Market versus Optimum Diversity in Open Economies: Theory and Quantitative Evidence

The inefficiency of the market under monopolistic competition and heterogeneous firms in closed economies is well established. However, insights regarding asymmetric countries which are open to trade are less developed. This paper offers a systematic analysis of this question using general demand structures and productivity distributions. First, we derive sufficient conditions that constrain the space of exogenous parameters, ensuring the existence and uniqueness of general equilibrium. Next, we demonstrate that distortions from a global social planner’s perspective in open economies can be described as shift effects on production schedules, resulting from differences in the fundamentals of asymmetric countries, and rotation effects on production schedules, determined by the demand structure. We apply these insights to quantify the distortions in terms of cutoffs, quantities, and welfare for China and the Rest of the World. Our results indicate that both economies have weak selections, with relatively more overproducing firms selling to China and more underproducing firms selling abroad. Additionally, we find that in some cases, China attains higher welfare levels under the market than the global social optimum