Handbook of International Economics Handbook of International Economics 4 VOLUME Edited by GITA GOPINATH Harvard University, Cambridge, MA, USA National Bureau of Economic Research, Cambridge, MA, USA ELHANAN HELPMAN Harvard University, Cambridge, MA, USA Canadian Institute for Advanced Research National Bureau of Economic Research, Cambridge, MA, USA KENNETH ROGOFF Harvard University, Cambridge, MA, USA National Bureau of Economic Research, Cambridge, MA, USA Amsterdam • Boston • Heidelberg • London • New York • Oxford Paris • San Diego • San Francisco • Singapore • Sydney • Tokyo North-Holland is an imprint of Elsevier North-Holland is an imprint of Elsevier The Boulevard, Langford Lane, Kidlington, Oxford OX5 1GB, UK Radarweg 29, PO Box 211, 1000 AE Amsterdam, The Netherlands Copyright © 2014 Elsevier B.V. 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British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging-in-Publication Data A catalog record for this book is available from the Library of Congress ISBN–13: 978-0-444-54314-1 For information on all North-Holland publications visit our website at http://store.elsevier.com/ Printed and bound in Poland 14 15 16 17 18 10 9 8 7 6 5 4 3 2 1 CONTRIBUTORS Mark Aguiar Princeton University, Princeton, NJ, USA Manuel Amador Federal Reserve Bank of Minneapolis, Minneapolis, MN, USA Pol Antràs Harvard University, Cambridge, MA, USA National Bureau of Economic Research, Cambridge, MA, USA Centre for Economic Policy Research, London, UK Ariel Burstein University of California, Los Angeles, CA, USA National Bureau of Economic Research, Cambridge, MA, USA Arnaud Costinot Massachusetts Institute of T echnology, Cambridge, MA, USA National Bureau of Economic Research, Cambridge, MA, USA Charles Engel University of Wisconsin, Madison, WI, USA National Bureau of Economic Research, Cambridge, MA, USA Gita Gopinath Harvard University, Cambridge, MA, USA National Bureau of Economic Research, Cambridge, MA, USA Pierre-Olivier Gourinchas University of California, Berkeley, CA, USA National Bureau of Economic Research, Cambridge, MA, USA Centre for Economic Policy Research, London, UK Keith Head Sauder School of Business, University of British Columbia, Canada Centre for Economic Policy Research, London, UK Jonathan Heathcote Federal Reserve Bank of Minneapolis, Minneapolis, MN, USA Centre for Economic Policy Research, London, UK Guido Lorenzoni Northwestern University, Evanston, IL, USA National Bureau of Economic Research, Cambridge, MA, USA ix x Contributors Giovanni Maggi Yale University, New Haven, CT, USA Graduate School of Economics, Getulio Vargas Foundation, Brasil National Bureau of Economic Research, Cambridge, MA, USA Thierry Mayer Sciences-Po, Paris, France Centre d'études prospectives et d'informations internationales, France Centre for Economic Policy Research, London, UK Marc J. Melitz Harvard University, Cambridge, MA, USA National Bureau of Economic Research, Cambridge, MA, USA Centre for Economic Policy Research, London, UK Nathan Nunn Harvard University, Cambridge, MA, USA National Bureau of Economic Research, Cambridge, MA, USA Fabrizio Perri Federal Reserve Bank of Minneapolis, Minneapolis, MN, USA National Bureau of Economic Research, Cambridge, MA, USA Centre for Economic Policy Research, London, UK Stephen J. Redding Princeton University, Princeton, NJ, USA National Bureau of Economic Research, Cambridge, MA, USA Centre for Economic Policy Research, London, UK Hélène Rey London Business School, London, UK National Bureau of Economic Research, Cambridge, MA, USA Centre for Economic Policy Research, London, UK Daniel Trefler University of Toronto, Toronto, ON, Canada National Bureau of Economic Research, Cambridge, MA, USA Andrés Rodríguez-Clare University of California, Berkeley, CA, USA National Bureau of Economic Research, Cambridge, MA, USA Stephen R. Yeaple Pennsylvania State University, University Park, PA, USA National Bureau of Economic Research, Cambridge, MA, USA INTRODUCTION TO THE SERIES The aim of the Handbooks in Economics series is to produce Handbooks for various branches of economics, each of which is a definitive source, reference, and teaching supplement for use by professional researchers and advanced graduate students. Each Handbook provides self-contained surveys of the current state of a branch of economics in the form of chapters prepared by leading specialists on various aspects of this branch of economics. These surveys summarize not only received results but also newer devel- opments, from recent journal articles and discussion papers. Some original material is also included, but the main goal is to provide comprehensive and accessible surveys. The Handbooks are intended to provide not only useful reference volumes for professional collections but also possible supplementary readings for advanced courses for graduate students in economics. Kenneth J. Arrow and Michael D. Intriligator xi PREFACE* Almost twenty years have passed since the publication of Volume 3 of the Handbook of International Economics in 1995. Much has changed since then, both in international trade and international macroeconomics. The changes are fourfold: (a) new questions have arisen as the world trade and payment system has evolved; (b) new data sets have become available; (c) new theoretical models have been designed to address new issues, but they have also enabled sharper and deeper analyses of older issues; and (d) new empirical studies have greatly enriched our understanding of the global economy. The chapters in this handbook review, illuminate, and interpret these developments in a systematic way, making this material—which is technical at times—accessible to professional economists and graduate students alike. Trade is covered in the first six chapters, and international macroeconomics is covered in the subsequent six chapters. 