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Approach. We now calculate the welfare gains from trade in our model. As we explain at length below, the size of the welfare gains depend crucially on the pattern of comparative advantage, which is determined by the cross-country pattern of correlation in productivity draws. Since there is surely considerable variation across countries in the pattern of compara- tive advantage, we do not, in this section, take a stand on a particular amount of correlation.

Instead, we provide results for the two extreme cases: (i)identicalHome and Foreign produc-

tivity draws, τ(ρ) = 1, and (ii)independent Home and Foreign productivity draws,τ(ρ) = 0.

These two cases allow us to show, in the sharpest possible manner, how the mechanisms un- derlying the gains from trade vary with the pattern of correlation. The first case provides an upper bound on the importance of pro-competitive effects while the second case essentially

corresponds to the workhorse BEJK model of variable markups. InSection 6below, we then

consider results for intermediate levels of τ(ρ) and explain how data on intra-industry trade

can be used to identify empirically reasonable values for τ(ρ).

5.1

Efficiency losses due to misallocation

To begin the analysis, we establish the potential gains from trade by calculating the efficiency losses due to misallocation in an economy closed to international trade. We start with the

economy with identical productivity draws, for which τ(ρ) = 1.

5.1.1 Economy with Taiwan’s import share

We conduct the following policy experiment. We choose producer-specific subsidies or taxes

to induce each producer to charge the same markup, ¯m. We assume that such subsidies

are financed via lump-sum taxes levied on consumers and hence can fully restore efficiency.

We consider two experiments that are reported in Table 4. In the first, labeled first-best,

we set ¯m = 1 and so eliminate both the dispersion and the level of markups. In the second

experiment, we set ¯mequal to the aggregate markup in the original economy, thus eliminating

we compute welfare gains including the transition path from the initial steady state; these are slightly smaller than would be obtained from a static comparison across steady states.

Losses relative to first-best. Panel A of Table 4 shows that the efficiency losses due to markups are large. Taking the benchmark economy to the first-best by eliminating markups altogether leads to large increases in output and consumption and welfare gains equivalent to a permanent 16.7% increase in consumption. This increase in welfare is due to a 4.6% increase in TFP and the reduction in the aggregate markup.

Losses from markup dispersion. The last column of Panel A of Table 4 shows that eliminating markup dispersion alone would generate significant welfare gains, equivalent to a 5.9% permanent increase in consumption, due to the 4.6% increase in TFP. Because of our assumption of log utility, with its offsetting income and substitution effects, the increase in TFP here leads to no change in employment.

5.1.2 Economy under autarky

How does international trade affect the efficiency losses from markups and misallocation?

To see this, consider the autarky version of the model. As shown in Panel B of Table 4,

the aggregate markup would increase from 1.48 to 1.75 in the absence of trade. Moreover, as shown above, the dispersion in markups would greatly increase as well. Starting from autarky, eliminating markups altogether would thus lead to much larger welfare gains of about 53%. Eliminating markup dispersion alone would generate significant welfare gains (34%) due to the 25% increase in TFP that results from reallocating factors of production.

Trade in this model is thus a powerful mechanism that reduces the extent of misallocation of factors of production and distortions to investment and employment decisions.

5.2

Welfare gains. Identical Home and Foreign productivity

We now calculate the welfare gains from trade for the case of identical Home and Foreign

productivity draws, τ(ρ) = 1. We follow Arkolakis, Costinot and Rodr´ıguez-Clare (2012a,

ACR hereafter) and study the welfare gains due to reductions intrade costs.20 _{The Appendix}

shows that all our findings are robust if we reduce tariffs rather than trade costs.

Table 5 reports the effect on welfare and the aggregate level of markups and TFP of symmetric trade cost reductions that increase the import share in both countries from 0 to

10%, 10 to 20%, and 20 to 30%. The model predicts large gains from moving from autarky

to a 10% import share: the welfare gains are equivalent to a 26.1% permanent increase in consumption. These gains are driven by a nearly 15% drop in markups, as well as by a nearly 13% increase in TFP. Interestingly, markups do not decline uniformly here. While markups in the domestic market decline (the revenue-weighted average markup declines by 13.9%), the markups in the export market increases considerably (the revenue-weighted average markup increases by more than 20%). Intuitively, the reduction in trade costs raises the exporters’ sectoral shares, allowing them to raise markups.

