesidual demanddemand curvecurve shiftsshifts inin fromfrom tthehe perspectiveperspective ofof thethe smallersmaller fi rmsrms withwith lowerlower outputoutput levelslevels thatthat operateoperate onon thethe hhigherigher partpart ofof thethe demanddemand curve:curve: here,here, thethe effecteffect ofof toughertougher competitioncompetition domi-domi- nnates.ates. However,However, fromfrom thethe perspectiveperspective ofof thethe largerlarger fi rmsrms thatthat operateoperate onon thethe lowerlower ppartart ofof thethe demanddemand curve,curve, thethe residualresidual demanddemand curvecurve hashas shiftedshifted out:out: here,here, thethe eeffectffect ooff tthehe llargerarger mmarketarket ssizeize ddominates.ominates. PPanelanel B ofof FigureFigure 3 showsshows thethe consequencesconsequences ofof thisthis demanddemand changechange forfor thethe ooperatingperating profiprofi tsts ofof fi rmsrms withwith differentdifferent costcost levelslevels ci . TThehe ddecreaseecrease inin demanddemand forfor tthehe smallersmaller fi rmsrms translatestranslates intointo a newnew lowerlower costcost cutoffcutoff c*′: FFirmsirms wwithith thethe highesthighest ccostost llevelsevels ((aboveabove c*′ ) ccannotannot survivesurvive thethe decreasedecrease inin demanddemand andand areare forcedforced toto eexit.xit. OnOn tthehe ootherther hand,hand, thethe fl atteratter demanddemand curvecurve isis advantageousadvantageous toto fi rmsrms withwith tthehe lowestlowest costcost levels:levels: theythey cancan adaptadapt toto thethe increasedincreased competitioncompetition byby loweringlowering ttheirheir mmarkuparkup ((andand hhenceence theirtheir price)price) andand gaininggaining somesome additionaladditional marketmarket share.share. ((RecallRecall thatthat thethe high-costhigh-cost fi rmsrms areare alreadyalready settingsetting lowlow markups,markups, andand cannotcannot lowerlower ttheirheir pricesprices toto induceinduce positivepositive demand,demand, asas thisthis wouldwould meanmean pricingpricing belowbelow theirtheir mmarginalarginal costcost ooff pproduction.)roduction.) Thus,Thus, thethe best-performingbest-performing fi rmsrms withwith thethe lowestlowest costcost llevelsevels ci nnowow earnearn increasedincreased operatingoperating andand netnet profiprofi ts.ts. PanelPanel B ofof FigureFigure 3 illustratesillustrates hhowow iincreasedncreased marketmarket sizesize generatesgenerates bothboth winnerswinners andand loserslosers amongstamongst fi rmsrms inin anan iindustry.ndustry. LLow-costow-cost fi rmsrms thrivethrive andand increaseincrease theirtheir profiprofi tsts andand marketmarket shares,shares, high-high- ccostost fi rmsrms ccontract,ontract, aandnd tthehe hhighestighest ccostost fi rmsrms exit.exit. IInn tthishis mmodel,odel, eeconomicconomic iintegrationntegration tthroughhrough mmarketarket eexpansionxpansion ddoesoes nnotot ddirectlyirectly affectaffect fi rmrm productivity.productivity. Nevertheless,Nevertheless, itit generatesgenerates anan overalloverall increaseincrease inin aaggregateggregate productivityproductivity asas marketmarket sharesshares areare rreallocatedeallocated fromfrom tthehe llow-productivityow-productivity fi rmsrms wwithith highhigh marginalmarginal costscosts toto thethe high-productivityhigh-productivity onesones withwith lowlow marginalmarginal costs.costs.

2 In contrast, when there is no uncertainty about marginal cost because all fi rms share the same cost c, then entry drives the realized net profi t to zero for all fi rms. With fi rm heterogeneity, expected net profi t is zero, but realized profi ts will vary as shown in panel B of Figure 2. 102 Journal of Economic Perspectives

Figure 3 Winners and Losers from Market Integration

A: Shift in a firm’s residual curve with international trade

Combined effect of bigger market size and more competition Price

D′

More competition (market size fixed) D

Quantity

B: Shift in operating profit with international trade

Operating profit Profit

c *

c *′

Exit

Winners Losers

Marginal Cost (MC)

Source: Authors. Gains from Trade when Firms Matter 103

Trade Costs, Export Decisions, and Trade Liberalization TThehe discussiondiscussion toto thisthis pointpoint hashas implicitlyimplicitly modeledmodeled economiceconomic integrationintegration asas a changechange inin marketmarket sizesize fromfrom a closedclosed economyeconomy withwith nono tradetrade allall thethe wayway toto a ssingleingle combinedcombined marketmarket withwith nono tradetrade barriers.barriers. InIn reality,reality, initialinitial tradetrade costscosts areare rrarelyarely soso highhigh asas toto blockblock allall tradetrade priorprior toto liberalization,liberalization, andand liberalizationliberalization reducesreduces ttradingrading costscosts withoutwithout fullyfully eliminatingeliminating them.them. InIn a numbernumber ofof ways,ways, thisthis kindkind ofof ppartialartial tradetrade liberalizationliberalization hashas a veryvery similarsimilar effecteffect toto thethe simplersimpler casecase ofof fullfull inte-inte- ggration.ration. WithWith partialpartial tradetrade liberalization,liberalization, thethe better-performingbetter-performing fi rmsrms expand,expand, thethe wworse-performingorse-performing oonesnes contract,contract, aandnd thethe worstworst performingperforming onesones exit.exit. ThisThis gener-gener- aatestes tthehe ssameame ttypeype ooff rreallocationeallocation eeffectffect ppreviouslyreviously ddescribedescribed aandnd lleadseads ttoo a rriseise iinn aaggregateggregate pproductivity.roductivity.3 HHowever,owever, aaddingdding ttraderade costscosts alsoalso allowsallows usus toto analyzeanalyze anan additionaladditional issue:issue: wwhetherhether fi rmsrms choosechoose toto export.export. WithWith ttraderade ccosts,osts, eexportingxporting iiss pprofirofi tabletable onlyonly forfor a subsetsubset ofof better-performingbetter-performing fi rms.rms. SomeSome fi rmsrms dodo notnot export,export, andand insteadinstead onlyonly sserveerve domesticdomestic consumers.consumers. WeWe nownow extendextend ourour theoreticaltheoretical modelmodel toto incorporateincorporate ttraderade costscosts aandnd fi rms’rms’ exportexport decisions.decisions. ForFor thisthis purpose,purpose, wewe cancan nono longerlonger analyzeanalyze a ssingleingle market:market: instead,instead, wewe needneed toto looklook aatt fi rms’rms’ decisionsdecisions inin bothboth thethe domesticdomestic andand eexportxport marketsmarkets jointly.jointly. FForor simplicity,simplicity, wewe considerconsider a specialspecial casecase wherewhere bothboth coun-coun- ttriesries areare symmetric,symmetric, ssoo tthathat ddemandemand cconditionsonditions inin bbothoth tthehe ddomesticomestic andand eexportxport mmarketsarkets wwillill bbee iidentical.dentical. AAssumessume tthathat a fi rmrm mustmust iincurncur aann aadditionaldditional ttraderade ccostost t fforor eacheach unitunit ofof outputoutput tthathat itit sellssells toto customerscustomers acrossacross thethe border.border. AsAs a resultresult ofof thisthis tradetrade cost,cost, eacheach fi rmrm wwillill setset a differentdifferent priceprice inin itsits exportexport marketmarket relativerelative toto itsits domesticdomestic market,market, whichwhich wwillill lleadead ttoo ddifferentifferent qquantitiesuantities soldsold iinn eeachach mmarket,arket, aandnd uultimatelyltimately ttoo ddifferentifferent pprofirofi t llevelsevels eearnedarned inin eacheach market.market. BecauseBecause wewe areare assumingassuming thatthat eacheach fi rm’srm’s marginalmarginal ccostost isis constantconstant andand doesdoes notnot varyvary withwith productionproduction levels,levels, thethe decisionsdecisions regardingregarding ppricingricing aandnd qquantityuantity ssoldold iinn eeachach mmarketarket ccanan bbee sseparated:eparated: a ddecisionecision rregardingegarding tthehe ddomesticomestic mmarketarket wwillill hhaveave nnoo eeffectffect oonn thethe profiprofi tabilitytability ofof differentdifferent decisionsdecisions forfor tthehe eexportxport mmarket.arket. CConsideronsider thethe casecase ofof fi rmsrms locatedlocated inin Home.Home. TheirTheir situationsituation regardingregarding theirtheir ddomesticomestic ((Home)Home) mmarketarket iiss eexactlyxactly aass wwasas iillustratedllustrated iinn FFigureigure 22,, eexceptxcept tthathat aallll tthehe ooutcomesutcomes ssuchuch aass pprice,rice, ooutput,utput, aandnd pprofirofi t relaterelate toto thethe domesticdomestic marketmarket only.only. NowNow cconsideronsider thethe eexportxport (Foreign)(Foreign) market.market. TheThe fi rmsrms faceface thethe samesame demanddemand curvecurve inin FForeignoreign asas theythey dodo inin HomeHome (the(the ttwowo ccountriesountries areare identical).identical). TheThe onlyonly differencedifference iiss thatthat eacheach fi rm’srm’s marginalmarginal costcost inin thethe exportexport marketmarket isis shiftedshifted upup byby thethe tradetrade ccostost t. WWhathat aarere thethe effectseffects ofof thethe tradetrade costcost onon thethe fi rms’rms’ decisionsdecisions regardingregarding thethe eexportxport market?market? A higherhigher marginalmarginal costcost inducesinduces a fi rmrm toto raiseraise itsits price,price, whichwhich leadsleads ttoo a lowerlower outputoutput quantityquantity soldsold andand toto lowerlower profiprofi tsts (as(as highlightedhighlighted inin FigureFigure 2).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

