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 ssinceince pprehistoricrehistoric ttimes.imes. OOurur ppre-urbanre-urban aancestorsncestors wwereere bbenefienefi t-t- T ttinging ffromrom llong-distanceong-distance ttraderade iinn oobsidianbsidian ssomeome 10,00010,000 yyearsears aago;go; PPlato’slato’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 wwhereashereas ttraderade wwasas ooncence ddominatedominated bbyy tthehe mmovementovement ooff ggoodsoods tthathat ccouldould oonlynly bbee pproduced,roduced, hharvested,arvested, oorr mminedined rregionally,egionally, tthehe internationalinternational tradetrade landscapelandscape iiss nnowow ddominatedominated bbyy ttwowo sstrikingtriking 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 ffromrom TToyotaoyota ((Japan),Japan), KiaKia ((Korea),Korea), GGeneraleneral MotorsMotors (United(United States),States), andand CheryChery ((China).China). DDittoitto fforor cconsumersonsumers inin JJapan,apan, KKorea,orea, aandnd tthehe UUnitednited States.States. TheThe secondsecond sstrikingtriking ffactact iiss tthathat wworldorld ttraderade isis ddominatedominated byby hhuge,uge, innovative,innovative, andand extraordi-extraordi- nnarilyarily pproductiveroductive fi rrms.ms. FForor example,example, IIntelntel iiss ssoo llargearge thatthat iitt iiss tthehe llargestargest iindustrialndustrial eemployermployer iinn bbothoth OOregonregon aandnd NNewew MMexicoexico aandnd aaccountsccounts fforor 2020 percentpercent ofof CostaCosta RRica’sica’s eexports.xports. CChina’shina’s FFoxconnoxconn infamouslyinfamously eemploysmploys 450,000450,000 workersworkers inin a single oonene ooff iitsts mmanyany eexport-orientedxport-oriented eelectronicslectronics ffactories.actories. TThesehese areare bigbig ccompaniesompanies . andand iiff yyouou aarere rreadingeading tthishis ddocumentocument oonn aann AApplepple ccomputeromputer yyouou knowknow tthathat ttherehere aarere ootherther llargearge ccompanies,ompanies, ttoo.oo. TThehe rrisingising prominenceprominence ooff iintra-industryntra-industry ttraderade andand hugehuge mmultinationalsultinationals hashas ttransformedransformed tthehe wwayay eeconomistsconomists tthinkhink aaboutbout tthehe ggainsains ffromrom trade.trade. InIn thethe past,past, wewe ffocusedocused oonn ggainsains tthathat sstemmedtemmed eeitherither ffromrom eendowmentndowment ddifferencesifferences ((wheatwheat fforor ■ 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 oore)re) oorr iinter-industrynter-industry ccomparativeomparative aadvantagedvantage ((DavidDavid Ricardo’sRicardo’s classicclassic exampleexample ooff cclothloth fforor pport).ort). TToday,oday, wwee ffocusocus oonn tthreehree ssourcesources ofof gainsgains fromfrom trade:trade: 1)1) love-love- oof-varietyf-variety ggainsains aassociatedssociated withwith intra-industryintra-industry ttrade;rade; 22)) aallocativellocative effieffi ciencyciency gainsgains aassociatedssociated wwithith sshiftinghifting llaborabor aandnd ccapitalapital ooutut ofof small,small, less-productiveless-productive fi rmsrms andand iintonto llarge,arge, mmore-productiveore-productive fi rrms;ms; aandnd 3)3) productiveproductive effieffi ciencyciency gainsgains associatedassociated withwith ttrade-inducedrade-induced iinnovation.nnovation. BBackack iinn tthehe 11980s,980s, a ““NewNew TTraderade TTheory”heory” waswas ddevelopedeveloped thatthat ffocusedocused onon intra-intra- iindustryndustry ttraderade iinn ddifferentiatedifferentiated goodsgoods producedproduced subjectsubject toto increasingincreasing returnsreturns toto sscale.cale. TThishis ttheoryheory ccenteredentered oonn aann elegantelegant tension:tension: cconsumersonsumers lovelove varietyvariety andand areare wwillingilling ttoo paypay a premiumpremium fforor a desireddesired pproduct,roduct, butbut asas tthehe marketmarket fragmentsfragments intointo nnicheiche pproducts,roducts, pproducersroducers sstruggletruggle ttoo aattainttain tthehe vvolumesolumes nneededeeded toto rrecoupecoup ttheirheir pproductroduct ddevelopmentevelopment ccosts.osts. IInternationalnternational ttraderade