Earlier in the chapter we described the way in which free trade allows countries to make the

Question:

Earlier in the chapter we described the way in which free trade allows countries to make the most of what they do well. Recent work in the trade area has also described the way in which free trade improves the productivity of firms within a country. Within a country we typically see firms of varying productivity.

If firms were in fact all producing exactly the same product, we would expect higher-cost firms to be driven out of business. In fact, firms are often producing products that are close substitutes, but not identical. Matchbox cars are like Hot Wheels cars but not identical. Under these conditions, industries will have firms with a range of productivity levels because some people will pay a little more for the particular product a firm supplies.

What happens when trade opens up? Now competition grows. Firms with good products and low costs can expand to serve markets elsewhere. They grow and often improve their cost through scale economies while doing so. Less productive firms find themselves facing tough competition from both foreign producers and from their domestic counterparts who now look even more productive than before.

Melitz and other economists have found that when we look at the distribution of firm productivity after big trade changes (like the free trade agreement between the United States and Canada in 1989) we see a big drop-off in the less productive firms. Trade not only exploits comparative advantage of countries, but it improves the efficiency of firms more generally.