Theoretically-Consistent Parameterization of a Multi-sector Global Model with Heterogeneous Firms

Parameter selection in Computable General Equilibrium (CGE) models of international trade is important for trade policy analysis as parameter values affect trade and welfare responses to changes in trade barriers. This is particularly important if the CGE model incorporates firm heterogeneity because it introduces a new margin of adjustment and changes the interpretation of parameter estimates. A remaining obstacle to fully understanding the insights of trade in CGE models with firm heterogeneity is the lack of an appropriate set of parameter estimates consistent with the underlying theory. Our objective in this paper is to solve for structural parameters that are theoretically consistent with firm heterogeneity models. Specifically, we focus on the elasticity of substitution across varieties. We distinguish between the extensive and intensive margins of trade flows and estimate two gravity equations by using country-level data for the motor vehicles and parts industry. Our results show that the elasticity values that are consistent with the firm heterogeneity theory are considerably lower than Armington (1969) elasticities used in the GTAP model. This implies that current implementations of Melitz-type models which use elasticities of substitution estimated in the absence of firm heterogeneity will give overly large trade volume responses to policy reforms.