WWee alsoalso knowknow thatthat ifif marginalmarginal costcost isis raisedraised aboveabove a thresholdthreshold levellevel c*, thenthen a fi rmrm ccannotannot profiprofi tablytably operateoperate inin thatthat market.market. Thus,Thus, wwhenhen ttherehere aarere ttraderade ccosts,osts, ssomeome fi rmsrms willwill fi ndnd itit profiprofi tabletable toto operateoperate inin thethe domesticdomestic marketmarket butbut notnot inin thethe exportexport mmarketarket becausebecause thethe tradetrade costcost pushespushes theirtheir marginalmarginal costcost forfor thatthat marketmarket aboveabove thethe tthresholdhreshold c*. FFigureigure 4 helpshelps toto visualizevisualize thethe productionproduction andand exportexport decisionsdecisions forfor allall fi rmsrms bbasedased onon ttheirheir mmarginalarginal ccostost ci. PanelPanel A ofof FigureFigure 4 separatesseparates a fi rm’srm’s operatingoperating profiprofi t iintonto a portionportion earnedearned fromfrom domesticdomestic sales,sales, andand a portionportion earnedearned fromfrom exportexport sales.sales.

((BothBoth pportionsortions areare functionsfunctions ofof a fi rm’srm’s marginalmarginal costcost ci aass iinn FigureFigure 2.)2.) BecauseBecause thethe oonlynly differencedifference betweenbetween thethe domesticdomestic aandnd eexportxport mmarketsarkets iiss tthehe aadditionaldditional pper-uniter-unit ttraderade costcost t, tthehe horizontalhorizontal distancedistance betweenbetween thethe twotwo curvescurves isis equalequal toto thethe tradetrade ccostost t. FirmFirm 1 eearnsarns ppositiveositive operatingoperating profiprofi tsts fromfrom salessales inin bothboth thethe domesticdomestic andand eexportxport markets:markets: itit wwillill exportexport andand reachreach consumersconsumers inin bothboth markets.markets. ThisThis willwill bebe tthehe ccasease fforor allall fi rmsrms withwith costcost belowbelow c* – t. OOnn thethe otherother hand,hand, fi rmrm 2 onlyonly earnsearns ppositiveositive operatingoperating profiprofi tsts fromfrom salessales inin thethe domesticdomestic market—andmarket—and thusthus chooseschooses notnot ttoo eexport.xport. AAnyny fi rmrm wwithith ccostost aabovebove c* – t willwill bebe inin thisthis sasa meme situationsituation andand thereforetherefore wwillill nnotot eexport:xport: thosethose fi rmsrms onlyonly serveserve theirtheir domesticdomestic market.market. AsAs before,before, thethe worstworst pperformingerforming fi rmsrms wwithith ccostost aabovebove c* cannotcannot profiprofi tablytably operateoperate atat allall (even(even inin theirtheir ddomesticomestic mmarket)arket) aandnd tthereforeherefore eexit.xit. PPanelanel B ooff FFigureigure 4 ssummarizesummarizes tthehe eeffectsffects ooff ttraderade lliberalization—aiberalization—a rreductioneduction iinn tthehe ttraderade ccostost t—fforor thosethose fi rmrm decisions.decisions. TThehe fi ggureure sshowshows tthehe ssameame ttwowo ooperatingperating pprofirofi t curvescurves ffromrom ppanelanel A bbothoth bbeforeefore aandnd aafterfter ((dasheddashed ccurves)urves) ttraderade lliberaliza-iberaliza- ttion.ion. TheThe operatingoperating profiprofi t forfor thethe domesticdomestic marketmarket shiftsshifts downdown duedue toto thethe increaseincrease iinn competitioncompetition (which(which shiftsshifts thethe residualresidual demanddemand curvecurve forfor thethe domesticdomestic marketmarket iinwardnward aass eexplainedxplained eearlier).arlier). SSomeome ooff tthehe hhigher-costigher-cost fi rmsrms tthathat uusedsed ttoo pproduceroduce fforor ddomesticomestic cconsumptiononsumption nnoo llongeronger eearnarn a ppositiveositive ooperatingperating pprofirofi t afterafter tradetrade lliberal-iberal- iizationzation aandnd eexit.xit. OOnn tthehe ootherther hhand,and, tthehe ooperatingperating pprofirofi t fforor tthehe eexportxport mmarketarket sshiftshifts uupp ddueue ttoo tthehe llowerower ttraderade ccost.ost. ((IncreasedIncreased ccompetitionompetition iinn tthehe eexportxport mmarketarket ttendsends ttoo rreduceeduce ooperatingperating pprofirofi ttss tthere,here, bbutut tthishis eeffectffect iiss ddominatedominated bbyy tthehe ddirectirect eeffectffect ooff tthehe ttraderade ccostost rreduction.)eduction.) A kkeyey eempiricalmpirical ppredictionrediction iiss tthathat ssomeome fi rmsrms sstarttart eexporting.xporting. SSpecifipecifi cally,cally, aamongmong tthehe fi rmsrms thatthat diddid notnot exportexport priorprior toto tradetrade liberalization,liberalization, onlyonly tthehe mmostost pproductiveroductive ooff tthesehese sstarttart eexporting.xporting.