The model also predicts a nonlinear relationship between openness and welfare (or TFP). Near autarky, the marginal gains from trade are very high. Even a small increase in the amount of competition faced by domestic producers is enough to reduce their markups sig- nificantly. At higher import shares, similar increases in openness lead to smaller welfare gains. As Table 5 shows, moving from an import share of about 10% to 20% increases welfare by 7.6% and TFP by 4.7%. Similarly, moving from an import share of 20% to 30% delivers even smaller gains — welfare increases by 5.8% and TFP increases by 3.9%.

Observe that the welfare gains do notarise due to the endogenously variable Armington

trade elasticity. Although the Armington elasticity does change in response to changes in

trade costs,Table 5 shows that these changes are not very large (from 8.45 in autarky to 7.4

in the economy with a 10% import share).

Ricardian gains. We next isolate the welfare gains arising due to pro-competitive ef- fects from those due to standard Ricardian effects (pure comparative advantage and love-of- variety). To do so, recall that allocations in our model are solely a function of the aggregate level of markups and TFP. In our model welfare increases via three channels: (i) the aggre- gate markup declines, (ii) markups become less dispersed, reducing misallocation and thus bridging the gap between the actual and the first-best level of TFP, and (iii) the first-best level of TFP increases. Since channels (i) and (ii) are only operative in a model with variable markups, while channel (iii) is also present in models with constant markups, we refer to the

Formally, we decompose the change in TFP in our model into two terms

∆ lnAt= ∆(lnAt−lnAF Bt ) + ∆ lnA

F B

t ,

whereAF B_t is the first-best level of TFP from (18)-(19). The first term on the right hand side

of this expression captures the extent to which opening up to trade reduces the TFP losses due to misallocation — the gap between the actual and first-best level of TFP. The second term is simply the change in the first-best level of TFP. Hence, by comparing the actual TFP changes in our model to those under the first-best, we can gauge the extent to which the increase in TFP is due to a reduction in misallocation, as opposed to Ricardian forces.

The row labeledRicardian TFP gainsinTable 5shows that the increases in the first-best

level of TFP are small here, on the order of 1 to 2%, and hence much smaller than the overall TFP gains. We thus conclude that pro-competitive effects account for the bulk of the welfare gains from trade in this version of the model.

5.3

Welfare gains. Independent Home and Foreign productivity

We next calculate the gains from trade for the polar opposite case of independent Home and

Foreign productivity draws,τ(ρ) = 0. Table 6shows that the gains from trade are again very

large, even for countries that are already open to trade. For example, a reduction in trade costs that raises the import share from autarky to 10% leads to an increase in welfare of 8.9%, while an increase in the import share from 10% to 20% leads to a much larger increase in welfare of 28.8%.

Crucially, however, the gains from trade here are not driven by declines in markups.

In fact, the pro-competitive gains from trade are now negative. To see this, note that in

this version of the model the aggregate markup increases as the economy moves away from

autarky, by 3.9% and 9.6% respectively, as the economy experiences a 0-10% and 10-20%

change in the import share. Similarly, as shown in the row labeled Ricardian TFP gains,

the first-best level of TFP increases by more than the actual level of TFP (8.8% vs. 8.2% for a 0-10% change in the import share and 26.3% vs. 25.4% for a 10-20% change in the import share). Hence, the degree of misallocation also increases as the economy opens to trade. Intuitively, relatively productive exporters face little competition abroad when trade barriers are reduced and thus find it optimal to increase their markups. This effect, unlike in the economy with identical draws, is no longer offset by the declines in markups of domestic producers. The market share of domestic producers is either wiped out by foreign competition

if the foreign producer in that industry happens to be the more productive one, or is not affected by foreign competition if the domestic producer happens to be more productive.

Trade does not lead to pro-competitive gains here for the simple reason that trade does not increase the amount of competition faced by highly productive domestic producers. Since productivity draws are independent across countries and drawn from a very fat-tailed distri- bution, it is rarely the case that a highly productive domestic producer also faces a highly productive foreign counterpart. Countries thus specialize in producing goods in individual sectors and there is little intra-industry trade even when economies are open. The overall gains are nevertheless high due to Ricardian effects. Since different industries are imperfectly substitutable, and since countries differ substantially in how productive producers in different industries are, opening to trade leads to large gains due to comparative advantage.

Finally, note fromTable 6that the Armington elasticity is much lower here in economies

that are open to trade. This is because, with a weak pattern of comparative advantage, there is considerable dispersion in sectoral import shares. If import shares are highly dispersed,

then, as equation (20) shows, the Armington elasticity is much closer to θ than to γ. We

return to this point when discussing the evidence for the amount of cross-country correlation in productivity below.