Handbook of International Economics

Handbook of International Economics

Volume 4

GITA GOPINATH

Harvard University, Cambridge, MA, USA National Bureau of Economic Research, Cambridge, MA, USA

ELHANAN HELPMAN

Harvard University, Cambridge, MA, USA Canadian Institute for Advanced Research National Bureau of Economic Research, Cambridge, MA, USA

KENNETH ROGOFF

Harvard University, Cambridge, MA, USA National Bureau of Economic Research, Cambridge, MA, USA

Table of Contents

Cover image

Title page

Copyright

Contributors

Introduction to the Series

Preface

1: Heterogeneous Firms and Trade

1 Introduction

2 Empirical Evidence

3 General Setup

4 Closed Economy Equilibrium

5 Open Economy with Trade Costs

6 Quantitative Predictions

7 Factor Abundance and Heterogeneity

8 Trade and Market Size

9 Endogenous Firm Productivity

10 Factor Markets

11 Conclusion

References

2: Multinational Firms and the Structure of International Trade

1 Introduction

2 Stylized Facts

3 Benchmark Model: An Extended Krugman (1980) Model

4 The Proximity-Concentration Hypothesis

5 Vertical Expansion

6 MultiCountry Models

7 Multinational Firm Boundaries

8 Conclusion

References

3: Gravity Equations: Workhorse,Toolkit, and Cookbook

1 Introduction

2 Micro-Foundations for Gravity Equations

3 Theory-Consistent Estimation

4 Gravity Estimates of Policy Impacts

5 Frontiers of Gravity Research

6 Directions for Future Research

7 Conclusion

References

4: Trade Theory with Numbers: Quantifying the Consequences of Globalization

1 Introduction

2 Getting Started

3 Beyond Armington

4 Evaluating Trade Policy

5 Numbers We Can Believe In?

6 Micro versus Macro Numbers

7 Life Without Gravity

8 Concluding Remarks

References

5: Domestic Institutions as a Source of Comparative Advantage

1 Introduction

2 Contracting and Property-Right Institutions: Impacts on Comparative Advantage

3 Informal Institutions and their Impacts on Comparative Advantage

4 Policies and the Indirect Impacts of Institutions on Comparative Advantage

5 The Impact of Trade and Comparative Advantage on Domestic Institutions

6 Conclusion

References

6: International Trade Agreements

1 Introduction

2 The Motives for Trade Agreements

3 The Design of Trade Agreements

4 Regional Trade Agreements

5 Conclusion

References

7: International Prices and Exchange Rates

1 Introduction

2 Empirical Evidence

3 A Simple Framework to Interpret Empirical Findings

4 Models with Desired Variable Markups

5 Other Models of Incomplete Pass-through

6 Industry Equilibrium

7 General Equilibrium

8 Conclusion

9 Appendix

References

8: Exchange Rates and Interest Parity

1 Exchange Rates and Interest Parity

2 Monetary Sticky-Price Models of Exchange Rates

3 Empirical Studies of Exchange Rates

4 Ex Ante Excess Returns and the Uncovered Interest Parity Puzzle

5 Conclusions

References

9: Assessing International Efficiency

1 Introduction

2 A Methodology for Assessing International Efficiency

3 Assessing Long-Run Efficiency

4 Assessing Efficiency in International Business Cycles

5 Conclusion

6 Appendix: Proof of Proposition 1

References

10: External Adjustment, Global Imbalances, Valuation Effects

1 Introduction

2 Stylized Facts

3 Long-Term Capital Flows in the Neoclassical Growth Model

4 Models of Global Imbalances

5 External Balance Sheets, Valuation Effects, and Adjustment

6 The International Monetary and Financial System

7 Conclusion

References

11: Sovereign Debt

1 Introduction: Conceptual Issues

2 Empirical Facts

3 A Benchmark Framework

4 Richer Notions of Default

5 Self-fulfilling Debt Crises

6 Incomplete-Market Models and their Quantitative Implementation

7 Concluding Remarks

References

12: International Financial Crises

1 Introduction

2 Fiscal-Monetary Imbalances

3 Overvaluation, Unemployment, and Multiple Equilibria

4 Financial Flows, Sudden Stops, and Balance Sheet Effects

5 Spread Spirals and Rollover Crises

6 Sources of Fragility

7 Concluding Remarks

References

Index

Copyright

Contributors

Introduction to the Series

The aim of the Handbooks in Economics series is to produce Handbooks for various branches of economics, each of which is a definitive source, reference, and teaching supplement for use by professional researchers and advanced graduate students. Each Handbook provides self-contained surveys of the current state of a branch of economics in the form of chapters prepared by leading specialists on various aspects of this branch of economics. These surveys summarize not only received results but also newer developments, from recent journal articles and discussion papers. Some original material is also included, but the main goal is to provide comprehensive and accessible surveys. The Handbooks are intended to provide not only useful reference volumes for professional collections but also possible supplementary readings for advanced courses for graduate students in economics.

Kenneth J. Arrow and Michael D. Intriligator

Preface*

Almost twenty years have passed since the publication of Volume 3 of the Handbook of International Economics in 1995. Much has changed since then, both in international trade and international macroeconomics. The changes are fourfold: (a) new questions have arisen as the world trade and payment system has evolved; (b) new data sets have become available; (c) new theoretical models have been designed to address new issues, but they have also enabled sharper and deeper analyses of older issues; and (d) new empirical studies have greatly enriched our understanding of the global economy.

The chapters in this handbook review, illuminate, and interpret these developments in a systematic way, making this material—which is technical at times—accessible to professional economists and graduate students alike. Trade is covered in the first six chapters, and international macroeconomics is covered in the subsequent six chapters.

