Trade Policy with Firm Heterogeneity, Variable Markups, and Foreign Direct Investment

Thesis (Ph.D.)--University of Washington, 2020The overarching theme of this dissertation is the analysis of trade policy implication in the presence of firm heterogeneity, variable markups, and multinational production. Chapter 1 surveys the main ingredients and results of heterogeneous firms trade policy literature that has been developing since the early 2000s. First, I present in great detail var- ious stylized facts regarding firm heterogeneity, firm-level markups, and the global structure of multinational production. Second, I summarize the results of the recent development of theoretical approaches of modeling the firm-level markups. Third, I discuss the theoretical frameworks that incorporates multinational production into heterogeneous firms framework. Fourth, I review the trade policy literature that features firm heterogeneity, variable markups, and multinational production. Finally, I highlight the contribution of this dissertation and discuss directions for future research. Chapter 2 introduces ad valorem tariff and horizontal FDI into the Melitz and Ottaviano [2008] framework, producing the first framework in the trade policy literature that incor- porates firm heterogeneity, variable markups, and multinational production. The model generates novel equilibrium implications. First, the presence of multinational production generates a competitive effect on the economy, and firms need to be more productive to survive the competition. Second, the ad valorem tariff and quadratic quasi-linear preference collectively result in an endogenous level of firm entry. Therefore, the impact of trade/tariff liberalization depends on the equilibrium number of firms. In the short-run, when the firm entry is prohibited, an increase in import tariff shields the domestic economy from the For- eign competition, making it easier for firms to survive. This result is overturned when firms can enter the market freely in the long-run. In the long-run, an increase in Home’s import tariff will make the Home country a more desirable environment to do business, attracting more entrants in the Home market, making the Home market more competitive. Firms need to be more productive to survive. Home’s tariff increase also makes it harder for the least productive Foreign exporters to survive, and triggers tariff-jumping FDI among the most productive exporters. Markups also respond to tariff change differently in the short-run vs. long-run, primarily due to the change of competitive environment associated with firm entry. Chapter 3 studies the welfare implication of tariff and optimal tariffs in an environment features firm heterogeneity, variable markups and FDI. The findings can be broadly sum- marized in three aspects. First, the quadratic quasi-linear preference generates multiple externalities in this economy, causing market outcome to differ from the socially optimum outcome systematically. Permitting FDI lowers the domestic cutoff levels and reduces the misallocation in the economy. Second, free trade is not always socially optimal. If the do- mestic cutoff is sufficiently high, an additional firm entry can improve social welfare. In this case, a positive import tariff is welfare-improving because it encourages firm entry. Third, both positively and normatively, the interaction of variable markup and FDI generates novel trade policy insights that are absent if consumers possess CES preference