A Dynamic Model of Trade with Heterogeneous Firms

This paper builds a dynamic general equilibrium trade model, in which heterogeneous intermediate goods are produced and traded in a Melitz (2003) type sector. These intermediate goods are used in the production of a final good, which can be used for consumption, capital accumulation, or investment in market entry. Therefore capital accumulation is the direct alternative to investing in firm entry. This has a number of implications. First, in the short run following trade liberalizations a higher interest rate will prevail, which will tend to shelter incumbent firms from increased competition by discouraging investment in entry of new firms. Second, different forms of trade liberalizations with the same impact on the share of expenditure on domestic variety will have different effects on consumption, and thus welfare, both during transitions and in steady-state, due to different effects on aggregate investment. Third, the accumulation of capital will add a time dimension to the anti-variety effects of trade liberalizations. In effect, capital accumulation generates rich adjustment dynamics both in the aggregate and at the firm level. Further, the study of transitions in this framework provides important insights regarding the effects of different forms of trade liberalizations in general and on welfare and individual firms in particular.