Evidence on Gains from Inter-Firm Reallocations IInn manymany ways,ways, thethe Canada–U.S.Canada–U.S. FreeFree TradeTrade AgreementAgreement isis a usefuluseful naturalnatural eexperimentxperiment forfor consideringconsidering thethe effectseffects ofof tradetrade integration.integration. TheThe policypolicy experimentexperiment iiss clearlyclearly defidefi ned:ned: itit dealtdealt onlyonly withwith marketmarket integrationintegration andand waswas notnot partpart ofof a largerlarger ppackageackage ooff mmacroeconomicacroeconomic rreformseforms tthathat ooftenften aaccompanyccompany ttraderade lliberalization.iberalization. TThehe eenactmentnactment ooff tthehe aagreementgreement wwasas llargelyargely uunanticipated:nanticipated: a CCanadiananadian ggeneraleneral eelectionlection wwasas ffoughtought oonn tthehe iissuessue oonene mmonthonth bbeforeefore tthehe aagreementgreement wwasas ttoo bbee ssignedigned iintonto llawaw aandnd pollsterspollsters unanimouslyunanimously predictedpredicted thatthat Canada’sCanada’s rulingruling party—alongparty—along withwith thethe ffreeree ttraderade aagreement—wouldgreement—would bebe ddefeatedefeated ((BranderBrander 1991;1991; ThompsonThompson 1993).1993). Thus,Thus, eevidencevidence aboutabout thethe extentextent ofof aggregateaggregate productivityproductivity changeschanges asas a resultresult ofof realloca-realloca- ttionsions aamongmong hheterogeneouseterogeneous fi rmsrms cancan bebe soughtsought byby lookinglooking atat thethe distributiondistribution ofof Marc J. Melitz and Daniel Trefl er 105

Figure 4 Export Decision and Trade Liberalization

A: Operating profits from domestic and export sales

Operating profit (domestic) Price Operating profit (export)

c * – t c * c c1 2 c

Exporters Nonexporters Exit

Marginal Cost (MC)

B: Effects of trade liberalization on firm decisions

Operating profit (domestic) Profit

Operating c * profit (export) c

New New exporters exit

Marginal Cost (MC)

Source: Authors. 106 Journal of Economic Perspectives

pproductivityroductivity acrossacross CanadianCanadian manufacturingmanufacturing plantsplants bbeforeefore aandnd aafterfter tthehe aagreement,greement, aatt entrantsentrants beforebefore andand afterafter thethe agreement,agreement, andand atat thethe productivityproductivity distributiondistribution ofof eexportersxporters aandnd nnonexporters.onexporters. TThehe agreementagreement camecame intointo effecteffect onon JanuaryJanuary 1,1, 1989.1989. PanelPanel A ofof FigureFigure 5 showsshows tthehe distributiondistribution ofof laborlabor productivityproductivity asas measuredmeasured byby value-addedvalue-added perper employeeemployee aacrosscross CCanadiananadian manufacturingmanufacturing plantsplants bothboth beforebefore thethe agreementagreement inin 19881988 andand inin 11996,996, whenwhen therethere hadhad beenbeen timetime forfor fi rmrm adjustmentsadjustments toto occur.occur. ForFor example,example, thethe 11996996 ccurveurve ssummarizesummarizes tthehe pproductivityroductivity ddistributionistribution ooff aallll 335,0005,000 CCanadiananadian mmanu-anu- ffacturingacturing plantsplants inin thatthat year.year. Clearly,Clearly, thethe distributiondistribution ofof fi rmsrms shiftedshifted rightward:rightward: bbetweenetween 19881988 andand 1996,1996, thethe shareshare ofof low-productivitylow-productivity plantsplants inin manufacturingmanufacturing ddeclinedeclined aandnd tthehe ssharehare ooff hhigh-productivityigh-productivity pplantslants rose.rose. TThehe horizontalhorizontal axisaxis isis basedbased onon a measuremeasure ofof thethe loglog ofof laborlabor productivity.productivity. HHowever,owever, ttoo eensurensure thatthat dispersiondispersion isis drivendriven byby within-industrywithin-industry ratherrather thanthan between-between- iindustryndustry differencesdifferences inin laborlabor productivity,productivity, wewe scalescale eacheach plant’splant’s loglog productivityproductivity byby ssubtractingubtracting fromfrom iitt tthehe mmedianedian llogog pproductivityroductivity ooff tthehe pplant’slant’s ffour-digitour-digit SSICIC iindustry.ndustry. TThus,hus, thethe medianmedian plantplant inin eacheach industryindustry hashas a scorescore ofof zerozero onon thethe horizontalhorizontal axis.axis. TThehe verticalvertical axisaxis showsshows thethe shareshare ofof plantsplants withwith thethe indicatedindicated levellevel ofof productivity.productivity. TThesehese frequenciesfrequencies areare weightedweighted byby plantplant employment;employment; otherwise,otherwise, tinytiny plantsplants thatthat aaccountccount fforor oonlynly a ttinyiny ffractionraction ooff ttotalotal eemploymentmployment wwouldould ddominateominate tthehe fi gure.gure. TToo ggetet a ssenseense ooff tthehe ddegreeegree ooff pproductivityroductivity ddispersion,ispersion, cconsideronsider tthehe hhorizontalorizontal aaxisxis ooff FFigureigure 5 aandnd ssupposeuppose tthathat llogog pproductivityroductivity aatt pplantlant A iiss oonene uunitnit hhigherigher tthanhan aatt pplantlant BB.. TThishis iiss eequivalentquivalent ttoo ssayingaying tthathat pplantlant A iiss tthreehree ttimesimes mmoreore pproductiveroductive tthanhan pplantlant BB.. IIff A iiss ffourour uunitsnits hhigherigher tthanhan BB,, tthenhen A iiss 5500 ttimesimes mmoreore pproductiveroductive tthanhan BB..4 OObviously,bviously, laborlabor productivityproductivity asas shownshown inin FigureFigure 5 isis notnot anan identicalidentical conceptconcept ttoo thethe horizontalhorizontal lineslines showingshowing levelslevels ofof marginalmarginal costcost inin thethe theoreticaltheoretical discussion.discussion. WWhenhen mmarginalarginal ccostsosts aarere low,low, wwee ttypicallyypically expectexpect productivityproductivity toto bebe high.high. Therefore,Therefore, tthehe iinversenverse ooff mmarginalarginal ccostsosts ((1/1/c) iiss ooftenften proxiedproxied inin empiricalempirical workwork byby productivity.productivity. TThehe pproductivityroductivity hheterogeneityeterogeneity shownshown forfor CanadianCanadian manufacturingmanufacturing fi rmsrms inin FFigureigure 5 isis a pervasivepervasive featurefeature ofof allall economieseconomies including,including, forfor example,example, thethe UnitedUnited SStatestates ((Bernard,Bernard, Eaton,Eaton, Jensen,Jensen, andand KortumKortum 2003),2003), manymany EuropeanEuropean economieseconomies ((MayerMayer andand OttavianoOttaviano 2008;2008; Bartelsman,Bartelsman, Hatiwanger,Hatiwanger, andand ScarpettaScarpetta 2009),2009), asas wwellell asas ChinaChina andand IndiaIndia (Hsieh(Hsieh andand KlenowKlenow 2009).2009). WagnerWagner (2007)(2007) surveyssurveys relatedrelated sstudiestudies fromfrom ccountriesountries allall aaroundround tthehe wworld,orld, rreportingeporting similarsimilar ppatternsatterns rregardingegarding wwidespreadidespread fi rmrm heterogeneityheterogeneity withinwithin industries.industries. Thus,Thus, thethe lessonslessons derivedderived fromfrom thisthis eexamplexample aarere nnotot sspecifipecifi c toto thethe CanadianCanadian experience.experience. WWhathat ccausedaused thethe changechange fromfrom 19881988 toto 19961996 inin thethe productivityproductivity distributiondistribution ofof CCanadiananadian manufacturingmanufacturing fi rms?rms? ItIt waswas largelylargely duedue toto thethe reallocationreallocation mechanismsmechanisms aacrosscross plantsplants describeddescribed above.above. TheThe fi rstrst ofof thesethese mechanismsmechanisms thatthat wewe examineexamine isis

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. 1 4 From the property of logs, φA/φB = e = 2.7 ≈ 3. For a difference of 4 units, e ≈ 50. On a more technical level, the fi gure 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

A: Labor productivity distribution of all Canadian manufacturing plants 1988 and 1996 (employment weighted) 40%

1988 30%

20% 1996 10%

0% –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) 40% Pre-FTA: Entrants 30% during 1980–88

