Optimal trade policy with monopolistic competition and heterogeneous firms

This paper derives optimal trade and domestic taxes for a small open economy containing a monopolistically competitive (MC) sector in which firms may have heterogeneous productivity levels. Domestic protection brings gains from expanding the number of product varieties on offer, but these gains (and the corresponding rates of domestic subsidy or of import tariffs) are reduced by heterogeneity of foreign exporters who may withdraw from the market. Our analysis encompasses special cases in which the domestic MC sector can expand or contract flexibly, or is of fixed size. In the latter case gains from protection arise from terms of trade effects and, since various margins of substitution are switched off, only the relative values of domestic taxes, import tariffs and export taxes matter.