ccreatesreates a llargerarger mmarketplace,arketplace, wwhichhich mmeanseans tthathat eeachach fi rrmm ccanan ooperateperate atat a llargerarger sscalecale aandnd hhenceence mmoreore fi rmsrms cancan survive.survive. TThehe rresultesult rreadseads llikeike aann aadvertisementdvertisement forfor ffreeree trade:trade: llowerower 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 iinn oourur eexamplexample aabovebove ooff mmidsizeidsize ccars.ars. SSeeee KKrugmanrugman ((1979,1979, 11980),980), HelpmanHelpman aandnd KKrugmanrugman ((1985),1985), aandnd HHelpmanelpman ((2011,2011, cchap.hap. 4)4) fforor a rrevieweview ofof love-of-varietylove-of-variety gainsgains ffromrom ttrade.rade. MMoreore rrecently,ecently, a ssecondecond ssourceource ooff ggainsains ffromrom ttraderade hhasas eemergedmerged ffromrom tthehe rresearchesearch ooff MMelitzelitz ((2003)2003) aandnd BBernard,ernard, EEaton,aton, JJensen,ensen, aandnd KKortumortum ((2003).2003). TThishis iiss tthehe fi rrm-levelm-level ““reallocation”reallocation” effecteffect thatthat arisesarises whenwhen therethere isis fi rmrm heterogeneity.heterogeneity. BByy fi rrmm hheterogeneityeterogeneity wwee mmeanean tthathat eevenven wwithinithin narrowlynarrowly defidefi nneded iindustriesndustries somesome fi rrmsms aarere mmuchuch llargerarger andand mmoreore pprofirofi ttableable thanthan othersothers because,because, forfor example,example, ttheyhey aarere mmuchuch mmoreore pproductive.roductive. GlobalizationGlobalization ggeneratesenerates bbothoth wwinnersinners andand loserslosers aamongmong fi rrmsms wwithinithin aann iindustryndustry aandnd tthesehese eeffectsffects aarere mmagnifiagnifi eded byby heterogeneity.heterogeneity. BBetter-performingetter-performing fi rrmsms thrivethrive aandnd eexpandxpand intointo foreignforeign markets,markets, whilewhile worse-worse- pperformingerforming fi rmsrms ccontractontract aandnd eveneven sshuthut downdown inin tthehe faceface ofof foreignforeign competition.competition. TThishis ggeneratesenerates a nnewew ssourceource ofof gainsgains fromfrom trade:trade: asas productionproduction isis concentratedconcentrated ttowardsowards bbetter-performingetter-performing fi rrms,ms, tthehe overalloverall effieffi ciencyciency ofof thethe industryindustry improves.improves. IInn tthishis wway,ay, gglobalizationlobalization rraisesaises aaverageverage effieffi ciencyciency within an industry. WWhyhy iiss iitt tthathat oonlynly tthehe bbetter-performingetter-performing fi rmsrms ggrow?row? GGlobalizationlobalization expandsexpands marketsmarkets butbut alsoalso iincreasesncreases ccompetitionompetition iinn tthosehose markets.markets. ThisThis ccompetitionompetition eeffectffect ddominatesominates forfor thethe wworse-performingorse-performing fi rrmsms wwhilehile tthehe iincreasedncreased mmarketarket aaccessccess ddominatesominates fforor tthehe bbetter-etter- pperformingerforming fi rrms.ms. AAlso,lso, a fi rm’srm’s internationalinternational expansion—whetherexpansion—whether byby exporting,exporting, bbyy ooffshoreffshore ooutsourcingutsourcing ooff iintermediatentermediate ccomponentsomponents andand aassembly,ssembly, oror bbyy buildingbuilding pplantslants aabroadbroad ((multinationals)—entailsmultinationals)—entails ssomeome uup-frontp-front fi xedxed costs;costs; andand onlyonly thethe bbest-performingest-performing fi rrmsms hhaveave tthehe ssalesales vvolumesolumes nneededeeded ttoo jjustifyustify tthesehese fi xedxed costs.costs. OOurur tthirdhird ssourceource ooff ggainsains ffromrom ttraderade ccomesomes ffromrom tthehe ppositiveositive iimpactsmpacts ooff llargerarger mmarketsarkets oonn innovation. NNewew pproductivity-enhancingroductivity-enhancing pproductsroducts andand processesprocesses requirerequire uup-frontp-front ddevelopmentevelopment ccosts.osts. TTraderade iintegration,ntegration, byby eexpandingxpanding tthehe ssizeize ooff tthehe mmarket,arket, eencouragesncourages fi rrmsms toto pponyony uupp thesethese developmentdevelopment dollars,dollars, andand thisthis inin turnturn raisesraises pproductivity.roductivity. TTheoriesheories