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Computable General Equilibrium (CGE) models incorporating firm heterogeneity can overcome the shortcomings of traditional Armington-based models in explaining changes in productivity and variety in the wake of reduced trade costs. In this paper, we present a new modeling framework where the firm heterogeneity theory of Melitz is introduced into the Global Trade Analysis Project (GTAP) model and calibrated to the GTAP 8 Data Base. The new mechanisms in the model are demonstrated in a stylized scenario with 3 regions (USA, Japan and the Rest of the World) and 2 sectors (manufacturing and non-manufacturing) where the elimination of tariffs levied by Japan on the import of US manufacturing goods is examined. Results are compared with those under monopolistic competition motivated by Krugman and under perfect competition motivated by Armington. The firm heterogeneity model incorporates endogenous variety, scale, productivity, and fixed cost effects into welfare change in addition to the traditional allocative efficiency and terms of trade effects. We observe that these effects are significant sources of welfare change. GTAP-HET presents the first GTAP implementation of firm heterogeneity. It is a powerful tool for policy analysis with improved abilities in tracing out productivity changes and entry/exit of firms following trade liberalization scenarios.
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