A Model of Trade with Ricardian Comparative Advantage and Intra-sectoral Firm Heterogeneity

In this paper, we merge the heterogenous firm model of Melitz (2003) with the Ricardian model of Dornbusch, Fisher and Samuelson (DFS 1977) to explain how the pattern of international specialization and trade is determined by the interaction of comparative advantage, economies of scale, country sizes and trade barriers. The model is able to capture the existence of inter-industry trade and intra-industry trade in a single unified framework. It explains how trade openness affects the pattern of international specialization and trade. It generalizes Melitz’s firm selection effect in the face of trade liberalization to a setting where the patterns of inter-industry trade and intra-industry are endogenous. Although trade openness is proved to be unambiguously welfare-improving in both countries, trade liberalization can lead to an antiMelitz effect in the larger country if it is sufficiently uncompetitive in the sectors in which it has the strongest comparative disadvantage but in which it still produces. In this case, the operating productivity cutoff is lowered while the exporting cutoff increases in the face of trade liberalization. This is because the DFS effect dominates the Melitz effect in these sectors. Consequently, the larger country can lose from trade liberalization.