Conclusions

Recent models of international trade with heterogeneous firms have opened up a new way for empirical CGE models to better understand the effects of trade liberalization. This paper builds a multi-region, multi-sector global CGE model with firm heterogeneity, monopolistic competition and fixed trade costs a la Melitz (2003) and calibrates it to the GTAP database. Some illustrative trade liberalization simulations using it demonstrate that the introduction of firm heterogeneity improves the ability of the CGE model to capture the trade expansion and welfare effects of trade liberalization. However, the model results are sensitive to the shape parameters of the firm productivity distribution. Future efforts need to be devoted to obtaining better estimates for the degree of firm heterogeneity.

Some important limitations of this study should be mentioned. First, the aggregation of countries in the CGE model may lead to some biases in the calibration of trade costs. Unlike the Armington model, the elasticity of trade flows with respect to the total demand in the destination market is greater than one in the Melitz model. Thus, differences in market size play a larger role in determining the trade pattern in the Melitz CGE model than in the conventional CGE models. In this new model, the aggregation of some small economies to a single region, such as the rest-of-the-world region, may be problematic because this aggregate region is actually composed of numerous small, disjointed markets rather than a large integrated market (Balistreri et al, 2007). Second, given the assumption of no free entry and exit, the total mass of potential firms in each sector is fixed and any adjustment in the extensive margin is solely due to the changes in the shares of firms engaged in a specific market. Thus, the model's results may overestimate the changes in the shares of exporting firms following a policy shock and the associated changes in productivity, but underestimate the variety gains brought by new entrants. A better description of the dynamic of firm entry and exit will be important for improving the performance of the model. Finally, the model can be improved in the modeling of the trade and use of intermediate goods. Some micro evidence has shown that firms are heterogeneous in terms of the use of imported intermediate inputs, and that trade liberalization can boost trade through the increased extensive margin in importers of intermediate goods (Ramanarayanan, 2006). A more realistic model of firm behavior in the use of intermediate inputs would make the CGE model potentially useful in explaining the rise of vertical integration and the rapid expansion of trade in intermediate goods in recent two decades.

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