Gains from Trade Under Monopolistic Competition

• Author: Robert C. Feenstra
• Date: 01 February 2016
• Published date: 01 February 2016
• DOI: http://doi.org/10.1111/1468-0106.12150

GAINS FROM TRADE UNDER MONOPOLISTIC

COMPETITION

ROBERT C. FEENSTRA*University of California, Davis and National Bureau of

Economic Research

Abstract. The monopolistic competition model in international trade predicts three sources of gains

from trade that are not present in traditional models: consumer gains from having access to new

import varieties of differentiated products; gains from a reduction in firm markups due to import com-

petition; and gains from the self-selection of more efficient firms into export markets, provided that

firms are heterogeneous in their productivities. With the added assumption that the distribution of

firms’productivity is Pareto, and with a support thatis unbounded above, we argue that only the third

source of gains from trade, due to the self-selection of firms, operates. This result helps to explain the

simple formula for the gains from trade found by Arkolakis et al. (2012). If the Pareto distribution is

bounded above, however, then all three sources of gains from trade operate once again.

1. INTRODUCTION

The monopolistic competition model in international trade predicts three sources

of gains from trade that are not present in traditional models. First, there are the

consumer gains from having access to new import varieties of differentiated

products. That source of gains from grade has been demonstrated for the United

States by Broda and Weinstein (2006), for example, using the formula for the ‘ex-

act’constant elasticity of substitution (CES) price index from Feenstra (1994).

These gains depend on one minus the share of expenditure on new imports, raised

to a negative power that depends on the elasticity of substitution in consumption.

Second, the monopolistic competition model also allows for gains from a

reduction in firm markups due to import competition. This second source of

gains was stressed in Krugman (1979), but has been absent from much of the

later literature due to the assumption of CES preferences, leading to constant

markups. Research in Feenstra and Weinstein (2010), using the translog expen-

diture function allows those gains to be measured for the United States. They

find that the welfare gains from reduced markups for the United States are of

roughly the same order of magnitude as the gains from product variety.

The extensionof the monopolistic competition model to allowfor heterogeneous

firms, due to Melitz (2003) and discussed in Section2, leads to a third source of

gains from the self-selection of more efficient firms into export markets. With the

added assumption that the distribution of firms’productivity is Pareto, as in

Chaney (2008),then that source of gains hasbeen shown to have a very simplefor-

mula by Arkolakis et al. (2012): the gains from trade depend on one minus the

share of expenditure on imports (equal to the share of expenditure on domestic

*Address for Correspondence: Robert C. Feenstra, University of California, Davis, and National

Bureau of Economic Research. E-mail: rcfeenstra@ucdavis.edu. The material in this article will ap-

pear in Chapter 6 of Robert C. Feenstra, Advanced International Trade, 2nd edition, to be released in

2015 by the Princeton University Press.

Pacific Economic Review, 21: 1 (2016) pp. 35–44

doi: 10.1111/1468-0106.12150

© 2016 Wiley Publishing Asia Pty Ltd

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