exogenously given and trade reform can only exert its effects through an increase in n, in this
model φ is endogenous and hence it can be influenced by trade integration.
Melitz shows that in the absence of any trade costs, a move from autarky to free trade has
no effect on the distribution of productivity levels and average productivity. In this case, the
effects of trade integration are identical to those predicted by Krugman (1980), i.e., a welfare
increasing expansion in the product variety, and firm heterogeneity has no impact on average
industry productivity.
In order to give firm heterogeneity an important role to play, two routes can be taken. One is
to relax the assumption of an exogenously fixed demand elasticity (σ) for each variety. The other
is to assume the existence of sunk entry costs into foreign markets.
As far as the former is concerned, (in a separate appendix) Melitz shows that, even in the ab-
sence of any trade costs, firm heterogeneity is crucial for the impact of trade when firms’ demand
elasticity endogenously increases with product variety, as in Krugman (1979). In this case, trade
integration among two identical countries expands the variety of products and hence increases the
elasticity of substitution among them. In turn, an increased elasticity of substitution induces a
reallocation of market shares towards more efficient firms and thus generates an aggregate pro-
ductivity gain. The intuition for this result is that a higher elasticity of substitution generates a
premium in terms of market shares in favor of firms charging a lower price, i.e., the more efficient
ones.
The second setting carefully explored by Melitz builds on the assumption of sunk entry costs
into foreign markets. Melitz refers to the results of empirical studies confirming that firms face
significant fixed costs associated with the entry into foreign markets: “These costs are related to
the fact that a firm must find and inform foreign buyers about its product and learn about the
foreign market. Further, it must adapt its product to foreign standards and set up new distribution
channels in the foreign country”.