1. INTERNATIONAL TRADE Neoclassical analysis of foreign trade focused on comparative advantage at the sectoral level, be it due to variation in productivity or factor endowments. Firms as suppliers of unique brands of differentiated products and monopolistic competition were integrated into trade theory in the 1980s (see Krugman 1995 for a review). Yet as much as these improvements have been important, they focused on sectoral outcomes by treating firms within industries as symmetric entities. Given the aim of that research, which was to expand the neoclassical framework to accommodate intraindustry trade and large volumes of trade between similar countries, the symmetry assumption was a reasonable simplification. Except that it proved to be inadequate for interpreting evidence that emerged in the 1990s concerning the participation of firms in foreign trade, as new firm- level data sets became available. In these data, exporting firms differ systematically from nonexporters. Scholars responded with the development of new models in which firms are heterogeneous, and these models guided empirical studies with the new rich data sets. Melitz and Redding review these developments in Chapter 1. After describing the patterns of firm heterogeneity in the data, they develop an integrated multisector ana- lytical framework for discussing many issues that have been analyzed in the recent lit- erature. In the data, exporters differ from nonexporters in a number of dimensions; e.g., exporters are bigger and more productive than nonexporters and they pay higher wages. *We thank the National Science Foundation for financial support. xiii xiv Preface Studies of trade liberalization show that it leads to substantial reallocation within indus- tries; low-productivity firms exit while market shares are reallocated to more productive firms, and especially to exporters. In addition, firms and product margins are important determinants of trade flows, because variation in the number of products explains a large fraction of the variation in trade volumes. These are some of the findings that motivated the original theoretical analysis that Melitz and Redding review in this chapter. The analytical framework consists of sectors that have the features developed in Melitz (2003), as well as a homogeneous good sector (although the latter is shut down in some applications). Firms enter an industry in anticipation of a productivity draw. After the entry cost is sunk and a firm’s productivity revealed, the firm has to decide whether to stay in the industry or exit. If it stays, it has to decide whether to serve only the domestic market or also export. There is a fixed cost of operation and a fixed cost of exporting, as well as variable trade costs. In the now familiar manner, firms choose among these strategies based on productivity: the least productive firms exit, the most productive become exporters, and intermediate-productivity firms serve only the domestic market. Although these results are not new, the exposition is new and intuitive, making the analysis accessible to many readers. This useful feature characterizes the entire chapter. It is especially helpful in the discussion of within-sectoral reallocations in response to declining trade costs and the home market effect. Melitz and Redding also explain how these models have guided estimation of trade flows and quantitative analysis. Some of these issues are discussed in more detail in Chapter 3 on gravity equations and in Chapter 4 on trade theory with numbers. They also discuss the integration of factor proportions into the multisector framework and some of its consequences, such as the relationship between factor endowments and endogenous sectoral productivity levels. Up to this point preferences for variety were assumed to be of the constant- elasticity-of-substitution type, resulting in constant markups in percentage terms. In Section 8, Melitz and Redding replace those preferences with a generalized quadratic system that yields linear demand functions with an intercept that depends on sectoral conditions. Under these circumstances markups vary across firms and they respond to demand and supply shocks. Since trade is costly, international markets are not fully integrated and market size impacts markups and average sectoral productivity levels. As a result, productivity is higher and markups are lower in larger economies. In this case multilateral trade liberalization leads to exit of low-productivity firms and market share reallocation toward more productive firms, including exporters, but in addition it reduces markups. The result is that prices are lower because of both higher productivity and lower markups. Section 9 then examines endogenous firm-specific productivity levels, by allowing firms to engage in innovation or technology adoption that augments their productivity draws. Choice of product scope for multiproduct firms is also considered, which provides Preface xv another endogenous source of productivity variation across firms. In a dynamic context this generates a complementarity between exports and productivity-enhancing invest- ments, because the payoff to productivity improvements is higher for exporting firms. A number of empirical studies have shown that key predictions of these models are consistent with the data. As a rule, exporters invest more than nonexporters in new technologies. And in the face of trade liberalization, multiproduct firms shed their worst products while nonexporters who switch to exporting invest the most in technology upgrading. Finally, Melitz and Redding review the recent literature on the impact of trade on wage inequity in the presence of labor market frictions. Unlike the neoclassical