A Parsimonious Approach to Incorporate Firm Heterogeneity in CGE-Models

Abstract

This paper proposes a parsimonious and intuitive way to incorporate Melitz-type firm heterogeneity in a CGE-model based on the conventional Armington trade structure. The Armington trade structure is extended with demand, supply, and trade cost shifters. Each sector can be modelled as either Melitz, Ethier-Krugman, or Armington, depending on the specification chosen for the shifters. The trade structure of the model can be calibrated based on two estimable parameters: the trade or tariff elasticity and the shape parameter of the size distribution of firms. With this setup fixed and iceberg trade costs are calibrated jointly based on observed import shares. The structure is incorporated within the standard GTAP model and changes to the GEMPACK code are discussed in detail. Changes in both trade values and welfare are decomposed. Experiments with global reductions in iceberg and fixed trade costs are simulated in a medium-size model with 11 countries, 11 sectors, and 6 production factors. The experiments show that the welfare effects are largest under Melitz, followed by Ethier-Krugman and Armington, although differences are modest.