Consider the standard version of the Melitz (2003) model that we studied in class.
a) (25 points) Assume that due to a breakdown of international agreements, there is a multilateral
increase in the variable trade cost, due to higher tariffs and non-tariff barriers. Show and
discuss the effects of this episode of trade ‘disintegration’ on firms’ survival on the domestic
and export market. Use equations and figures to construct your argument.
b) (25 points) What is the impact of the increase in the variable trade cost discussed above on
the economy’s real income (GDP)? Explain the different channels through which welfare (real
income) is affected. Who wins and who loses from this episode of trade disintegration? Explain.
Now assume that firms can choose to reach the foreign country via export or MNA, as we saw in
class.
c) (25 points) Abstracting from the general equilibrium effect on the aggregate demand shifter,
that is keeping B constant, derive and discuss the effects of the increase in variable trade cost
discussed above on firms’ choice between export and MNA. Derive and discuss the effect of
an increase in the plant-level fixed cost fD on firms’ choice between export and MNA. Use
equations and figures to construct your argument.
c) (25 points) Allowing for the general equilibrium effect on the aggregate demand shifter, derive
and discuss the effects of the increase in variable trade cost on firms survival on the domestic
market, and on firms’ choice between export and MNA. Hint: the free entry condition can be
written as
Ez≥zD[(z/zD)^(σ−1)− 1]fD+Ez≥zX[(z/zX)^(σ−1)− 1]fX+Ez≥zI[(z/zI)^(σ−1)− 1](fX + fD) = fe
Recall that you can express zI as a function of zX, using the equilibrium conditions. Thus,
you can analyse the equilibrium using the same graphical exposition we saw for the standard
Melitz model.
