Heterogeneous Firms, Trade, and Economic Policy:Insights from a Simple Two-Sector Model

The robust empirical finding that exporting firms are systematically different from firms thatmerely serve domestic consumers has inspired the development of a new brand of tradetheory, the theory of heterogeneous firms and trade. The establishment of a canonical modeldue to Melitz (2003) has induced a recent wave of research which explores various policyissues and policy instruments. This paper uses a simple tractable two-sector model ofmonopolistic competition as unifying framework to bring out key lessons of this recentresearch. We address the gains from trade, country asymmetries involving technologypotentials, market sizes, trade openness and various business conditions as well as theinternational repercussions that emerge when countries non-cooperatively choose entrysubsidies and their levels of basic research. We also reinvestigate the process of market exit....