1 International Trade

Neoclassical analysis of foreign trade focused on comparative advantage at the sectoral level, be it due to variation in productivity or factor endowments. Firms as suppliers of unique brands of differentiated products and monopolistic competition were integrated into trade theory in the 1980s (see Krugman 1995 for a review). Yet as much as these improvements have been important, they focused on sectoral outcomes by treating firms within industries as symmetric entities. Given the aim of that research, which was to expand the neoclassical framework to accommodate intraindustry trade and large volumes of trade between similar countries, the symmetry assumption was a reasonable simplification. Except that it proved to be inadequate for interpreting evidence that emerged in the 1990s concerning the participation of firms in foreign trade, as new firm-level data sets became available. In these data, exporting firms differ systematically from nonexporters. Scholars responded with the development of new models in which firms are heterogeneous, and these models guided empirical studies with the new rich data sets.

Melitz and Redding review these developments in Chapter 1. After describing the patterns of firm heterogeneity in the data, they develop an integrated multisector analytical framework for discussing many issues that have been analyzed in the recent literature. In the data, exporters differ from nonexporters in a number of dimensions; e.g., exporters are bigger and more productive than nonexporters and they pay higher wages. Studies of trade liberalization show that it leads to substantial reallocation within industries; low-productivity firms exit while market shares are reallocated to more productive firms, and especially to exporters. In addition, firms and product margins are important determinants of trade flows, because variation in the number of products explains a large fraction of the variation in trade volumes. These are some of the findings that motivated the original theoretical analysis that Melitz and Redding review in this chapter.

The analytical framework consists of sectors that have the features developed in Melitz (2003), as well as a homogeneous good sector (although the latter is shut down in some applications). Firms enter an industry in anticipation of a productivity draw. After the entry cost is sunk and a firm’s productivity revealed, the firm has to decide whether to stay in the industry or exit. If it stays, it has to decide whether to serve only the domestic market or also export. There is a fixed cost of operation and a fixed cost of exporting, as well as variable trade costs. In the now familiar manner, firms choose among these strategies based on productivity: the least productive firms exit, the most productive become exporters, and intermediate-productivity firms serve only the domestic market.

Although these results are not new, the exposition is new and intuitive, making the analysis accessible to many readers. This useful feature characterizes the entire chapter. It is especially helpful in the discussion of within-sectoral reallocations in response to declining trade costs and the home market effect.

Melitz and Redding also explain how these models have guided estimation of trade flows and quantitative analysis. Some of these issues are discussed in more detail in Chapter 3 on gravity equations and in Chapter 4 on trade theory with numbers. They also discuss the integration of factor proportions into the multisector framework and some of its consequences, such as the relationship between factor endowments and endogenous sectoral productivity levels.

Up to this point preferences for variety were assumed to be of the constant-elasticity-of-substitution type, resulting in constant markups in percentage terms. In Section 8, Melitz and Redding replace those preferences with a generalized quadratic system that yields linear demand functions with an intercept that depends on sectoral conditions. Under these circumstances markups vary across firms and they respond to demand and supply shocks. Since trade is costly, international markets are not fully integrated and market size impacts markups and average sectoral productivity levels. As a result, productivity is higher and markups are lower in larger economies.

In this case multilateral trade liberalization leads to exit of low-productivity firms and market share reallocation toward more productive firms, including exporters, but in addition it reduces markups. The result is that prices are lower because of both higher productivity and lower markups.

Section 9 then examines endogenous firm-specific productivity levels, by allowing firms to engage in innovation or technology adoption that augments their productivity draws. Choice of product scope for multiproduct firms is also considered, which provides another endogenous source of productivity variation across firms. In a dynamic context this generates a complementarity between exports and productivity-enhancing investments, because the payoff to productivity improvements is higher for exporting firms.

A number of empirical studies have shown that key predictions of these models are consistent with the data. As a rule, exporters invest more than nonexporters in new technologies. And in the face of trade liberalization, multiproduct firms shed their worst products while nonexporters who switch to exporting invest the most in technology upgrading.

Finally, Melitz and Redding review the recent literature on the impact of trade on wage inequity in the presence of labor market frictions. Unlike the neoclassical writings that discussed wage inequality across workers with different characteristics, such as differences in human capital, the new literature emphasizes residual wage inequality—wage inequality between workers with similar characteristics—that has become a large contributor to the inequality of earnings. Firm heterogeneity plays an important role in this relationship, both theoretically and empirically, because firms with varying attributes within sectors pay different wages to workers with similar characteristics.

In Chapter 2, Antràs and Yeaple review the evolution of ideas about the role of multinational firms in the world’s trading system. Much has happened on this front since the publication of the previous volume of the Handbook of International Economics. On the theoretical side the internalization decision has been afforded new foundations and within-industry firm heterogeneity has been extended to cover multinationals. On the empirical side new hypotheses emanating from the novel theory have been examined with rich new data sets.

Antràs and Yeaple first review some stylized facts about the operation of multinational corporations. Some of these are similar to stylized facts about trade flows; e.g., foreign direct investment (FDI) is concentrated within the group of rich countries and it exhibits large two-way flows (intraindustry FDI). There are, however, substantial differences across sectors; e.g., multinationals operate primarily in capital-intensive and R&D-intensive sectors. Within sectors, both the parents of multinationals and their affiliates tend to be larger, more productive, more R&D intensive, and more export oriented than nonmultinational corporations. And moreover, parents tend to specialize in R&D while affiliates tend to sell goods primarily in the host countries.

