Firm heterogeneity and costly trade: A new estimation strategy and policy experiments

We build a tractable partial equilibrium model in the spirit of Melitz (2003) to help understand the role of trade preferences given to developing countries, as well as the efficacy of various subsidy policies. The model allows for firm level heterogeneity in both demand and productivity and lets the mass of firms that enter be endogenous.Trade preferences given by one country have positive spillovers on exports to others in this model. Preferences given by the EU to Bangladesh in an industry raise profits, resulting in entry, and some of these firms also export to the US. In contrast, simple competitive models would predict a fall in exports to the US. Such spillovers are shown to be large when exports are not constrained by quotas, suggesting that unilateral preferences given to developing countries might be more efficacious than expected in promoting their exports.The parameters of the model are estimated using cross sectional customs data on Bangladeshi exports of apparel to the US and EU. Counterfactual experiments regarding the effects of reducing costs, both fixed and marginal, or of trade preferences (with distortionary Rules of Origin) offered by an importing country are performed. The counterfactuals show that reducing fixed costs at various levels has very different effects and suggest that such reductions are more effective in promoting exports when applied at later stages when firms are more committed to production. A subsidy of 1.5 million dollars to industry entry costs raises exports by only 40 cents for every dollar spent, but when applied to fixed costs of production, it raises exports by $25 per dollar spent.