Heterogeneity and Applied General Equilibrium Models of Trade: Lessons from the Canada-US Free Trade Agreement

Applied General Equilibrium models of trade failed to predict the sec-toral changes in trade volumes following the Canada-US Free Trade Agreement. These models utilized a representative firm framework and used econometric estimates for the elasticities of substitution be-tween home and foreign goods. I take a different approach on both fronts, modeling plants as heterogeneous and calibrating the elastic-ities to match estimated markups in each sector. I introduce these features by adapting a Hopenhayn (1992) model of plant entry and exit and embed this in a multisector trade model. The resulting model is very similar to Melitz (2003), but I focus on quantifying the effects of trade liberalization on trade flows and industrial structure. I cal-ibrate the model using trade data between the United States and Canada before their Free Trade Agreement and evaluate the model’s performance using later data. By successively shutting down various features of the model, I isolate the contribution of each. I find that calibrating the elasticities to markups improves the fit between model predictions and data significantly, from weighted correlations which are negative to values of 0.36. Incorporating plant heterogeneity and industrial data improves the weighted correlation to 0.77. ∗I am grateful to Timothy J. Kehoe for his guidance. I also thank Tom Holmes, Ed Prescott, and Sam Kortum for their suggestions. I thank Ron Leung and participants in the Minnesota Macro Workshop for their help. All remaining errors are my own. 1