Grounded by Gravity: A Well-Behaved Trade Model with Industry-Level Economies of Scale

Abstract

Although economists have long been interested in the implications of Marshallian externalities (i.e., industry-level external economies of scale) for trading economies, the large number of equilibria that they typically imply has kept such externalities out of the recent quantitative trade literature. This paper presents a multi-industry trade model with industry-level economies of scale that nests a Ricardian model with Marshallian externalities as well as multi-industry versions of Krugman (1980} and Melitz (2003). The behavior of the model depends on two industry-level elasticities: the trade elasticity and the scale elasticity. We show that there is a unique equilibrium if the product of the trade and scale elasticities is weakly lower than one in all industries. The welfare analysis reveals that if this condition is satisfied then all countries gain from trade, even when the scale elasticity varies across industries. The presence of scale economies tends to lower the gains from trade except if the country specializes in industries with relatively high scale elasticities. On the other hand, scale economies amplify the gains from trade liberalization except if it leads to reallocation towards industries with relatively low scale elasticities.