Modelling heterogeneous firms and non-tariff measures in free trade agreements using Computable General Equilibrium

A vast body of literature supports with empirical evidence the findings of Melitz (2003) which has led to various attempts to integrate it into Computable General Equilibrium (CGE) models to distinguish the intensive and extensive trade margin and to consider love of variety effects as well as variable and fixed costs of bilateral trade. These viewpoints are especially important for modern free trade agreements (FTAs) analysis where impacts depend largely upon changes in non-tariff measures (NTMs) affecting trade cost. However, existing Melitz extensions for CGEs seem to struggle with numerical stability problems limiting sectoral and regional detail. That greatly reduces their usefulness for policy relevant analysis. We, therefore, develop a Melitz extension for a modular CGE with a focus on a numerical stability. Using the Transatlantic Trade and Investment Partnership (TTIP) proposal as an illustrative example, we treat 22 manufacturing out of 57 sectors based on Melitz in an application with ten global regions and compare our findings to an Armington specification. Our results confirm the larger welfare and trade changes under the Melitz setting suggested both by theory and by empirical findings. We finally compare the sensitivity of trade and welfare impact when the same cost savings associated with reduced NTMs are differently allocated to variable and fixed cost of bilateral trade. We find in our application that the change in traded quantities is more sensitive to bilateral variable cost while welfare increases are more driven by reduced fixed cost, reflecting love of variety effects. Overall, the application underlines that our numerically robust implementation of the Melitz model in a CGE allows applications with high sectoral detail and thus opens the door to a more widespread application in impact assessments.