Welfare Effects of Trade Liberalization with Intra-Industry Reallocations : The Importance of Preferences and Market Failures

This paper shows that the novel gains from trade liberalization driven by intra-industry reallocations (Melitz (2003)) are not robust to changes in the preference structure. In the Melitz (2003) setting the unambigousness of the welfare effect depends crucially on the assumption of traditional CES preferences, which ensures equivalence of the market equilibrium and the social planner solution. For other preferences this equivalence is broken and trade liberalization may reduce welfare by magnifying market failures. An exact condition for trade liberalization to reduce overall welfare is derived under the assumptions of generalized CES preferences and a specific distribution (Pareto) of firm heterogeneity