Problem set 6

First we find the productivity cut-off by setting the output of the cutoff firm to zero:

¿
c (ϕ )= ( )
a ϕ ¿ 12
wλ
−a=0

ϕ ¿ =awλ
Then we substitute wλ in the optimal output:

( )
1
ϕ 2
c ( ϕ )=a ¿ −a
ϕ
 ( )
1
ϕ 2
We need to substitute the optimal quantity c ( ϕ )=a −a into the demand function:
ϕ¿

1
p ( ϕ )=
λ( c ( ϕ ) +a)
1

1 ( ϕ¿) 2
p ( ϕ )= =
( )
ϕ 12 1
λa ¿ aλ ϕ 2
ϕ
¿
ϕ
Then recall that aλ= and substitute it into the pricing equation to obtain:
w

( )
1
w w ϕ
p ( ϕ )= 1
= · ¿ 2
ϕ ϕ
( ϕ¿ ϕ ) 2

( ) is increasing in the firm’s productivity.

1
ϕ 2
Where the markup ¿
ϕ

Given the result from part (b), it is straightforward to show that:

( )
1
w ϕ 2
p ( ϕ )− −1
( )
¿ ¿ 1
π( ϕ) ϕ ϕ ϕ
= = =1− 2

( )
r (ϕ ) p (ϕ) ϕ 12 ϕ
¿
ϕ
Tougher competition (higher ϕ ¿ ) reduces the firm level profit share. This is because with more
competition firm's markups are lower. Furthermore, the firm-level profit share increases in
productivity ϕ . This is because more productive firms charge higher markups since, by selling
larger quantities of output, they face a less elastic demand curve.

We start with the firm revenues:

r ( ϕ )=Lp ( ϕ ) c ( ϕ )=L· ( )(( ) )

w ϕ 12 ϕ 1
· ¿ · a ¿ 2 −a =¿
ϕ ϕ ϕ

( )
1 1
¿ aLw ¿− 1
=¿
ϕ
(ϕϕ ) ¿ 2

( ( ))
ϕ¿ 1
aLw
¿ ¿ · 1− 2
ϕ ϕ

The total variable cost of the firm is:

L·
w
ϕ
w
(( ) )
ϕ 1
· c ( ϕ ) =L· · a · 2 −a =¿
ϕ ϕ

(( ) )
¿ 1 ¿
aLw ϕ ϕ
¿ 2
−
ϕ¿ ϕ ϕ

Firm profit is:

(
π ( ϕ )=L p ( ϕ ) · c ( ϕ )−
w
ϕ
c ( ϕ ) =¿ )
¿
aLw
ϕ
¿ 1−2
( ( ) )
ϕ¿ 12 ϕ¿
ϕ
+
ϕ
First, to make sure that the steps below are clear notice that:

[ ( )] =¿
∞

∫( )
∞
ϕ ¿ a −θ−1 ¿ a −ϕ
−θ−a
·ϕ dϕ= ( ϕ ) ·
ϕ
¿ ϕ θ+a ϕ
¿

( )
¿ −θ
a ϕ
−θ−a
(ϕ )
¿ ( ϕ ¿ ) · −0+ =
θ+ a θ+ a

Let us compute the aggregate profit share and begin with the numerator:

( ( ) )
∞ ∞ ¿ 1 ¿
∫ π ( ϕ ) g ( ϕ) dϕ=∫ aLw
¿ ϕ
¿ 1−2
¿
ϕ
ϕ
2
+
ϕ
ϕ
·θ b θ ϕ−θ−1 dϕ=¿
ϕ ϕ

∫( ( ) )
∞
aLwθ b θ ϕ ¿ 12 ϕ ¿ −θ −1
¿ ¿ 1−2 + ϕ dϕ=¿
ϕ ϕ
ϕ ¿ ϕ

( )
θ ¿ −θ−1 1 2 1
aLwθ b ( ϕ ) · − + =¿
θ 1 θ+ 1
θ+
2
¿ −θ−1
aLw b ( ϕ )
θ
¿
(2 θ+1)( θ+1)
The denominator is:

( ( ))
∞ ∞
aLw ϕ¿ 1
∫ r ( ϕ ) g ( ϕ ) dϕ=∫
¿ ¿ ϕ
¿ · 1−
ϕ
2
θ b θ ϕ−θ−1 dϕ=¿
ϕ ϕ

∫( ( ) )
∞
aLwθ b θ ϕ¿ 1
−θ−1
¿ ¿ 1− 2
ϕ dϕ=¿
ϕ ϕ
ϕ ¿

( )
θ ¿ −θ−1 1 1
¿ aLwθ b ( ϕ ) · − =¿
θ 1
θ+
2
 −θ−1
aLw bθ ( ϕ ¿ )
¿
2 θ+1
The aggregate profit share is then:
∞

∫ π ( ϕ ) g ( ϕ) dϕ
Π ϕ ¿
1
= =
R ∞ θ+ 1
∫ r ( ϕ ) g ( ϕ ) dϕ
¿
ϕ

An increase in competition (higher ϕ ¿ ), as seen above, reduces the firm-level profit share. However,
it also affects the selection of firms: low-productivity firms exit with an increase in competition
(since the cutoff is higher). Since the profit share is declining in productivity, it is the firm with low
profit share that exit. This is a composition effect which tends to increase the profit share, because
the surviving firms have higher profit share. Thus, although the profit share of each surviving firms
declines, the firms with the lowest profit share exit. These two opposing forces cancel each other
when productivity is Pareto distributed.
Setting profits to zero yields:
π ij ( ϕ ¿ij ) =0

( )
1−σ
τ ij wi
Bj ¿ −f ij =0
ϕ ij

( )
1
¿ Bj 1−σ
ϕ =τ ij w i
ij
f ij

Profits can then be rewritten as:

