The Basic Framework of the Melitz Model - Essay Example

? of affiliation (a) Outline the basic framework of the Melitz model (see Sections 2, 3 and 5 of the paper). In particular, what key assumptions does the author make? In what sense can his model be described as one of monopolistic competition? The framework of the Melitz model focuses on analysis of intra industrial effects of the international firms on trade. The model lays emphasis on the manner in which exposure to the international trade is likely to induce the entrance of more productive firms into the export market. At the same time, least productive firms will be forced out and only produce for domestic market, this in turn will also lead to the exit of the least productive firms (Melitz, 2003). The Melitz model uses heterogeneous firms to perform its analysis under the general states of equilibrium. This concept explains how the exit of least productive firms leads to allocation of huge market shares to the well performing firms thus resulting into increase in productivity level. This indicates how certain firms are exposed to many opportunities by exit of the other non-performing ones. This paper also adapts the model for monopolistically competitive firms, that is, only highly competitive firms are given consideration under general equilibrium conditions. In addition, the concept suggests that uncertainty in production is a very important aspect and can help a great deal when trying to explain the behavior of firms. Uncertainty creates a business environment in which the players cannot predict the outcome of their competition and each firm therefore competes at its best. Also under this theory, there is an assumption that only the most productive firms that earn positive results remain in the competition. This analysis further puts focus on long run effects of this type of trade on performance and behavior of firms under different levels of productivity. Another very important aspect that this study emphasizes on is the introduction of dynamic future oriented market entry decisions by firms that are facing sunk costs of market entry. The study has focused on the importance of such market cost of such market entries and their effects on the firms’ competition. Description of the model The Melitz model focuses on three aspects to analyze its studies. These include demand, production, and aggregation. These aspects are relative and are majorly the key determinants in decision-makings. Demand Demand relates to consumer preferences. The preferences relating to the representative of the consumer can be got by CES utility function all over a range of goods that is represented by the company. The function below can be used in this analysis (w)q dw]1/p ? represent the value of the mass of the goods available. The available goods are considered a substitute which implies that P is less than 1, but greater than 0. 0 < p < 1. But the elasticity of substitution that exists between two commodities of -0 = 1(1 - p) > 1 Consumer behavior in regards to demand can be analyzed by considering a set of products that the consumer takes against the aggregate price of the commodities. The presence of simultaneous entry and exit during the state of steady equilibrium can be attributed to the sunken market entry cost. It also explains the survival probabilities of exporting firms in the market (Johnson, 2010). These aggregates can be applied in deriving optimal consumption and decisions regarding expenditure of various individuals. Production The industry has many firms, and each of these firms chooses to produce variety of products w. the production process is viewed to require only one important factor, that is labor. The factor of production labor L is in-elastically available at its total level. The technological level of these firms is represented by cost functions hat show constant marginal cost that is characterized by fixed overhead cost. Labor used can therefore be represented using linear function for output q i.e 1= f + q/q. An assumption that all firms share similar fixed cost f which is greater than zero; f > 0 Regardless of productivity, every firm is assumed to face a residual demand curve whose elasticity is constant. The firms are therefore compelled to choose a similar profit maximizing mark up. Therefore a much more productive firm is entitled to achieving large outputs and revenues, offer lower prices for their goods and earn more profits as compared to the big firms. Aggregation A state of equilibrium is characterized by the mass of firms and distribution of productivity levels. All these variables are then put over the subset of (0, ox) in such an equilibrium state, the collective price can be given by q is the weighted average of the productive levels of the firms and it is always independent of the no. of firms M in the market. Therefore, an industry comprising of M firms that have any level of productivity and yields similar average productivity level will induce similar outcome aggregate as an industry that has M firms that have similar levels of productivity. The existing conditions during the equilibrium state will always ensure S in finite. Melitz Model can therefore be described as monopolistic competition because it basically analyses well performing firms. At the same time, it neglects the non performing firms which are pushed out of the market. b) Explain the meaning of the cut-o¤ productivity level ' Why is this cut-off Important in this model? Cut of productivity level of the firms refer to the lowest level in which the firms can produce. Cut off productivity level is important in determining the firms that have great potential in terms of output and have intentions of operating for a longer period in the market. Through this, the average productivity level of a firm can also be established. (c) Describe the effects of a decrease in variable trade costs in the open economy. In particular, comment on the entry and exit of firms and the reallocation of market shares and explain the underlying mechanism. What happens if variable trade costs disappear entirely (i.e. _ = 1 in the notation of this model) and there are no other costs associated with trade? Variable trade costs are the company expenses that vary with the company level of output. Therefore when variable costs increases, the company production also increases significantly. If the variable costs are reduced, then the level of output will also decrease. Such costs may include direct labor or direct materials that are used in production. Therefore, in an open economy, if the quantity of variable trace costs is decreased then the overall productivity of the economy will decrease significantly. The variable costs being the basic factors of production have many effects on the industry productivity. Before entry into any industry, firms’ are often distributed in terms of levels of productivity. Therefore, only firms with average productivity levels can compete effectively in the market. Therefore there is easy entrance for such stable firms. The export decision is normally a decision that only the firm can make depending on its productivity. Trade can in many ways affect the existence of surviving firms. One of the ways is through increase in product competition in the market. There is often an increase in number of firms operating in an economic system this increase creates a stiff competition. In such stiff competitions, only the strong firms can survive, the weak firms are thus eliminated from the system. The fact that foreign competitors are brought into the picture also causes a stiff competition to these domestic firms (Sornarajah, 2010). The foreign competitors produce more; hence, the domestic firms cannot compete effectively with them. The above channel is however not applicable in this case; this is due to its monopolistic and peculiar nature that only restricts it to C.E.S preferences. Price elasticity of demand normally does not change due to number or the varieties that are competing. Therefore, in cases where entry into a system is costly, the minor firms are eliminated thus allowing the large firms an easy entry since they can afford the cost of entry. In case, the variable trade costs disappear entirely, only a few firms will be in a position to operate effectively. This is because most firms will lack the basic factors of production that is required to facilitate the entire production. In that case, the firms will produce little or none, and such can only be used for domestic purposes. The variable costs are normally the basic factors that firms look for. In cases where they are diminishing, firms are left with nothing to operate with hence fall out. During such times, many firms withdraw from the competition and only the strong firms remain to counter the difficult market situation. In conclusion, the Melitz model describes the various ways through which exposure to trade affects the entry and exists of firms. This paper also discusses the aggregate industry, and how its growth affects the players in the market. The paper was written on basis of a dynamic industry model that is in a monopolistic competition under the general equilibrium settings. Market entry can be expensive especially due to the international entry costs, but once a firm identifies its productivity, it can gauge its performance in the market. Unlike entry, exit into the industry is considered easy; this is due to the high level of competition that exists between these trading firms. Due to the highly increasing cost of operation and production, only strong financially stable firms can compete fairly in the market. As a result, firms that are more productive are introduced into the economy thus a significant growth. Such competition is therefore very healthy and efficient especially in open economies. Bibliography Melitz, Marc (2003), Market Dynamics and Productivity in Developing Countries, Springer New York. Johnson, T. E, & Bade, D. L. (2010). Export/Import Procedures and Documentation. New York, Amacom. Sornarajah, M. (2010). The international law on foreign investment. Cambridge, Cambridge University Press. Read More