After presenting this evidence, Antràs and Yeaple develop a simple analytical framework of trade with monopolistic competition that includes multinational corporations (MNCs), but no within-industry heterogeneity. They apply it to horizontal FDI, driven by the proximity-concentration tradeoff. In this view a firm can serve a foreign market via export or subsidiary sales. The former entails variable trade costs—such as tariffs or freight—that are saved by the latter mode of operation, while FDI entails fixed costs of acquiring and operating a production unit in the foreign country, which are saved by exporting. The evidence, based on U.S. data, supports this tradeoff: export relative to subsidiary sales is lower in sectors with high variable trade costs and higher in sectors with high plant-level fixed costs.

Following this discussion, the theory is extended to include heterogeneous firms. Now the most productive firms become multinational corporations while the least productive (that remain in the industry) serve only the domestic market. Firms with intermediate productivity levels serve foreign markets via export sales. This sorting pattern holds in several data sets. The model also predicts a proximity-concentration tradeoff, and it adds to it an impact of the degree of sectoral heterogeneity. That is, export relative to subsidiary sales is expected to be smaller in sectors with more productivity dispersion.

Vertical FDI is next examined. In this case firms choose to fragment their production process, locate some activities—such as R&D or design—in the headquarters and therefore in the home country, and other activities—such as production of intermediate inputs or assembly—in host countries of subsidiaries. Since this motive for FDI is primarily driven by cost considerations, differences in factor prices play a key role in these decisions. But firm heterogeneity is also important, and the models predict, consistent with the data, that within sectors more productive firms source their inputs from foreign countries. In the U.S. data, imports of inputs from foreign subsidiaries are highly concentrated among a small number of very large multinationals, and these subsidiaries are located in a small number of countries that include Canada, Mexico, and Ireland. There is, however, substantial variation across sectors and countries in export relative to subsidiary sales. In particular, U.S. firms export less relative to subsidiary sales in skill-intensive sectors to countries that are skill abundant.

Next, Antràs and Yeaple provide a detailed discussion of theories of the boundaries of firms, including their implications for multinational corporations. These include the transaction costs and property rights approaches to firms’ boundaries. In addition to clearly explaining the insights from this literature, they develop several generalizations of key results. Here too firm heterogeneity plays center stage as do new features such as the role of incomplete contracts, the degree of contractibility of various activities, and the varying ability to contract in different countries. As in previous models, offshoring is concentrated among high-productivity firms, and the most productive among them engage in foreign direct investment. In addition, the property rights model predicts more integration in headquarter-intensive sectors, leading to larger shares of intrafirm trade, and subtle differences between the impact of better contractibility of headquarter and nonheadquarter activities. The latter predictions contrast with predictions of the transactions cost approach to boundaries of the firm, which are the same for all improvements in contractibility. A review of the evidence suggests that it is in line with several implications of the property rights approach.

We have chosen to devote an entire chapter to the use of gravity equations for the estimation of trade flows. Although these equations have been widely used for empirical analysis since Tinbergen introduced them in 1962, the theoretical foundations of these equations had been sketchy and only recent work has provided satisfactory formulations. As a result, empirical analysis of trade flows relies now more than ever before on theoretical foundations, and these foundations have also helped to develop estimation methods that are rooted in theory. This important literature is reviewed by Head and Mayer in Chapter 3.

The chapter starts with a historical review of the fundamental equation, developing three related definitions. It then proceeds to describe a sequence of theoretical models that yield gravity equations. Some are based on demand conditions, others on supply conditions. Some are competitive, others use monopolistic competition. Some have symmetric firms, others have heterogeneous firms. This part shows clearly the broad and wide reach of Tinbergen’s original idea.

After reviewing the theory, Head and Mayer discuss theory-consistent estimation, covering a number of techniques. This section is more than useful, because it includes a very clear discussion of the advantages and limitations of alternative methods, including a Monte Carlo study of the main estimators.

Among the uses of gravity equations, estimates of the effects of policies—such as free trade agreements and currency areas—on trade promotion have been prominent. The chapter discusses these estimates, distinguishing between partial and general equilibrium effects, as well as broader issues of quantitative analysis based on gravity equations. It also covers recent research on estimation procedures that account for the presence of zero trade flows in data sets with many countries, and the separation of the intensive from the extensive margin of trade flows.

In Chapter 4, Costinot and Rodríguez-Clare discuss the use of structural gravity equations for quantitative assessments of the consequence of globalization. After reviewing a variety of models that yield gravity equations, they show that a number of them share a similar formula for the gains from trade. The ingredients of this formula are the proportional decline of the share of spending on a country’s own goods and the elasticity of trade with respect to variable trade costs. This characterization applies to models of perfect competition and models of monopolistic competition, including models with firm heterogeneity, that satisfy certain macro restrictions.

Calibrated versions of these models can be used to compute in a simple way gains from trade. Such computations shed light on the role of various ingredients in the theory, serving as a theory with numbers. For example, the gains are sensitive to the inclusion of many sectors and intermediate inputs.

In addition to gains from trade, structural gravity models can be used to evaluate the impact of trade policies, such as tariffs, by performing counterfactual exercises. These include the computation of optimal unilateral tariffs and comparisons of uniform versus nonuniform tariffs with the same average rate of protection. The chapter closes with a discussion of quantitative approaches that do not rely on gravity models.

In Chapter 5, Nunn and Trefler discuss an entirely new line of research, concerning the role of domestic institutions in shaping comparative advantage. This topic was not covered in previous volumes of the Handbook of International Economics, simply because the relevant literature has developed only recently.

