Trade and Domestic Policies under Monopolistic Competition

Should trade agreements constrain domestic policies? We analyse this question using a model with monopolistic competition and constant-elasticity-of-substitution demand. We develop a welfare decomposition to show that welfare changes induced by trade and domestic policies can be decomposed into consumption and production efficiencies and terms-of-trade effects. We analyse the reasons to sign trade agreements and compare shallow and deep trade agreements, modelled according to GATT-WTO rules. Under monopolistic competition, unlike deep trade agreements, shallow agreements with market access commitments may not achieve efficiency because terms of trade can be improved without reducing market access by increasing the set of foreign firms selling domestically.