20% FTA: Entrants during 1988–96 10%

0% –2 –1 0 1 2 3 4 5 6

C: Labor productivity distribution of exporters and nonexporters, 1996 (employment weighted)

40% 35% 30% Nonexporters, 1996 25% Exporters, 1996 20% 15% 10% 5% 0% –2 –1 0 1 2 3 4 5 6

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 fi gure. 108 Journal of Economic Perspectives

tthehe fallfall inin tthehe ssurvivalurvival tthresholdhreshold ofof marginalmarginal ccost—thatost—that is,is, tthehe lleftwardeftward sshifthift ooff c* inin ppanelanel B ofof FigureFigure 4.4. TheThe empiricalempirical counterpartcounterpart toto a fallfall inin c* iiss a riserise inin thethe break-break- eevenven levellevel ofof productivity.productivity. OneOne cancan examineexamine thisthis mechanismmechanism byby lookinglooking eithereither atat eexitxit ratesrates oror atat entryentry rates.rates. SinceSince a plantplant maymay notnot exitexit untiluntil itit hashas completedcompleted thethe mmultiyearultiyear processprocess ofof depreciatingdepreciating itsits fi xedxed capital,capital, itit isis bestbest toto looklook atat entryentry rates,rates, wwhichhich adjustadjust moremore quicklyquickly toto shocksshocks suchsuch asas a freefree tradetrade agreement.agreement. PanelPanel B ofof FFigureigure 5 displaysdisplays thethe productivityproductivity levelslevels ofof newnew entrantsentrants toto CanadianCanadian manufacturingmanufacturing bbothoth forfor thethe pre-agreementpre-agreement periodperiod (1980–1988)(1980–1988) andand forfor thethe periodperiod immediatelyimmediately aafterfter tthehe aagreementgreement ccameame iintonto fforceorce ((1988–1996).1988–1996). TTherehere waswas a sstrikingtriking ddeclineecline inin tthehe eentryntry rratesates ooff pplantslants wwithith pproductivityroductivity nearnear oror belowbelow thethe median.median. ToTo useuse a sportssports aanalogy,nalogy, iinn thethe earlierearlier periodperiod manymany low-productivitylow-productivity plantsplants mademade thethe cutcut andand joinedjoined tthehe teamteam whilewhile inin thethe laterlater periodperiod a numbernumber ofof suchsuch low-productivitylow-productivity plantsplants nono llongeronger mmadeade tthehe ccut.ut.5 TThehe patternpattern herehere isis conficonfi rmedrmed byby moremore formalformal econometriceconometric analysisanalysis (specifi(specifi - ccally,ally, binary-outcomebinary-outcome regressionsregressions ofof exitexit onon plantplant characteristicscharacteristics asas wellwell asas industryindustry aandnd timetime controls).controls). ForFor example,example, BaggsBaggs (2005)(2005) andand BaldwinBaldwin andand GuGu (2006)(2006) showshow tthathat thethe freefree tradetrade agreementagreement tarifftariff cutscuts raisedraised exitexit byby a largelarge amount.amount. LileevaLileeva ((2008)2008) estimatesestimates thatthat thethe freefree tradetrade agreementagreement tarifftariff cutscuts raisedraised exitexit ratesrates byby asas mmuchuch asas 1616 percent,percent, withwith allall ofof thethe increaseincrease involvinginvolving thethe exitexit ofof nonexporters.nonexporters. BBernard,ernard, Jensen,Jensen, andand SchottSchott (2006)(2006) fi nndd similarsimilar resultsresults forfor U.S.U.S. plantsplants facedfaced withwith UU.S..S. tarifftariff reductions.reductions.

Trade Costs and the Export Decision A ccentralentral predictionprediction ofof thethe theorytheory isis thatthat inin thethe presencepresence ofof tradetrade costs,costs, onlyonly llow-cost,ow-cost, hhigh-productivityigh-productivity fi rmsrms export.export. PanelPanel C ofof FigureFigure 5 showsshows thethe distributiondistribution ooff CCanadiananadian pplantslants sseparatelyeparately fforor eexportersxporters aandnd nnonexporters.onexporters. Clearly,Clearly, tthehe ddistribu-istribu- ttionion forfor exportersexporters isis toto thethe rightright ooff tthathat fforor nnonexporters.onexporters. OnOn average,average, CanadianCanadian eexportersxporters areare 4040 ppercentercent moremore pproductiveroductive thanthan nnonexportersonexporters inin thethe samesame iindustryndustry ((BaldwinBaldwin andand GGuu 22003).003). SinceSince tthehe sseminaleminal wworkork ooff BBernardernard aandnd JJensenensen (1995),(1995), a hhugeuge bodybody ofof researchresearch coveringcovering dozensdozens ofof countriescountries hashas foundfound thisthis samesame patternpattern ofof hhigherigher pproductivityroductivity fforor eexportersxporters rrelativeelative ttoo nnonexporters.onexporters.6

5 Bernard and Jensen (1999), Trefl er (2004), Lileeva (2008), and Lileeva and Trefl er (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 fi rms do not export—and conversely—why some low- productivity fi rms export. Marc J. Melitz and Daniel Trefl er 109

A mmuchuch mmoreore ddemandingemanding ppredictionrediction ooff tthehe ttheoryheory ddealseals wwithith whowho willwill start exporting in response to falling trade costs. PanelPanel B ofof FigureFigure 4 showsshows thatthat thosethose whowho sstarttart exportingexporting will bebe amongamong thethe mostmost productiveproductive ofof thosethose whowho nevernever exportedexported bbefore.efore. ToTo testtest thisthis prediction,prediction, LileevaLileeva andand TreflTrefl eerr (2010)(2010) examinedexamined a samplesample ooff overover 5,0005,000 CanadianCanadian manufacturingmanufacturing plantsplants thatthat hadhad nevernever exportedexported priorprior toto tthehe Canada–U.S.Canada–U.S. freefree tradetrade agreement.agreement. A veryvery largelarge percentagepercentage ofof thesethese plantsplants ((4040 percent)percent) startedstarted exportingexporting afterafter thethe agreementagreement camecame intointo forceforce onon JanuaryJanuary 1,1, 11989.989. LileevaLileeva andand TreflTrefl erer examineexamine whetherwhether thesethese plantsplants startedstarted exportingexporting becausebecause ooff thethe U.S.U.S. tarifftariff cutscuts and,and, moremore importantly,importantly, whetherwhether thosethose thatthat startedstarted exportingexporting bbecauseecause ofof thethe tarifftariff cutscuts werewere moremore productiveproductive thanthan nonexporters.nonexporters. ToTo thisthis end,end, LLileevaileeva andand TreflTrefl eerr dividedivide upup theirtheir samplesample intointo quartilesquartiles ofof thethe 19881988 distributiondistribution ooff laborlabor productivityproductivity (with(with thethe quartilesquartiles defidefi nedned separatelyseparately forfor eacheach industryindustry toto netnet ooutut industryindustry characteristics).characteristics). OnlyOnly 2020 percentpercent ofof thethe plantsplants inin thethe bottombottom quar-quar- ttileile ofof laborlabor productivityproductivity startedstarted exportingexporting becausebecause ofof thethe tarifftariff cuts,cuts, comparedcompared toto nnearlyearly 6060 percentpercent ofof thethe plantsplants fromfrom thethe toptop quartilequartile ofof laborlabor productivity.productivity. (These(These eestimatesstimates areare fromfrom a probitprobit regressionregression inin whichwhich thethe dependentdependent variablevariable isis 1 ifif thethe pplantlant startedstarted exportingexporting andand 0 ifif thethe plantplant remainedremained a nonexporter.nonexporter. TheThe keykey inde-inde- ppendentendent variablevariable isis a plant-specifiplant-specifi c measuremeasure ofof thethe changechange inin thethe U.S.U.S. tariff.tariff. ThisThis mmeasureeasure isis describeddescribed below.)below.) TheThe keykey conclusionconclusion isis that,that, amongamong fi rmsrms thatthat diddid notnot eexportxport beforebefore tradetrade liberalization,liberalization, thethe mostmost productiveproductive ofof thesethese werewere threethree timestimes mmoreore likelylikely toto startstart exportingexporting inin responseresponse toto thethe U.S.U.S. tarifftariff cuts.cuts. ThisThis isis asas predictedpredicted iinn panelpanel B ofof FigureFigure 4.4.7