The chapter begins with a discussion of contracting institutions. One view is that in two countries with similar technologies and factor prices, unit costs may differ due to differences in the quality of the legal systems, and that the cost differences vary across industries if the reliance on contracts is not the same in all of them. To evaluate this hypothesis it is necessary to develop sectoral measures of contract intensity and country measures of the quality of the legal systems. Scholars have indeed developed such indexes and the empirical studies show that countries with better legal systems tend to export relatively more in contract-intensive sectors. Moreover, the contribution of this source of comparative advantage to trade flows is quite large. There are, of course, significant methodological issues involved in this analysis, and they are clearly laid out in the chapter.

Other institutional features that have been studied include financial development and labor market institutions. Nunn and Trefler review the empirical literature and provide comparable joint estimates of various measures of product market, financial market, and labor market institutions on comparative advantage. Similarly to previous studies, they find that the impact of these institutional features on comparative advantage is comparable in size to the impact of factor endowments.

The chapter then proceeds to discuss informal institutions and cultural beliefs in shaping trade flows, and Nunn and Trefler relate the analysis of contracting institutions to outsourcing and integration covered in greater detail in Chapter 2. Finally, they discuss the historical evidence on reverse causality, from international trade to the formation of domestic institutions. These include episodes from the commercial revolution and the African slave trade.

The final chapter of those concerning trade, written by Giovanni Maggi, is devoted to international trade agreements. Although similar topics are covered in Volume 3 of the Handbook of International Economics, significant progress has been made since its publication in 1995. The chapter starts with a discussion of motives for trade agreements, using simple models to illustrate them. Importantly, the models include political economy considerations.

One motive for trade agreements is based on the terms-of-trade theory, which argues that a trade agreement avoids a Prisoners’ Dilemma inherent in trade wars, and thereby leads to a more efficient outcome. This is an old argument that has received much attention and has been greatly refined over the years. A second motive concerns commitments. In this view trade agreements commit the government vis à vis domestic interest groups, thereby eliminating the implementation of some undesirable trade policies. This argument has also been refined in important ways in recent years. Finally, arguments that build on the new trade theory have been further developed. In this view of the world, trade policies impact firm entry and exit and reallocate profits across firms and countries. As a result, governments have incentives to engage in trade policies that take advantage of these responses, often at the expense of other countries. Trade agreements can mitigate some of these concerns. New empirical studies have addressed these motives and the chapter reviews the evidence.

Next comes a discussion of the design of trade agreements. The developments in this area are particularly novel. Naturally, in the absence of design costs this issue would not be challenging. In practice, however, these costs can be substantial. Maggi discusses two types of costs: contracting frictions, such as contract incompleteness, and imperfect enforcement. These shed light on the roles of various World Trade Organization (WTO) rules, such as the presence of binding trade instruments but nonbinding domestic policy instruments, the principle of reciprocity, or the most favored nation clause. They also shed light on the dispute settlement mechanism that was introduced with the formation of the WTO (which replaced the General Agreement on Tariffs and Trade (GATT) in 1995) after the completion of the Uruguay Round of trade negotiations.

In the final section Maggi discusses the formation of regional trade agreements that have proliferated since the formation of the WTO. The discussion includes the economic and political determinants of such agreements and the impact of these agreements on multilateral trade negotiations.

2 International Macroeconomics

As with international trade, international macroeconomics has seen major advances over the past two decades, driven both by new data sets and new theory. New databases have allowed researchers to explore nuances in classic questions such as the law of one price and the financial significance of current account deficits in novel ways with surprising results. Early models of financial market integration based on trade in bonds and a limited set of financial instruments have been supplanted by models with a much richer range of instruments. These range from models with complete asset markets to those with very specific frictions in goods and/or financial markets. One very specific friction, resulting from the inability of sovereign nations to legally commit to international debt repayments was taken up in the previous handbook. However, there have been major advances in both theoretical sophistication and empirical foundations in this central area of research, so we revisit the issue here in a separate chapter. The reader may note that this volume does not include a separate chapter on New Open Economy Macroeconomic Models (following Obstfeld and Rogoff, 1996). We decided that this topic had already been covered recently by Corsetti et al. (2010) in the Handbook of Monetary Economics. We now turn to the individual chapters on international macroeconomics.

One of the fundamental issues explored in international macroeconomics is the relation between exchange rates and other macroeconomic variables. The first two chapters survey the progress made in understanding this relation with a focus on developments since the last handbook was published in 1995.

The first chapter by Burstein and Gopinath, International Prices and Exchange Rates, surveys recent empirical and theoretical developments on the relation between exchange rates and prices. Empirical research on the extent of convergence in prices, in a common currency, across locations has been ongoing for several decades. This literature on purchasing power parity and exchange rate pass-through received a major boost as an increasing number of micro data sets on prices became available over the last decade. This has meant that we now know facts about price dispersion down to the level of a universal product code (UPC) sold by the same firm across locations within and across country borders. Similarly we have information on the sensitivity of prices to exchange rate changes at various stages of the retail chain, from at-the-dock prices, to wholesale prices and to retail prices with prices observed at high frequencies and for long periods of time.

Burstein and Gopinath first organize a large number of recent empirical results under the heading of five empirical findings and then provide a simple theoretical framework to interpret the facts. They do so by nesting in reduced form the various theoretical channels that can dampen the response of prices to exchange rates and that can generate price dispersion. They then describe recent developments in the literature that endogenously generate variable markups and pricing to market. These models add many realistic features to the pricing decisions of firms such as firm heterogeneity, consumer search, inventories, and distribution costs and complement the arrival of rich micro data in enhancing our understanding of the link between exchange rates and prices.

