Productivity spillovers, terms of trade, and the "home market effect"

This paper analyzes the welfare implications of international spillovers related to productivity gains, changes in market size, or government spending. We introduce trade costs and endogenous varieties in a two-country general-equilibrium model with monopolistic competition, drawing a distinction between productivity gains from manufacturing efficiency and those related to firms' lower cost of entry or product differentiation. Our model suggests that countries with lower manufacturing costs have higher GDP but supply a smaller number of goods at a lower international price. Countries with lower entry and differentiation costs also have higher GDP, but supply a larger array of goods at improved terms of trade. The sign of the international welfare spillovers depends not only on terms of trade, but also on consumers' taste for variety. Higher domestic demand has macroeconomic implications that are similar to those of a reduction in firms' entry costs.