By Ariel Burstein and Marc Melitz
In this paper, we analyze the transition dynamics associated with an economy’s response to trade liberalization. We start by reviewing the recent literature that incorporates firm dynamics into models of international trade. We then build upon that literature to characterize the role of firm dynamics, export-market selection, firm-level innovation, and firms’ expectations regarding the time path of liberalization in generating those transition dynamics following trade liberalization. These modeling ingredients generate substantial aggregate transition dynamics as they shift and shape the endogenous distribution of firms over time. Our results show how the responses of trade volumes, innovation, and aggregate output can vary greatly over time depending on those modeling ingredients. This has important consequences for many issues in international economics that rely on predictions for the effects of globalization over time on those key aggregate outcomes.
CGE models have been pretty bad at predicting the consequences of NAFTA. Can more modern models perform better, especially dynamic ones? This is quite important, as the costs to trade liberalization are believed to be mostly in the transition dynamics. This paper shows it is very difficult to do, as small changes in the assumptions can lead to quite different trajectories. This calls more more and better empirical studies to better ground the specification of these models.