writ- ings that discussed wage inequality across workers with different characteristics, such as differences in human capital, the new literature emphasizes residual wage inequality— wage inequality between workers with similar characteristics—that has become a large contributor to the inequality of earnings. Firm heterogeneity plays an important role in this relationship, both theoretically and empirically, because firms with varying attributes within sectors pay different wages to workers with similar characteristics. In Chapter 2, Antràs and Yeaple review the evolution of ideas about the role of mul- tinational firms in the world’s trading system. Much has happened on this front since the publication of the previous volume of the Handbook of International Economics. On the theoretical side the internalization decision has been afforded new foundations and within-industry firm heterogeneity has been extended to cover multinationals. On the empirical side new hypotheses emanating from the novel theory have been examined with rich new data sets. Antràs and Yeaple first review some stylized facts about the operation of multina- tional corporations. Some of these are similar to stylized facts about trade flows; e.g., foreign direct investment (FDI) is concentrated within the group of rich countries and it exhibits large two-way flows (intraindustry FDI). There are, however, substantial dif- ferences across sectors; e.g., multinationals operate primarily in capital-intensive and R&D-intensive sectors. Within sectors, both the parents of multinationals and their affiliates tend to be larger, more productive, more R&D intensive, and more export oriented than nonmultinational corporations. And moreover, parents tend to specialize in R&D while affiliates tend to sell goods primarily in the host countries. After presenting this evidence, Antràs and Yeaple develop a simple analytical frame- work of trade with monopolistic competition that includes multinational corporations (MNCs), but no within-industry heterogeneity. They apply it to horizontal FDI, driven by the proximity-concentration tradeoff. In this view a firm can serve a foreign market via export or subsidiary sales. The former entails variable trade costs—such as tariffs or freight—that are saved by the latter mode of operation, while FDI entails fixed costs of acquiring and operating a production unit in the foreign country, which are saved by exporting. The evidence, based on U.S. data, supports this tradeoff: export relative to xvi Preface subsidiary sales is lower in sectors with high variable trade costs and higher in sectors with high plant-level fixed costs. Following this discussion, the theory is extended to include heterogeneous firms. Now the most productive firms become multinational corporations while the least productive (that remain in the industry) serve only the domestic market. Firms with intermediate productivity levels serve foreign markets via export sales. This sorting pat- tern holds in several data sets. The model also predicts a proximity-concentration trad- eoff, and it adds to it an impact of the degree of sectoral heterogeneity. That is, export relative to subsidiary sales is expected to be smaller in sectors with more productivity dispersion. Vertical FDI is next examined. In this case firms choose to fragment their produc- tion process, locate some activities—such as R&D or design—in the headquarters and therefore in the home country, and other activities—such as production of intermediate inputs or assembly—in host countries of subsidiaries. Since this motive for FDI is pri- marily driven by cost considerations, differences in factor prices play a key role in these decisions. But firm heterogeneity is also important, and the models predict, consistent with the data, that within sectors more productive firms source their inputs from for- eign countries. In the U.S. data, imports of inputs from foreign subsidiaries are highly concentrated among a small number of very large multinationals, and these subsidiaries are located in a small number of countries that include Canada, Mexico, and Ireland. There is, however, substantial variation across sectors and countries in export relative to subsidiary sales. In particular, U.S. firms export less relative to subsidiary sales in skill- intensive sectors to countries that are skill abundant. Next, Antràs and Yeaple provide a detailed discussion of theories of the boundaries of firms, including their implications for multinational corporations. These include the transaction costs and property rights approaches to firms’ boundaries. In addition to clearly explaining the insights from this literature, they develop several generalizations of key results. Here too firm heterogeneity plays center stage as do new features such as the role of incomplete contracts, the degree of contractibility of various activities, and the varying ability to contract in different countries. As in previous models, offshoring is concentrated among high-productivity firms, and the most productive among them engage in foreign direct investment. In addition, the property rights model predicts more integration in headquarter-intensive sectors, leading to larger shares of intrafirm trade, and subtle differences between the impact of better contractibility of headquar- ter and nonheadquarter activities. The latter predictions contrast with predictions of the transactions cost approach to boundaries of the firm, which are the same for all improvements in contractibility. A review of the evidence suggests that it is in line with several implications of the property rights approach. We have chosen to devote an entire chapter to the use of gravity equations for the estimation of trade flows. Although these equations have been widely used for empirical