The Competitive Effects of Heterogeneous Firms Facing Capacity Constraints Under International

There is a long standing tradition in industrial organization studying the impact of capacity con-straints on market competition. However, this tradition has not spread to modern international trade. This paper develops a model of international trade where firms are heterogeneous across two dimensions; capacity and productivity. The introduction of capacity generates two novel channels, an effect of composition and a substitution effect, which have important implications for competition and how equilibrium responds to market size and trade policy. When capacity is relatively “tight”, the model yields results similar to a market where firms tacitly collude. This is due to a prevalence of constrained firms charging higher prices (the effect of composition) boosting the average price level. When capacity is relatively abundant, the model’s predictions are akin to those of Melitz and Ottaviano (2008). With trade, capacity constraints endogenize heterogenous exporters ’ decisions across destinations (the substitution effect), which can mag-nify or dampen the effect of composition depending upon relative market characteristics. The novel channels of the model rationalize features common in firm-level data, but not new trade theory. Substitution across destinations and low levels of production from a number of relatively efficient firms, for example, are anomalous to the majority of prevalent new trade theories bu