Tariffs, Trade and Productivity: A Quantitative Evaluation of Heterogeneous Firm Models

Holger Breinlich and Alejandro Cunat

A number of regional trade agreements (RTAs), such as the Transatlantic Trade and Investment Partnership (TTIP) between the EU and the U.S., are currently being negotiated by trading blocs around the world. Traditionally, so-called computable general equilibrium (CGE) trade models have been used to try to forecast the likely economic effects of such RTAs. However, these models have been criticised for their poor forecasting performance which has been linked to their neglect of the effects of trade on aggregate productivity and trade growth along the so-called extensive margin (i.e., trade increases due to more firms trading or due to firms trading more products). A new generation of trade models with heterogeneous firms explicitly incorporates these additional margins and could potentially improve upon the earlier CGE models.

In this Nottingham School of Economics research paper, published in the Economic Journal, Holger Breinlich and Alejandro Cunat evaluate whether the new heterogeneous firm models live up to their potential in the context of the Canada - US Free Trade Agreement (CUSFTA) of 1989. They compute predicted increases in trade flows and measured productivity and compare them to the post-CUSFTA increases observed in the data. Their central finding is that most models predict increases in measured productivity that are too low by an order of magnitude relative to predicted increases in trade flows. However, they also find that a simple extension of the baseline models that allows for within-firm productivity increases can reconcile model predictions with the data. Breinlich and Cunat conclude that if the current generation of heterogeneous firm models is to be used for the purpose of forecasting the effects of RTAs, incorporating sources of within-firm productivity increases is essential.

Forthcoming Economic Journal, “Tariffs, Trade and Productivity: A Quantitative Evaluation of Heterogeneous Firm Models”, by Holger Breinlich and Alejandro Cunat

http://dx.doi.org/10.1111/ecoj.12218

View all featured publications