Simulations

To explore the properties of the firm-heterogeneity CGE model, I run several trade liberalization simulations and contrast the outcomes of the model to a benchmark standard Armington CGE model with homogeneous firms. The first simulation involves a lowering of the global manufacturing tariff by 50%. The second simulation involves a reduction in variable trade costs τ^s_ij in the manufacturing sectors by 5%. The third simulation involves a cut in fixed exporting costs in manufacturing sectors by 50%. Table 2 [ PDF 54.6KB | 1 page ] shows the welfare effects of these trade liberalization experiments. The results of the first two simulations from a standard homogeneous firm CGE model are also reported in Table 2.¹⁴

The CGE model with firm heterogeneity predicts a global welfare gain of $75.0 billion from the 50% global manufacturing tariff cut, nearly double the estimate of the standard Armington CGE model. The difference between the two models results from the fact that simulation of the variable trade costs reduction is less prominent in the Armington model. A 5% reduction in variable trade costs in manufacturing sectors would lead to $328.3 billion in global welfare gains in the firm heterogeneity model, in contrast to an estimate of $310.6 billion from Armington CGE model. However, it is important to mention here that tariff and iceberg trade costs are different in nature: a tariff represents a money transfer while iceberg trade costs actually burn up resources. As global manufacturing exports account for 16% of world GDP, a 5% reduction in variable trade costs would bring a direct efficiency gain of 0.8% to world GDP. If this part is excluded, the indirect welfare gains of a reduction in variable trade are US$58.9 billion for the firm heterogeneity model and US$41.2 billion for Armington CGE model, still showing a relatively large difference between the two models. The results in Table 1 also suggest that the welfare effects of cutting fixed exporting costs are significant: a 50% cut in manufacturing fixed exporting costs brings five times larger gains than an identical percentage reduction in tariffs.

Compared with the standard Armington CGE mode with constant returns to scale technology and homogeneous firms, the firm heterogeneity model introduces three additional channels through which trade liberalization yields welfare gains. The first is the Dixit-Stiglitz “love-ofvariety effect,” i.e., the welfare gains from the entry of firms and the associated increase in variety. Trade liberalization tends to lead to an increase in the number of exporting firms and to greater product variety for domestic consumers if the losses in the number of domestic suppliers are more than offset by the number of new foreign exporters. The second channel is the productivity gains from intra-industry resource reallocation explained in Section 2. This is a unique channel in the firm heterogeneity model, as the productivity is taken as given in both the Armington model and Krugman (1979) new trade theory model. The third channel is scale effects. Increased import competition drives out inefficient domestic producers and results in a smaller number of producing firms. Due to increasing returns to scale, average costs usually fall even if they are partly offset by the increased fixed exporting costs associated with a larger number of exporting firms.¹⁵

Table 3 [ PDF 43.1KB | 1 page ] and Table 4 [ PDF 43.1KB | 1 page ] report changes of firm numbers and average productivity in the aggregated manufacturing sector under the three trade liberalization simulations. As predicted by the theoretical model, trade liberalization leads to fewer domestic firms, but encourages more firms to engage in exporting activities. In the tariff reduction simulation, regions with high initial tariff rates (Africa, India) experience larger decreases in the number of domestic firms. However, their numbers of exporting firms also expand most due to their small numbers of exporting firms prior to liberalization. The reduction of variable trade costs results in a relatively even increase in exporting firms across all the regions. But its impact on the number of domestic firms differs. Regions that are more open to international trade or less competitive in manufacturing sectors experience larger decreases in their numbers of domestic firms. The impact of a cut in fixed exporting costs on the number of exporting firms is quite large. For most regions, the number of exporting firms would increase by 110-155%.

Table 4 [ PDF 43.1KB | 1 page ] shows that the productivity gains from a 50% cut in manufacturing tariff are sizeable for Africa and India, whose average productivity of domestic suppliers in the manufacturing sector rise by 2.8% and 2.6%, respectively. The US, Japan and EU gain only modestly in productivity given their already low manufacturing tariffs. However, the sector-wide average productivity is also affected by the entry and output expansion of exporting firms. In the cases of Australia and New Zealand, the NIEs, ASEAN and Africa, because of the relatively high ratios of exporting firm in manufacturing sector, the new entrants into exports are less efficient and their entry causes smaller gains in the average productivity of all producing firms relative to that of domestic suppliers. For the other regions, new exporting firms are more efficient than the industry average, and thus contribute to a further rise in sector-wide average productivity.

The productivity gains for domestic suppliers from a 5% reduction of variable trade costs range from 0.8 (Japan) to 2.2 (EU, NIEs and ASEAN). This estimate is smaller than the 4.7% productivity increase obtained by Bernard, Eaton, Jensen and Kortum (2003) for the US, using a probabilistic Ricardian model with Bertrand competition to consider the same percentage drop in world trade barriers. However, the result is more or less consistent with a recent study by Del Gatto, Mion and Ottaviano (2006), who calibrate a multi-country multisector firm heterogeneity model based on Melitz and Ottaviano (2005) to 11 EU countries and find that a 5% reduction in intra-EU trade costs generates an average productivity gain of 2.13% for the EU countries.

A final issue that needs to be discussed is the trade effects of trade liberalization. Table 5 [ PDF 53.9KB | 1 page ] shows changes in real exports under the trade liberalization simulations, and again, contrasts them with the results from a standard Armington CGE model.¹⁶ Generally, the trade expansion induced by trade liberalization is 40% stronger in the firm heterogeneity model than that in the Armington model. In the new model with its particular parameters, the elasticities of world trade with respect to overall tariff, variable trade costs and fixed exporting costs are 0.13, 2.5 and 0.1, respectively.

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