While the first of the international macro chapters focuses on the impact of nominal exchange rates on prices the second chapter by Engel, Exchange Rates and Interest Parity, surveys advances in research on the topic of what determines nominal exchange rates. Engel provides an organizing framework around an interest parity condition for the large literature that investigates the connect or disconnect between exchange rates and macro fundamentals. This interest parity condition ties the current value of the nominal exchange rate to nominal interest rate differentials, the expected future value of the exchange rate, and a residual term that captures deviations from uncovered interest parity (UIP). He first surveys the traditional monetary approach to exchange rate determination that assumes UIP holds. Unlike the discussion in the previous handbook chapter on this same topic this chapter surveys the monetary approach through the lens of the dynamic and stochastic New Keynesian literature. This analysis highlights the implications for exchange rates, both from a theoretical perspective and for empirical testing, of the endogeneity of monetary rate setting and of more empirically motivated assumptions of price setting such as the distinction between producer and local currency pricing. Recent empirical tests of the ability of the monetary approach to explain and forecast exchange rates, both in and out of sample are described.

Then the chapter takes up recent developments on the residual term that captures deviations from UIP. There have been several recent developments in understanding this residual, including finance-based models of foreign exchange risk premia, heterogeneous private information, deviations from strict rational expectations, and other imperfections in capital markets. Engel provides a teachable framework for several of the insights of these models, discusses the empirical success of these newer approaches, and concludes with suggestions for future research that will help to improve our understanding of what determines nominal exchange rates.

The next two chapters survey the literature on international risk sharing, allocation of capital across countries, and current account dynamics. Are resources efficiently allocated across countries, and if not, what are the welfare gains from increasing efficiency? This important question and the research therein is the subject of the chapter by Heathcote and Perri titled Assessing International Efficiency. The previous handbook did contain an excellent chapter on real business cycle models by Marianne Baxter, however, Heathcote and Perri provide some novel perspectives on the considerable literature that has evolved since then. In particular, there exists a long tradition in international macroeconomics of enumerating so-called puzzles related to, among others, cross-country co-movements in consumption, in investment, and co-movement between consumption and the real exchange rate. Heathcote and Perri depart from the language of puzzles and instead provide a unified framework to assess international efficiency both at business cycle frequencies and over the long-run. By doing so, they highlight the inter-connectedness between the various puzzles and discuss the relative merits of using quantities, such as relative consumption, versus prices, such as the real exchange rate, versus asset portfolio choices in assessing efficiency. The main analysis is performed in a neoclassical environment with symmetric countries but allowing for departures from asset market completeness. This provides a useful benchmark to measure disagreements between theory and data.

The chapter by Gourinchas and Rey, External Adjustment, Global Imbalances, Valuation Effects, begins with a summary of recent empirical facts on capital flows, including those related to global imbalances and potential inefficiencies in resource allocation across countries. These facts have given rise to new models on the direction of capital flows that emphasize asymmetries across countries at various stages of development. This focus on asymmetries distinguishes the analysis in this chapter from the preceding chapter. The literature provides explanations for global imbalances based on cross-country differences in the ability of domestic agents to insure within-country idiosyncratic risk and cross-country differences in the ability of countries to supply stores of value/financial assets. Differences in demographic trends and the interaction between trade and finance frictions are also shown to generate capital movements that differ from the predictions of a neoclassical model. Gourinchas and Rey provide a valuable common framework within which to understand the different models. They highlight that the models share the feature that advanced economies can exhibit higher autarky real returns as compared to emerging economies thus rationalizing capital flows from emerging to advanced markets.

Another important development in the literature on external adjustment is the role of asset valuations in understanding changes in a country’s net foreign asset position. These valuation effects can arise from capital gains/losses on a country’s external portfolio including those from exchange rate movements when a country’s assets and liabilities are denominated in different currencies. This channel of external adjustment is separate from the traditional trade channel which was the focus of the previous handbook chapter on this topic. Gourinchas and Rey survey this new literature on valuation effects, the role it plays in understanding changes in a country’s net foreign asset position and its quantitative importance for long-run solvency. The chapter concludes with a discussion of the differences across countries in the composition of their external balance sheets and its implications for the functioning of the international monetary and financial system.

The last two chapters survey the literature on sovereign debt and on financial crises. Aguiar and Amador, in their chapter Sovereign Debt review major developments in the literature on sovereign debt, default, debt overhang, and debt crises. The chapter first provides a quick summary of the leading empirical facts on sovereign debt. A distinguishing feature of sovereign debt is the limited mechanisms that exist for enforcing repayment. Accordingly, Aguiar and Amador provide a benchmark framework for debt and repayment decisions in an environment of limited commitment toward repayment. Their benchmark environment is a novel organizing framework that clarifies the main mechanisms of several seminal papers in the literature and highlights the negative consequences of limited commitment on risk-sharing, investment, and growth. The constrained efficient contracts they describe require state-contingency, but as they point out even with non-state contingent debt in reality there exists ex post state-contingency with renegotiations and haircuts. They use the benchmark framework and extensions such as unobservable shocks to clarify concepts of equilibrium default, renegotiation, excusable default, and inexcusable default. They also provide a description of self-fulfilling debt crises that results from coordination failures across foreign lenders.

Over the past decade there has been a growth in research that aims to quantify models of sovereign debt and match features of the data including the frequency of default and observed levels of debt to GDP in countries. Aguiar and Amador survey this literature and clarify the central features required by these models to match the empirical facts, including describing the dimensions along which the quantitative models perform poorly. Needless to say, in a world where many advanced countries, particularly in the periphery of Europe, are struggling with very high debt levels and low growth, the topic of sovereign defaults is likely to continue to remain a very active area of research.

