Melitz Model

Question 1

Main ideas

Answer 1

more productive firms earn larger profits
with fixed costs, only the most profitable (productive) firms export (consistent with empirical evidence above: small fraction of firms exports, the most productive ones)
opening up to trade leads to resource reallocation to productive firms

Question 2

Melitz model setup

Answer 2

Economic environment:
2 identical countries (n countries in Melitz’s (2003) original work)
Increasing returns to scale production technology using labor as the only input
Monopolistic competition

Question 3

melitz key assumptions

Answer 3

Key new assumptions
Fixed entry cost fe (in terms of labor) to set up a firm
After paying fe, firms draw marginal productivity of labor from distribution G()
Fixed cost to serve domestic market fd
Trade: iceberg trade cost , and fixed cost of exporting fx

Question 4

explain consumption/production and ZCP in Melitz model

Answer 4

page 35

Question 5

equilibrium under autarky conditions

Answer 5

1) “Free entry condition” (FE): Firms make zero profits in expectation. Appendix: FE
2) Full employment condition (or labor market clearing condition).

Question 6

what happens under trade?

Answer 6

page 37 - (2 ZPC)

Question 7

explain selection into exporting

Answer 7

page 38

Question 8

explain firm exit

Answer 8

page 38

Question 9

what are the gains from trade?

Answer 9

In the Melitz model, trade impacts welfare through various channels:
additional import varieties (+)
reduced domestic varieties (−)
Selection effect: least productive firms exit and most productive firms start exporting
(expand size), i.e., average productivity increases