Dixit-Stiglitz approaches to international trade: Enough is enough

Economics

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Abstract:

We show that the Melitz (2003) continuum interpretation of the Dixit- Stiglitz monopolistic competition model does not represent a reasonable limit of a large finite economy unless it is built on a micro-foundation of heterogeneous agents. We argue for both theoretical and empirical reasons that each of these heterogeneous agents must choose consume at most a strictly bounded number of commodities instead of a strictly positive quantity of each of the infinite number of goods produced (as in Melitz). We show in a highly general framework that this implies that (1) the benefits to product diversity converge to zero as the economy gets large and (2) the proportion of imports goes to zero as countries get large in the presence of non-zero iceberg costs. We offer a new theoretical approach to product innovation that highlights embedded assumptions in Dixit-Stiglitz that we argue drive counter-factual results.