The final chapter by Lorenzoni on International Financial Crises provides an overview of the theoretical developments in our understanding of international crises over the last thirty years. With the globalization of capital flows, a typical crisis combines features of sudden stops in capital flows, banking crises, and sovereign debt crises along with currency crises. While the previous handbook chapter focused exclusively on currency crises this chapter covers both the monetary and financial aspects of crises. Today, of course, we better understand the profound empirical and theoretical linkages across different types of crises. Lorenzoni starts with a description of the earlier models of currency crises and highlights the implications for capital flows when countries follow policies that are inconsistent with the maintenance of a fixed exchange rate regime. Similarly, he describes speculative attack models of currency crises. Next, he describes crises that originate with shocks to the current account, that is when there is a sudden stop in capital inflows for exogenous reasons and traces out the implications for the real economy, as a function of the exchange rate regime. He demonstrates the possible contractionary effects of exchange rate devaluations through the weakening of the country and firms’ balance sheets, when assets and liabilities are denominated in different currencies.

Lastly the chapter surveys the literature that tries to explain why countries may end up with vulnerabilities to crises such as too large a current account deficit or an overvalued exchange rate or large sovereign debt. Here he describes the various approaches taken in the literature such as the impact of externalities that arise from the possibility of future government bailouts and the impact of pecuniary externalities when borrowers do not internalize the effect of their decisions on the real exchange rate that in turn affects their borrowing constraints. Lorenzoni then concludes with suggestions for future research especially those arising from the ongoing euro zone crises.

In conclusion, we would like thank a number of people who have helped us with this book. We are very grateful to James Anderson, Philippe Bacchetta, Fernando Broner, Arnaud Costinot, Dave Donaldson, Jonathan Eaton, Robert Feenstra, Fabio Ghironi, Gene Grossman, Olivier Jeanne, Andrei Levchenko, Karen Lewis, Rachel McCulloch, John McLaren, Virgiliu Midrigan, Maurice Obstfeld, Paolo Pesenti, Vincenzo Quadrini, Esteban Rossi-Hansberg, Robert Staiger, Jón Steinsson, Daniel Trefler, and Mark Wright who were discussants for the various chapters at a conference organized in September 2012 where the chapters were presented. Their comments were very influential in shaping the chapters. We would also like to thank Raluca Dragusanu, Wenxin Du, Rohan Kekre, Mikkel Plagborg-Moller, Ran Shorrer, and Vania Stavrakeva, who took very helpful notes during the conference. A very special thanks is owed to our assistant at Harvard, Jane Trahan, who aided the project at every stage of the process, and who played a central role in organizing the September 2012 conference.

Gita Gopinath and Kenneth Rogoff

Harvard University and NBER

Elhanan Helpman

Harvard University, CIFAR and NBER

References

1. Corsetti G, Dedola L, Leduc S. Optimal monetary policy in open economies. In: Friedman BM, Woodford M, eds. Handbook of Monetary Economics. vol. 3. Elsevier; 2010:861-933.

2. Krugman PR. Increasing returns, imperfect competition and the positive theory of international trade. In: Grossman GM, Rogoff K, eds. Handbook of International Economics. Elsevier; 1995:1243-1277.

3. Melitz MJ. The impact of trade on intra-industry reallocations and aggregate industry productivity. Econometrica. 2003;71:1695-1725.

4. Obstfeld M, Rogoff KS. Foundations of International Macroeconomics. MIT Press Books. The MIT Press; 1996.

*We thank the National Science Foundation for financial support.

Chapter 1

Heterogeneous Firms and Trade*

Marc J. Melitza, b, c and Stephen J. Reddingb, c, d,    aHarvard University, Cambridge, MA, USA, bNational Bureau of Economic Research, Cambridge, MA, USA, cCentre for Economic Policy Research, London, UK, dPrinceton University, Princeton, NJ, USA

Abstract

This chapter reviews the new approach to international trade based on firm heterogeneity in differentiated product markets. This approach explains a variety of features exhibited in disaggregated trade data, including the higher productivity of exporters relative to non-exporters, within-industry reallocations of resources following trade liberalization, and patterns of trade participation across firms and destination markets. Accounting for these empirical patterns reveals new mechanisms through which the aggregate economy is affected by trade liberalization, including endogenous increases in average industry and firm productivity.

Keywords

Firm heterogeneity

International trade

Productivity

JEL classification codes

F10

F12

F14

1 Introduction

Theoretical research in international trade increasingly emphasizes firm-level decisions in understanding the causes and consequences of aggregate trade. Motivated by empirical findings using micro-level data on plants and firms, this theoretical literature emphasizes heterogeneity in productivity, size, and other characteristics even within narrowly defined industries. This heterogeneity is systematically related to trade participation, with exporters larger and more productive than non-exporters even prior to entering export markets. Trade liberalization leads to within-industry reallocations of resources, which raise average industry productivity, as low-productivity firms exit and high-productivity firms expand to enter export markets. The increase in firm scale induced by export market entry enhances the return to complementary productivity-enhancing investments in technology adoption and innovation, with the result that trade liberalization also raises firm productivity.

Models of firm heterogeneity provide a natural explanation for these and other features of disaggregated trade data that cannot be directly interpreted using representative firm models (whether based on comparative advantage or love of variety). From a positive perspective, accounting for these features of disaggregated trade enhances the predictive power of our models for patterns of trade and production. More broadly, theories of firm heterogeneity and trade have improved our understanding of the mechanisms through which an economy responds to trade. This is especially important from a policy perspective: for example, identifying potential winners and losers from trade liberalization, and generating counterfactual predictions for changes in policies related to trade. Finally, from a normative view, understanding all of the margins along which an economy adjusts to trade can be important for evaluating the overall welfare gains from trade. As we show more formally below, it is only under strong conditions that aggregate outcomes (at the sector or country level) are sufficient statistics for the overall welfare gains from trade. Even when these strong conditions hold, heterogeneous and homogeneous firm models can have quite different distributional implications for wage inequality, unemployment, and the political economy of trade protection.