Quantifying the Gains from Trade Due to Reallocation across Heterogeneous Plants IInn tthehe wwakeake ooff tthehe CCanada–U.S.anada–U.S. ffreeree ttraderade aagreement,greement, CCanadiananadian mmanufacturinganufacturing pproductivityroductivity roserose sharply.sharply. WeWe havehave shownshown thatthat partpart ofof thisthis productivityproductivity gaingain waswas duedue ttoo thethe reallocationreallocation mechanismsmechanisms highlightedhighlighted byby thethe theory.theory. ButBut howhow importantimportant werewere tthesehese iinn qquantitativeuantitative ttermserms fforor pproductivityroductivity ggrowthrowth aandnd ooverallverall wwelfare?elfare? IInn tthehe cconventionalonventional aapproachpproach ttoo eestimatingstimating tthehe ggainsains ffromrom ttrade,rade, tthehe ffocusocus iiss onon measuringmeasuring wwelfare,elfare, oorr mmoreore sspecifipecifi cally,cally, onon thethe incomeincome a ssocietyociety wwouldould bbee wwillingilling toto ppayay fforor llowerower ttariffs.ariffs. TThesehese ““compensatingcompensating vvariation”ariation” ggainsains aarere ttypicallyypically dderivederived ffromrom mmodelsodels tthathat 11)) mmakeake a llargearge nnumberumber ooff pparametricarametric aassumptionsssumptions ((assumingassuming vveryery sspecifipecifi c functionalfunctional formsforms forfor ppreferencesreferences tthathat ddetermineetermine tthehe eextentxtent ooff pproductroduct ddifferentiation,ifferentiation, aass wwellell aass fforor tthehe uutilitytility dderivederived ffromrom llove-ove- oof-variety),f-variety), andand 22)) mmakeake uusese ooff pparameterarameter eestimatesstimates aaboutbout wwhichhich wwee aarere hhighlyighly uuncertain.ncertain. InIn sshort,hort, a llotot ooff uuncertaintyncertainty ssurroundsurrounds wwelfare-gainelfare-gain eestimates.stimates. IInn tthehe hheterogeneous-fieterogeneous-fi rmsrms lliterature,iterature, tthehe ffocusocus hhasas sshiftedhifted ttoo eestimatingstimating pproductivityroductivity ggainsains rratherather tthanhan wwelfare.elfare. TThehe llastast ttwowo ddecadesecades hhaveave sseeneen mmajorajor iimprovementsmprovements iinn oourur aabilitybility ttoo estimateestimate productivityproductivity gains,gains, bothboth becausebecause ofof thethe creationcreation ofof

7 On a related note, profi ts play a key role in all the mechanisms of our model. Baggs and Brander (2006) confi rm that profi ts move in the expected directions. In particular, they fi nd that falling Canadian tariffs are associated with declining Canadian profi ts, especially for import-competing fi rms, while falling U.S. tariffs are associated with increasing Canadian profi ts, especially for export-oriented fi rms. 110 Journal of Economic Perspectives

hhigh-quality,igh-quality, fi rm-levelrm-level llongitudinalongitudinal ddataata aandnd bbecauseecause ooff mmethodologicalethodological ddevelop-evelop- mmentsents aimedaimed aatt eexploitingxploiting tthesehese ddata.ata. TThus,hus, aalthoughlthough pproductivityroductivity ggainsains aarere nnotot tthehe samesame asas welfarewelfare gains,gains, wewe havehave muchmuch greatergreater conficonfi dencedence inin ourour estimatesestimates ofof tthehe productivityproductivity ggainsains aassociatedssociated wwithith ffreerreer ttrade.rade. TThehe pproductivityroductivity gainsgains associatedassociated withwith thethe reallocationreallocation ofof marketmarket sharesshares acrossacross fi rmsrms followingfollowing thethe Canada–U.S.Canada–U.S. freefree tradetrade agreementagreement areare usefullyusefully brokenbroken intointo ttwowo ccomponents.omponents. FFirst,irst, the fall in the U.S. tariffs allowedallowed CanadianCanadian plantsplants toto exportexport mmore.ore. TThishis sshiftedhifted tthehe ccompositionomposition ooff ooutpututput ttowardsowards hhigh-productivityigh-productivity exportersexporters aandnd aawayway ffromrom llow-productivityow-productivity nnonexporters.onexporters. LLileevaileeva aandnd TTreflrefl erer (2010)(2010) estimateestimate tthathat tthehe ffallall iinn UU.S..S. ttariffsariffs ccausallyausally rraisedaised CCanadiananadian mmanufacturinganufacturing pproductivityroductivity byby 44.1.1 ppercentercent viavia thisthis eexport-compositionxport-composition channel.channel. Second,Second, the fall in the Canadian tariffs lleded toto a shiftshift inin domesticdomestic marketmarket shares—exportersshares—exporters gainedgained marketmarket shareshare atat tthehe eexpensexpense ofof nonexporters.nonexporters. InIn thethe extreme,extreme, manymany nonexportersnonexporters simplysimply wentwent outout ooff business.business. TreflTrefl erer (2004)(2004) calculatescalculates thatthat thisthis selectionselection effecteffect increasedincreased overalloverall CCanadiananadian mmanufacturinganufacturing pproductivityroductivity bbyy 44.3.3 ppercent.ercent.8 PPuttingutting thesethese numbersnumbers together,together, wewe seesee thatthat thethe reallocationreallocation andand selectionselection eeffectsffects inducedinduced byby thethe freefree tradetrade agreementagreement generatedgenerated a productivityproductivity increaseincrease ofof 88.4.4 ppercentercent (4.1(4.1 + 44.3).3) fforor CCanadiananadian manufacturing.manufacturing. ThisThis representsrepresents a massivemassive pproductivityroductivity increaseincrease inin justjust a shortshort time—especiallytime—especially whenwhen oneone considersconsiders thatthat thisthis pproductivityroductivity gaingain ddidid nnotot ccomeome ffromrom pproductivityroductivity iimprovementsmprovements aatt tthehe pplantlant llevel:evel: iitt oonlynly ccameame ffromrom tthehe sshiftinghifting ooff mmarketarket sshareshares ffromrom lless-ess- ttoo mmore-productiveore-productive pplants.lants. CCanadaanada isis nnotot tthehe onlyonly countrycountry toto havehave experiencedexperienced suchsuch a substantialsubstantial produc-produc- ttivityivity bboostoost ffromrom rreallocationseallocations ddrivenriven bbyy ttraderade lliberalization.iberalization. BBernardernard aandnd JJensenensen ((2004)2004) fi ndnd thatthat almostalmost halfhalf ofof aallll UU.S..S. mmanufacturinganufacturing pproductivityroductivity ggrowthrowth dduringuring 11983–1992983–1992 isis eexplainedxplained bbyy tthehe rreallocationeallocation ooff rresourcesesources ttowardsowards eexporters.xporters. PPavcnikavcnik ((2002)2002) sstudiestudies tthehe rresponseesponse ooff tthehe CChileanhilean mmanufacturinganufacturing ssectorector ttoo a mmassiveassive ttraderade lliberalizationiberalization eepisodepisode tthathat ttookook pplacelace ffromrom 11979979 ttoo 11986.986. SShehe fi ndsnds thatthat two-thirdstwo-thirds ooff thethe ensuingensuing 1919 percentpercent increaseincrease inin productivityproductivity (another(another exampleexample ofof a massivemassive iincreasencrease inin aggregateaggregate productivity)productivity) waswas generatedgenerated byby compositioncomposition changeschanges withinwithin iindustriesndustries duedue toto a reallocationreallocation ofof marketmarket sharesshares towardstowards more-effimore-effi cientcient producers.producers. SSurveysurveys byby GreenawayGreenaway andand KnellerKneller (2007)(2007) andand WagnerWagner (2007)(2007) summarizesummarize thethe cconnectionsonnections betweenbetween tradetrade liberalizationliberalization andand aggregateaggregate productivity—includingproductivity—including tthishis reallocationreallocation effecteffect acrossacross heterogeneousheterogeneous fi rrms—forms—for a widewide rangerange ofof studiesstudies aandnd countries.countries.

