A Model of Trade with Ricardian Comparative Advantage and Intra-sectoral Firm Heterogeneity

In this paper, we incorporate Ricardian comparative advantage into a multi-sector version of Melitz's (2003) model to explain the pattern of international specialization and trade. The model is able to capture the existence of inter-industry trade and intra-industry trade in a single unified framework. Trade liberalization can lead to a "reverse-Melitz outcome" in the two-way trade sectors in which the country has the strongest comparative disadvantage, if the country is sufficiently large or its tariff reduction is sufficiently asymmetric compared with its trading partners. In this case, the productivity cutoff for survival is lowered while the exporting cutoff increases in the face of trade liberalization, leading to reductions in real wage in terms of these goods. This is because the inter-sectoral resource allocation (IRA) effect together with the unilateral liberalization (UL) effect dominate the Melitz selection effect in these sectors. Analyses of data of Chinese manufacturing sectors confirm our hypotheses. Our model can be extended to capture the effect that, in the comparative advantage sector, it is possible that firms that sell domestically have higher average productivity than firms that do not, as documented by Lu (2010) and others.