The remainder of this chapter is structured as follows. Section 2 reviews empirical evidence from micro data that motivates theories of heterogeneous firms and trade. Section 3 introduces a general theoretical framework for modeling firm heterogeneity in differentiated product markets. Section 4 characterizes the model’s closed economy equilibrium, while Section 5 examines the implications of opening to trade. In Section 6 we parameterize the firm productivity distribution and examine the model’s quantitative predictions. Section 7 embeds this model of firm heterogeneity within the integrated equilibrium framework of neoclassical trade theory. Section 8 relaxes the assumption of constant elasticity of substitution (CES) preferences to introduce variable mark-ups and examine the effects of market size on the selection of firms into production and exporting. Section 9 explores a variety of extensions, where firm productivity is also endogenous. Section 10 discusses factor markets and the income distributional consequences of trade liberalization. Section 11 concludes.

2 Empirical Evidence

The theoretical literature on firm heterogeneity and trade has been influenced by a number of empirical findings from micro data. One first set of empirical findings showed that firms participating in trade perform better along a number of dimensions. Using US Census data, Bernard and Jensen (1995, 1999) find that exporters are larger, more productive, more capital intensive, more skill intensive, and pay higher wages than non-exporters within the same industry. While the early empirical literature using plant and firm data focused on exports, more recent research using customs transactions data has shown that importers display many of the same characteristics as exporters. Indeed, firms that simultaneously export and import typically exhibit the highest levels of performance (see for example Bernard et al., 2007a,b, 2009).¹

A second set of empirical results highlights the prominence of compositional effects across firms (within sectors). Dunne et al. (1989) show that around one third of US manufacturing plants enter and exit every five years. Exitors are smaller on average than incumbents and new entrants have higher average employment growth rates conditional on survival than incumbents, consistent with a Darwinian process of selection operating across plants and firms. Davis and Haltiwanger (1992) find that gross job creation and destruction across plants are much larger than would be needed to achieve the observed net changes in employment between industries, implying substantial reallocations within rather than across industries. Evidence that such compositional changes are important for the effects of trade liberalizations comes from a number of large-scale liberalization reforms. In the aftermath of the Chilean trade liberalization, Pavcnik (2002) finds that roughly two thirds of the 19% increase in aggregate productivity is the result of the reallocation of resources from less to more efficient producers. While early empirical studies focused on documenting these compositional effects and contrasting export-orientated, import-competing, and non-traded industries, more recent research has connected intra-industry reallocation to direct policy measures of trade liberalization such as import tariffs. Following the Canada–US Free Trade Agreement (CUSFTA), Trefler (2004) finds that industries experiencing the deepest Canadian tariff cuts reduced employment by 12% but increased labor productivity by 15%.²

While the above empirical studies focus on reallocation in production, other related research emphasizes the role of firm and product margins in understanding patterns of trade. Using French export data by firm and destination market, Eaton et al. (2004) find that more than 60% of the variation in exports across markets of different size is explained by the extensive margin of the number of exporting firms. Using US export data by firm, product and destination market, Bernard et al. (2011) show that all of the negative effect of distance on bilateral trade flows is accounted for by the extensive margins of the number of exporting firms and exported products. Therefore, larger aggregate trade flows are not achieved by a simple scaling up of trade at the disaggregated level, but rather involve substantial entry, exit, and reallocations of market shares across suppliers to different markets.

A third set of empirical findings provides evidence that plant or firm performance responds to the trading environment along a number of dimensions including overall productivity, technology adoption, the number and type of products supplied, and mark-ups of price over marginal cost. In Pavcnik (2002), one third of the increase in aggregate productivity following Chilean trade liberalization is attributed to increases in productivity within plants. Bustos (2011) and Lileeva and Trefler (2010) find that the entry into export markets induced by foreign trade liberalization stimulates the adoption of new technologies. Baldwin and Gu (2009) and Bernard et al. (2011) show that Canadian plants and US firms respectively rationalize product scope following CUSFTA. Levinsohn (1993) and Harrison (1994) find pro-competitive effects of trade liberalization in reducing mark-ups in Turkey and Cote d’Ivoire respectively. De Loecker and Warzynski (2012) uncover differences in mark-ups between exporters and non-exporters.

In the next section, we introduce a general theoretical framework for modeling firm heterogeneity in differentiated product markets that accounts for many of the empirical features outlined above. In particular, the model rationalizes performance differences between exporters and non-exporters, the contribution of exit and reallocation to aggregate productivity growth following trade liberalization, and the role of compositional changes in patterns of bilateral trade. Naturally, the model is an abstraction and does not capture all of the features of the data. For example, the baseline version of the model assumes constant mark-ups, and hence abstracts from pro-competitive effects of trade liberalization, although we relax this assumption in a later section. Furthermore, much of our analysis concentrates on heterogeneity in productivity and size across firms, and hence does not capture the rich range of dimensions along which trading and non-trading firms can differ. Additionally, the baseline version of the model yields sharp predictions such as a single productivity threshold above which all firms export and a stable ranking of the sales of exporting firms across all destination markets. Although these sharp predictions are unlikely to be literally satisfied in the data, they capture systematic relationships or average tendencies in the data, such as the higher average productivity of exporters and the correlation of relative exporter sales across destination markets.