8 Specifi cally, Trefl er (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 fi nds 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

IInn thisthis ssection,ection, wewe movemove ffromrom tthishis ““between-plant”between-plant” eeffectffect iinn wwhichhich productiveproductive pplantslants expandexpand atat thethe expenseexpense ofof less-productiveless-productive plantsplants toto ourour thirdthird sourcesource ofof gainsgains ffromrom ttrade:rade: a “within-plant”“within-plant” effecteffect inin whichwhich tradetrade raisesraises productivityproductivity ofof individualindividual pplantslants bbyy rraisingaising tthehe rreturnseturns ttoo iinnovation.nnovation. AAtt lleasteast aass ffarar bbackack aass SSchmooklerchmookler ((1954),1954), eeconomistsconomists hhaveave kknownnown tthathat tthehe llargerarger tthehe mmarket,arket, tthehe mmoreore pprofirofi tabletable itit isis forfor fi rmsrms toto investinvest inin productivity-enhancingproductivity-enhancing aactivities.ctivities. FirmsFirms inin llargearge mmarketsarkets hhaveave tthehe llargearge ssalesales vvolumesolumes nneededeeded ttoo jjustifyustify iincur-ncur- rringing tthehe highhigh fi xedxed costscosts ofof innovation.innovation. TheThe U.S.U.S. tarifftariff cutscuts thatthat werewere partpart ofof thethe UU.S.–Canada.S.–Canada freefree tradetrade aagreementgreement ggreatlyreatly iincreasedncreased tthehe ssizeize ooff tthehe mmarketarket ffacedaced bbyy CCanadiananadian fi rms.rms. ItIt shouldshould thereforetherefore havehave encouragedencouraged CanadianCanadian fi rmsrms toto increaseincrease ttheirheir eexportingxporting and ttoo iincreasencrease theirtheir investmentsinvestments inin productivity-enhancingproductivity-enhancing tech-tech- nnologies.ologies. WeWe sstarttart hhereere wwithith a sshorthort eextensionxtension ttoo tthehe ttheoreticalheoretical mmodelodel tthathat ccapturesaptures hhowow llargerarger mmarketsarkets ggenerateenerate incentivesincentives forfor somesome fi rmsrms toto innovate,innovate, andand thenthen turnturn ttoo eempiricalmpirical eevidence.vidence.

A Theory of Market Size and Firm Innovation

SSupposeuppose tthathat aann iinnovationnnovation processprocess requiresrequires anan up-frontup-front fi xedxed costcost fI aandnd iinn rreturneturn ggeneratesenerates a reduction inin marginalmarginal costcost ΔcI . ThatThat is,is, innovationinnovation reducesreduces mmarginalarginal costcost ffromrom c toto c − ΔcI . A fi rmrm thatthat producesproduces q unitsunits ofof outputoutput andand engagesengages iinn iinnovationnnovation wwillill llowerower iitsts pproductionroduction ccostsosts bbyy q × ΔcI . TThehe fi rmrm wwillill weighweigh thisthis costcost ssavingaving aagainstgainst tthehe fi xedxed innovationinnovation costcost fI , andand innovateinnovate ifif q × ΔcI > fI oorr

f q > _I . Δc I

In words, only fi rms with large volumes q (that is, those with initially lower levels of marginal cost) will fi nd it profi table to innovate. What happens to this fi rm-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 FForor eevidencevidence onon thethe linklink fromfrom ggrowthrowth ooff ttraderade ttoo wwithin-fiithin-fi rmrm productivity,productivity, wwee turnturn againagain toto Canada’sCanada’s experienceexperience withwith thethe freefree tradetrade agreement.agreement. LileevaLileeva andand TTreflrefl eerr (2010)(2010) looklook atat theirtheir samplesample ofof 5,0005,000 CanadianCanadian manufacturingmanufacturing plantsplants thatthat diddid nnotot exportexport priorprior toto 19881988 andand dividedivide thesethese plantsplants intointo thosethose thatthat startedstarted exportingexporting aafterfter tthehe ppassageassage ooff tthehe ffreeree ttraderade aagreementgreement aandnd tthosehose tthathat ddidid nnot.ot. IInn tthehe rrawaw ddata,ata, tthehe llaborabor pproductivityroductivity ooff tthosehose tthathat sstartedtarted ttoo eexportxport rroseose 2299 ppercentercent mmoreore tthanhan fforor nnonexporters;onexporters; sstartingtarting ttoo eexportxport wwasas hhighlyighly ccorrelatedorrelated wwithith wwithin-plantithin-plant pproductivityroductivity ggrowth.rowth. OfOf course,course, thisthis 2929 percentpercent numbernumber doesdoes notnot taketake intointo accountaccount a seriousserious 112 Journal of Economic Perspectives

