Allocative Effi ciency, Mark-ups, and the Welfare Gains from Trade

This paper develops an index of allocative effi ciency that depends upon the distribution of mark-ups across goods and is separable from an index of standard Ricardian gains from trade. It determines how changes in trade frictions affect allocative efficiency in an oligopoly model of international trade, decomposing the effect into the cost-change channel and the price-change channel. Formulas are derived shedding light on the signs and magnitudes of the two channels. In symmetric country models, trade tends to increase allocative effi ciency through the cost-change channel, yielding a welfare benefit beyond productive effi ciency gains. In contrast, the price-change channel has ambiguous effects on allocative effi ciency. ∗Holmes: Department of Economics, the University of Minnesota, Federal Reserve Bank of Minneapolis, and the National Bureau of Economic Research; Hsu: School of Economics, Singapore Management University; Lee: Sauder School of Business, the University of British Columbia. This paper grew out of work initially circulated under the title, “Plants, Productivity, and Market Size, with Head-to-Head Competition.” We are very grateful for discussion comments from Donald Davis and Marc Melitz on this earlier work. We have also benefited from discussions with various colleagues and in particular thank Sam Kortum and Jim Schmitz. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.