3 General Setup

We begin by outlining a general framework for modeling firm heterogeneity following Melitz (2003).³ Throughout this chapter, we rely on models of monopolistic competition that emphasize product differentiation and increasing returns to scale at the level of the firm. Although this framework provides a tractable platform for analyzing a host of firm decisions in general equilibrium, it neglects strategic interactions between firms. Bernard et al. (2003) develop a heterogeneous firm framework that features head to head competition between firms, while Neary (2010) surveys the literature on oligopoly and trade in general equilibrium. In our monopolistic competition framework, all interactions between firms operate through market indices such as the mass of competing firms, and statistics of the price distribution. We begin by developing the industry equilibrium with heterogeneous firms, before embedding the sectors in general equilibrium. We start with a closed economy and then examine the implications of opening to international trade. To highlight the implications of firm heterogeneity as starkly as possible, we begin by considering a static (one-period) model, before turning to consider dynamics in a later section.⁴

3.1 Preferences

:

(1)

sectors, there is a continuum of horizontally differentiated varieties, and preferences are assumed to take the Constant Elasticity of Substitution (CES) Dixit and Sitlitz (1977) form:

(2)

This representation of consumer preferences, in which varieties enter utility symmetrically, implicitly imposes a choice of units in which to measure the quantity of each variety. There is no necessary relationship between this normalization and the units in which physical quantities of output are measured for each product in the data. Mapping physical quantities of output back to utility requires taking a stand on the relative weight of products in utility, which depends (among other things) on product quality.⁵

is given by:

is the price index dual to (2):

as given.⁶

3.2 Technology

, because even if factor prices are equalized across sectors in competitive factor markets, unit costs will still in general differ across sectors due to differences in factor intensity. The composite factor (with the same aggregation of labor inputs) is used for all productive activities within the industry, including both variable and fixed costs (incurred for overhead production as well as for entry and market access).can be summed across sectors and set equal to the country’s aggregate labor endowment.

units of a variety is therefore:

.

3.3 Firm Behavior

. From the first-order condition for profit maximization, the equilibrium price for each variety is a constant mark-up over marginal cost:

which implies an equilibrium firm revenue of:

and an equilibrium firm profit of:

This constant mark-up of price over marginal cost is an implication of CES preferences and monopolistic competition, and ensures that higher firm productivity is passed on fully to consumers in the form of a lower price. Since demand is elastic, this lower price implies higher revenue for more productive firms. While we focus on productivity as the source of revenue heterogeneity across firms, heterogeneity in product quality across firms can be captured by relaxing the assumption that varieties enter preferences symmetrically in proportionally scales both revenues and gross profits.

3.4 Firm Performance Measures and Productivity

A key implication of the CES demand structure is that the relative outputs and revenues of firms depend solely on their relative productivities:

where a higher elasticity of substitution implies greater differences in size and profitability between firms for a given difference in relative productivity.

, revenue per variable input is constant across firms. Revenue-based productivity, however, varies because of the fixed production cost:

. A higher productivity draw increases variable input use and revenue, with the result that the fixed input requirement is spread over more units of revenue.⁹

is a catch-all that includes all sources of heterogeneity in revenue relative to factor inputs across firms, including differences in technical efficiency, management practice, firm organization, and product quality. For most of our analysis, we take firm productivity as exogenously determined upon entry. In later sections, we consider several extensions of our general framework that introduce an endogenous component to firm productivity and model its evolution over time. Opening further the black box of the firm remains an interesting area for further research, including the microfoundations of heterogeneity in firm productivity and the dynamics of firm productivity over time. While CES preferences and monopolistic competition imply that productivity and product quality enter equilibrium firm revenue in exactly the same way, different sources of revenue heterogeneity could have different implications in other frameworks. Furthermore, there are many other dimensions along which firms can be heterogeneous besides revenue per unit of input (e.g. factor intensity and product attributes).

3.5 Firm Entry and Exit

.

at which a firm makes zero profits:

(3)

The relationship between profits and productivity is shown graphically in make positive profits net of the sunk entry cost. Free entry implies that in equilibrium, this expected measure of ex-ante profits (inclusive of the entry cost) must be equal to zero:

(4)

Figure 1.1

This framework captures a number of the features of micro data discussed above. Heterogeneity in firm productivity generates the systematic differences in firm employment, revenue, and profits observed in micro data (see for example produce) delivers the empirical regularity that exiting firms are less productive than surviving firms (as in Dunne et al., 1989).

4 Closed Economy Equilibrium

can be determined independently of the other equilibrium variables.

4.1 Sectoral Equilibrium

in that sector. The zero-profit condition . Combining these two conditions, we obtain a single equation that determines the productivity cutoff:

(5)

, the free entry condition :

nor the distribution of any of the firm performance measures. Those sector aggregates will only influence the mass of firms. Before deriving this relationship between sector aggregates and the mass of firms, we describe some important properties of the distribution of firm performance measures.

We start by noting that the free entry condition (4) pins down the average profit (and hence the average revenue) of active firms:

be the productivity of the firm earning those average profits and revenues. From the free entry condition :

of active firms as in our current setup with heterogeneous firms.

, we can write the factor market equilibrium condition equating demand and supply for the sector’s composite input as:

.

, changes in this measure of market size must be reflected one-for-one in the mass of both active firms and entrants. This result is analogous to is endogenously determined.) The result that market size affects neither firm selection nor the distribution of firm size is very specific to our assumption of CES preferences. In section 8, we analyze other preferences that feature a link between market size and both firm selection and the distribution of firm performance measures (size, price, mark-ups, profit).

4.2 General Equilibrium

.

. The mass of firms in each sector is

The results on the efficiency of the market equilibrium from Dixit and Sitlitz (1977) hold in