pproblemroblem ooff rreverseeverse causality:causality: doesdoes exportingexporting leadlead toto increasedincreased productivityproductivity oror doesdoes iincreasedncreased pproductivityroductivity lleadead ttoo eexporting?xporting? TToo answeranswer thisthis question,question, oneone needsneeds anan instrumentinstrument forfor exporting:exporting: thatthat is,is, oneone nneedseeds anan eventevent thatthat causescauses a fi rmrm toto exportexport butbut thatthat doesdoes notnot directlydirectly affectaffect itsits pproductivityroductivity growth.growth. AsAs LileevaLileeva andand TreflTrefl erer (2010)(2010) show,show, “plant-specifi“plant-specifi c”c” tarifftariff cutscuts fi t tthehe bbillill aass aann iinstrument.nstrument. CConsideronsider a ssingleingle CCanadiananadian pplantlant ccalledalled LLumber-umber- jjackack aandnd tthehe mmanyany pproductsroducts iitt pproduces.roduces. EEmpirically,mpirically, pproductsroducts aarere ddefiefi nedned veryvery nnarrowly,arrowly, atat tthehe ssix-digitix-digit llevelevel ooff tthehe HHarmonizedarmonized SSystemystem pproductroduct cclassifilassifi cation,cation, soso tthathat therethere areare thousandsthousands ofof productsproducts inin manufacturing.manufacturing. ForFor eacheach productproduct producedproduced bbyy Lumberjack,Lumberjack, oneone cancan calculatecalculate thethe U.S.U.S. tarifftariff cut.cut. AveragingAveraging thesethese tarifftariff cutscuts aacrosscross allall ofof Lumberjack’sLumberjack’s productsproducts yieldsyields a plant-specifiplant-specifi c tarifftariff cut.cut. ThisThis plant-plant- sspecifipecifi c tarifftariff cutcut hashas enormousenormous powerpower inin predictingpredicting whetherwhether a CanadianCanadian plantplant sstartstarts exportingexporting andand howhow muchmuch itit exports.exports. TheThe tarifftariff cutcut alsoalso hashas nono directdirect impactimpact eeitherither theoreticallytheoretically oror empiricallyempirically onon a plant’splant’s productivityproductivity growth.growth. ItIt isis thusthus a novelnovel aandnd validvalid instrument.instrument. LLileevaileeva andand TreflTrefl erer (2010)(2010) actuallyactually dodo somethingsomething fancierfancier thanthan instrumentalinstrumental vvariables—theyariables—they estimateestimate thethe locallocal averageaverage treatmenttreatment effecteffect (LATE).(LATE). ThisThis isis thethe eeffectffect oonn pproductivityroductivity ooff sstartingtarting ttoo eexportxport for those plants that started exporting because of the tariff cuts. TThus,hus, unlikeunlike previousprevious studiesstudies ofof thethe causalcausal impactsimpacts ofof exportingexporting onon pproductivity,roductivity, ttheirheir workwork onlyonly usesuses informationinformation drawndrawn fromfrom plantsplants thatthat werewere likelylikely ttoo bbee aaffectedffected byby thethe freefree tradetrade agreement.agreement. UsingUsing theirtheir plant-specifiplant-specifi c tarifftariff instru-instru- mmentent andand thethe locallocal averageaverage treatmenttreatment effecteffect estimator,estimator, theythey establishestablish thatthat thethe freefree ttraderade aagreementgreement caused thethe productivityproductivity ofof newnew exportersexporters toto riserise byby 15.315.3 percent.percent. SSinceince thisthis 15.315.3 percentpercent riserise occurredoccurred inin plantsplants thatthat accountedaccounted forfor 2323 percentpercent ofof CCanadiananadian manufacturingmanufacturing output,output, thethe 15.315.3 percentpercent riserise inin laborlabor productivityproductivity ooff nnewew eexportersxporters raisedraised overall CanadianCanadian manufacturingmanufacturing productivityproductivity byby 3.53.5 percentpercent ((3.53.5 = 115.35.3 × 00.23;.23; sseeee TTableable 2 bbelow).elow). LLileevaileeva aandnd TTreflrefl erer (2010)(2010) thenthen tracetrace thethe sourcessources ofof thisthis productivityproductivity gaingain bbackack ttoo iinvestmentsnvestments inin productivity.productivity. TheThe authorsauthors examineexamine advancedadvanced manufacturingmanufacturing ttechnologiesechnologies andand ratesrates ofof innovationinnovation atat thesethese plants.plants. TableTable 1 presentspresents thethe results.results. CConsideronsider thethe fi rstrst row,row, whichwhich dealsdeals withwith managementmanagement techniquestechniques essentiallyessentially associ-associ- aatedted withwith leanlean manufacturing.manufacturing. InIn thethe periodperiod immediatelyimmediately afterafter implementationimplementation ofof tthehe freefree tradetrade agreement,agreement, 1616 percentpercent ofof newnew exportersexporters adoptedadopted suchsuch techniques,techniques, 1100 ppercentageercentage pointspoints moremore tthanhan nnonexportersonexporters did.did. TThehe fi nalnal column,column, whichwhich reportsreports llocalocal averageaverage treatmenttreatment effecteffect (LATE)(LATE) estimates,estimates, showsshows thatthat 7 ofof thethe 1010 percentagepercentage ppointsoints waswas attributableattributable toto thethe effectseffects ofof increasedincreased exportingexporting resultingresulting fromfrom thethe U.S.U.S. ttariffariff cuts.cuts. AsAs shownshown inin TableTable 1,1, similarsimilar resultsresults holdhold forfor thethe adoptionadoption ofof otherother tech-tech- nnologiesologies aandnd fforor iinnovation.nnovation. TThesehese resultsresults breakbreak withwith thethe discussiondiscussion ofof Bernard,Bernard, Jensen,Jensen, Redding,Redding, andand SchottSchott ((2007)2007) iinn tthishis jjournal,ournal, wwhoho ccorrectlyorrectly aarguergue tthathat mmostost ccarefulareful sstudiestudies sshowhow eexportingxporting does not rraiseaise productivity.productivity. OverOver thethe years,years, however,however, a fewfew carefulcareful studiesstudies havehave foundfound ootherwise,therwise, aass iinn CCanadaanada ((BaldwinBaldwin aandnd GGuu 22003,003, 22004;004; LLileevaileeva 22008),008), iinn nnineine AAfricanfrican ccountriesountries (Van(Van BiesebrockBiesebrock 2005),2005), andand inin SloveniaSlovenia (De(De LoeckerLoecker 2007).2007). LópezLópez (2005)(2005) pprovidesrovides aann ooverallverall ssurvey.urvey. Marc J. Melitz and Daniel Trefl er 113

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 Trefl er (2010). Note: “LATE” is the local average treatment effect.

WWhathat hashas recentlyrecently buttressedbuttressed thethe minorityminority viewview thatthat a riserise inin exportingexporting cancan lleadead toto a riserise inin productivityproductivity isis a spatespate ofof paperspapers isolatingisolating thethe causalcausal mechanismsmechanisms tthroughhrough whichwhich exportingexporting affectsaffects productivity.productivity. WeWe havehave alreadyalready seenseen thethe market-sizemarket-size mmechanismechanism ooff LLileevaileeva aandnd TTreflrefl erer (2010).(2010). BustosBustos (2011a,(2011a, b)b) developsdevelops a relatedrelated mmodelodel ooff sscale-biasedcale-biased technologytechnology choice,choice, whichwhich sheshe takestakes toto ArgentineanArgentinean fi rm-levelrm-level ddataata fforor tthehe 11992–1996992–1996 period.period. BustosBustos (2011b,(2011b, tabletable 6)6) showsshows thatthat fi rmsrms thatthat beganbegan eexportingxporting betweenbetween 19921992 aandnd 11996996 aalsolso iincreasedncreased ttheirheir ttechnologyechnology sspending.pending. BBustosustos ((2011a)2011a) showsshows thatthat technologytechnology spendingspending increasedincreased mostmost inin sectorssectors thatthat experi-experi- eencednced improvedimproved accessaccess toto BrazilianBrazilian productproduct marketsmarkets (through(through thethe tarifftariff cutscuts inin thethe MMercosurercosur regionalregional tradetrade agreement).agreement). InIn a seriesseries ofof studiesstudies ofof TaiwaneseTaiwanese electronicselectronics eexporters,xporters, Aw,Aw, Roberts,Roberts, andand WinstonWinston (2007)(2007) andand Aw,Aw, Roberts,Roberts, andand XuXu (2008,(2008, 2011)2011) sshowhow eempiricallympirically thatthat therethere isis a complexcomplex dynamicdynamic interplayinterplay betweenbetween thethe decisionsdecisions ttoo exportexport andand conductconduct researchresearch andand development,development, withwith today’stoday’s decisionsdecisions aboutabout oonene affectingaffecting tomorrow’stomorrow’s decisionsdecisions aboutabout thethe other—andother—and bothboth affectingaffecting futurefuture pproductivity.roductivity. ExtendingExtending thisthis dynamicdynamic methodologymethodology toto generalgeneral equilibrium,equilibrium, ShenShen ((2011)2011) alsoalso fi ndsnds strongstrong complementaritiescomplementarities betweenbetween exportingexporting andand productivity-productivity- eenhancingnhancing investmentsinvestments amongamong SpanishSpanish fi rms.rms. Bloom,Bloom, Draca,Draca, andand VanVan ReenenReenen ((2011)2011) showshow thatthat importimport competitioncompetition fromfrom ChinaChina hashas ledled toto increasesincreases inin R&D,R&D, ppatenting,atenting, informationinformation technology,technology, andand totaltotal factorfactor productivityproductivity amongamong moremore tech-tech- nnologicallyologically aadvanceddvanced EEuropeanuropean fi rms.rms. AtkesonAtkeson andand BursteinBurstein (2010)(2010) areare thethe onlyonly oonesnes ttoo eexaminexamine eexportingxporting aandnd iinvestingnvesting iinn pproductivityroductivity wwithinithin a ffull-blownull-blown ggeneraleneral eequilibriumquilibrium aanalysis.nalysis. TTheyhey fi ndnd thethe generalgeneral equilibriumequilibrium feedbacksfeedbacks areare important.important.

A New Dimension of Heterogeneity IInn oourur ttheoreticalheoretical modelmodel above,above, fi rmsrms belowbelow a certaincertain productivityproductivity thresholdthreshold sshouldhould notnot bebe exporting.exporting. YetYet inin thethe empiricalempirical workwork reviewedreviewed above,above, wewe sawsaw thatthat mmanyany llow-productivityow-productivity CCanadiananadian plantsplants startedstarted exportingexporting inin responseresponse toto UU.S..S. ttariffariff ccuts.uts. TTherehere isis a ssecondecond ppuzzleuzzle tthathat wwee hhaveave nnotot yyetet nnoted:oted: LLileevaileeva aandnd TTreflrefl erer (2010,(2010, ttableable 33)) reportreport thatthat thethe plantsplants thatthat gainedgained mostmost fromfrom startingstarting toto exportexport (both(both inin ttermserms ooff pproductivityroductivity gainsgains andand increasedincreased innovation)innovation) werewere primarilyprimarily plantsplants thatthat 114 Journal of Economic Perspectives

iinitiallynitially hadhad lowlow productivity.productivity. ThatThat is,is, amongamong plantsplants thatthat startedstarted toto export,export, thethe bbenefienefi t waswas greatestgreatest forfor thethe least-productiveleast-productive plants.plants. TToo seesee why,why, considerconsider a fi rmrm thatthat isis justjust indifferentindifferent betweenbetween investinginvesting andand notnot iinvesting.nvesting. FromFrom thethe earlierearlier equation,equation, indifferenceindifference meansmeans thatthat q = fI / cI , w wherehere cI isis thethe reductionreduction inin marginalmarginal costcost oror thethe increaseincrease inin productivity.productivity. RearrangingRearranging (cI = fI / q) andand notingnoting thatthat salessales q areare increasingincreasing inin initialinitial productivity,productivity, wewe arrivearrive aatt a ssimpleimple cconclusion.onclusion. Among the set of fi rms that are just indifferent between innovating and not innovating, tthehe less-productive,less-productive, low-low-q fi rrmsms mmustust eexpectxpect llargerarger productivityproductivity ggainsains cI fromfrom innovation.innovation. LileevaLileeva andand TreflTrefl er’ser’s (2010)(2010) resultsresults stronglystrongly conficonfi rmrm tthishis pprediction.rediction.

Conclusions

RRecentecent rresearchesearch iintonto tthehe wwelfareelfare ggainsains ffromrom iintra-industryntra-industry ttraderade hhaveave ffocusedocused oonn tthreehree ssourcesources ooff ggains:ains: 11)) ggainsains ffromrom iincreasedncreased vvarietyariety aandnd eeconomiesconomies ooff sscale,cale, 22)) pproductivityroductivity ggainsains aatt tthehe iindustryndustry llevelevel ffromrom sshiftinghifting rresourcesesources aawayway ffromrom llow-ow- pproductivityroductivity fi rrmsms aandnd ttowardsowards hhigh-productivityigh-productivity fi rms,rms, aandnd 33)) pproductivityroductivity ggainsains aatt tthehe fi rrmm llevelevel ffromrom iinnovatingnnovating fforor a llargerarger mmarket.arket. EEachach ooff tthesehese mmechanismsechanisms hhaveave pprovenroven ttoo bbee hhighlyighly iimportantmportant eempiricallympirically iinn tthehe ccontextontext ooff tthehe eexhaustivelyxhaustively sstudiedtudied CCanada–U.S.anada–U.S. ffreeree ttraderade aagreement,greement, aandnd aalsolso aappearppear iimportantmportant iinn mmanyany ootherther lless-ess- sstudiedtudied ccontexts.ontexts. IIndeed,ndeed, BBalistreri,alistreri, HHillberry,illberry, aandnd RRutherfordutherford ((2011)2011) sshowhow tthathat aaddingdding fi rmrm hheterogeneityeterogeneity ttoo sstandardtandard ccomputableomputable eequilibriumquilibrium mmodelsodels ooff ttraderade rraisesaises tthehe ggainsains ffromrom ttraderade lliberalizationiberalization bbyy a mmultipleultiple ooff ffour.our. EEmpiricalmpirical cconfionfi rmationrmation ooff tthehe ggainsains ffromrom ttraderade ppredictedredicted bbyy mmodelsodels wwithith hheterogeneouseterogeneous fi rmsrms rrepresentsepresents oonene ooff tthehe ttrulyruly ssignifiignifi cantcant aadvancesdvances iinn tthehe fi eldeld ofof internationalinternational eeconomics.conomics. WWee ssummarizeummarize thethe causalcausal effectseffects ofof thethe freefree tradetrade agreementagreement onon overalloverall CCanadiananadian manufacturingmanufacturing productivityproductivity inin TableTable 2.2. AsAs thethe lastlast rowrow shows,shows, CanadianCanadian mmanufacturinganufacturing laborlabor productivityproductivity roserose byby 13.813.8 percent.percent. TheThe ideaidea thatthat a singlesingle ggovernmentovernment policypolicy couldcould raiseraise productivityproductivity byby suchsuch a largelarge amountamount andand inin suchsuch a sshorthort ttime-spanime-span iiss ttrulyruly rremarkable.emarkable. IInn wwritingriting this his review,review, wewe havehave focusedfocused onon thethe netnet gainsgains fromfrom trade.trade. YetYet thethe modelmodel wwee havehave developeddeveloped highlightshighlights howhow intra-industryintra-industry tradetrade willwill generategenerate bothboth winnerswinners aandnd losers.losers. ForFor example,example, inin thethe contextcontext ofof thethe Canada–U.S.Canada–U.S. freefree tradetrade agreement,agreement, TTreflrefl erer (2004)(2004) showsshows thatthat 1212 percentpercent ofof thethe workersworkers inin low-productivitylow-productivity fi rmsrms lostlost ttheirheir jobs.jobs. RecentRecent researchresearch suggestssuggests thatthat AmericanAmerican workersworkers areare similarlysimilarly strugglingstruggling iinn responseresponse toto thethe ChineseChinese importimport surgesurge (Liu(Liu andand TreflTrefl erer 2011;2011; Autor,Autor, Dorn,Dorn, andand HHansonanson 22011).011). Clearly,Clearly, thisthis suggestssuggests anan importantimportant rolerole forfor policiespolicies thatthat provideprovide anan aadequatedequate safetysafety netnet andand t ransitionalransitional assistanceassistance forfor thosethose affectedaffected workers.workers. TheThe blowblow ttoo tthosehose wworkersorkers ccouldould bbee ccushionedushioned bbyy ppoliciesolicies tthathat iimpedempede tthehe rreallocationeallocation pprocessrocess aacrosscross fi rms.rms. However,However, suchsuch policies—aspolicies—as opposedopposed toto policiespolicies thatthat provideprovide somesome formform ooff ddirectirect aassistancessistance toto tthehe aaffectedffected wworkers—wouldorkers—would alsoalso entailentail a ssubstantialubstantial long-runlong-run ccost.ost. AfterAfter all,all, itit isis preciselyprecisely thisthis reallocationreallocation processprocess thatthat generatesgenerates somesome ofof thethe llong-runong-run ggainsains tthathat wwee hhaveave ddescribed.escribed. IInn aaddition,ddition, ppoliciesolicies tthathat sseekeek ttoo iimpedempede tthehe Gains from Trade when Firms Matter 115

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%

Source: Trefl er (2004) and Lileeva and Trefl er (2010). rreallocationeallocation processprocess byby makingmaking fi rmrm contractionscontractions andand expansionsexpansions costliercostlier wouldwould alsoalso rreduceeduce tthehe ppotentialotential ggainsains ttoo fi rmrm innovationinnovation andand hencehence leadlead toto lessless innovationinnovation andand ffurtherurther depressdepress thethe ppotentialotential llong-runong-run ggainsains ffromrom ttrade.rade. NNonetheless,onetheless, iitt iiss iimportantmportant ttoo rememberremember thatthat therethere areare winnerswinners andand loserslosers fromfrom tradetrade liberalizationliberalization notnot justjust aamongmong fi rms,rms, bbutut aalsolso aamongmong ttheirheir eemployees.mployees.

■ Trefl er 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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