( )
1−σ
τ ij wi
π ij ( ϕ ) =B j −f ij
ϕ

( ( ) )
1−σ
B j τ ij wi
¿ f ij −1
f ij ϕ

(( ) )
¿ 1−σ
ϕ ij
¿ f ij −1
ϕ

The two cutoffs are:

( )
1
¿ Bj 1−σ
ϕ ij =τ ij w i
wj f

( )
1
Bj
ϕ ¿jj =τ jj w j 1−σ
wjf

Taking the ratio yields:

¿
ϕ ij =ϕ jj
¿
( )
τ ij wi
τ jj w j

Since τ jj =1, we get:

 ¿
ϕ ij =ϕ jj
¿
( ) τ ij w i
wj

We are first going to use the optimal quantity c ij ( ω ) and price pij (ω) previously found. Then we use
¿
the definition of B j and ϕ ij , to obtain that firm ϕ revenues are:

L j w j σ 1−σ
( )
1−σ
τ ij wi
r ij ( ϕ )= pij ( ϕ ) L j c ij ( ϕ )= 1−σ · =¿
P j ( σ−1 )
1−σ
ϕ

( ) =¿
1−σ
τ ij w i
¿ σ Bj
ϕ

σ f ( ) =¿
¿ 1−σ
ϕ ij
ij
ϕ

¿σ w f ( )
¿ 1−σ
ϕ ij
j
ϕ

∞
g i ( ϕ)
r ij =∫ r ij ( ϕ ) · ¿ dϕ
¿
ϕ ij 1−G(ϕ ij )

( )
θ
∞
ϕ
¿ 1−σ
( ϕ ¿ij)
¿ ∫ σ w j f ij θ· dϕ
ϕ
¿
ij
ϕ ϕ θ+1
1−σ +θ
∞
( ϕ ¿ij )
¿ θσ w j f ∫ 2 +θ−σ
dϕ
ϕij
¿
ϕ
 [ ]
∞
¿ 1−σ +θ −ϕ −1−θ +σ
¿ θσ w j f ( ϕ ij ) ·
1+θ−σ ϕ ij
¿

¿ 1−σ +θ
¿ θσ w j f ( ϕ ij ) · [ ϕ−1−θ+ σ
1+θ−σ ]
θσ w j f
¿
1+θ−σ

The total value of export is given by the product of the average revenues of exporting firms
computed in part (f) and the total mass of firms that export from i to j:
θσ w j f ¿ −θ
Rij =M ij r ij =M i · ·(ϕ )
1+θ−σ ij

¿ ¿
Since ϕ ij =ϕ jj ( )
τ ij w i
wj
, we obtain:

( )
−θ
θσ w j f ¿ τ ij w i
Rij =M i · ϕ jj ·
1+θ−σ wj

( )( )
1+θ
θσf wj Mi
1+ θ−σ ( ϕ ¿jj )θ θ
( τ ij wi )
The export share is:
Rij
λ ij = J
=¿
∑ R vj
v=1

Mi
θ
( τ ij wi )
¿ J
Mv
∑ θ
v=1 ( τ vj w v )
Examining the numerator, we find that the expenditure share on goods from country i increases with
the number of firms from i M i (which depends on the size of country i , although we did not
compute it here). The expenditure share decreases with the labor cost of delivering the good w i τ ij.
Notice that the denominator is related to the multilateral resistance term we examined in class as it
captures the overall openness of country j . In fact, the denominator is a function of all the iceberg
trade costs that are required to export to country j .
The key implication from the gravity model is that the trade between two countries increases with
the size of the two countries and it decreases with their distance. Thus, since Germany is larger than
Denmark, we would expect Germany to have the largest export volumes. Relative to their size, we
expect Denmark to export more than Germany. The reason is as follows. Since Germany is larger
than Denmark, we expect Germany to trade more with itself than Denmark does. Hence, Denmark
will export more relative to its size than Germany.

First, consider the size of Norway and Germany. Germany is larger than Norway, which suggests
larger trade flows between Denmark and Germany. Second, although Norway and Germany are
relatively close to Denmark, Denmark shares a border with Germany, but it doesn't with Norway.
This fact suggests larger trade between Germany and Denmark. Finally, as both Denmark and
Norway are Scandinavian countries, one could assume that there are some cultural connections
between the two countries that would promote their trade flows.

Both Austria and Denmark are of similar size, and both share a border with Germany. However,
Austrians and Germans speak the same language, which would suggest larger trade flows between
these two countries.
See problem set for the exercise description:

For the first regression we see a positive relation between the GDP of the destination and Danish
exports. The slope of the line is 1,06.
This indicates that Denmark exports more to larger economies.
We plot the export value divided by the destination GDP. We are going to control in a way for the
size of the destination by taking the total export value of Denmark to a destination j divided by the
GDP in country j. We then plot that against the distance to destination j.
For this regression we see a negative relation between distance and Danish exports. The slope of the
line is -0,8.
This indicates that Denmark exports less to economies that are further.

The results from the regression indicate that exports are increasing in GDP, both for origin and
destination. We also see that exports are decreasing in distance, which is what we also found in part
(a). All the added control variables have the signs that we would expect of them.
Regression output
(1) (2)
log_value log_value
 log_origin_GDP 1.195*** 1.186***
(0.00742) (0.00733)
log_destination_GDP 0.900*** 0.891***
(0.00727) (0.00720)
log_dist -1.369*** -1.020***
(0.0188) (0.0227)
Common Border 0.948***
(0.0950)
Common Language 0.789***
(0.0458)
Colonial Relationship 0.713***
(0.122)
Common Currency 0.517***
(0.0930)
Regional Trade 0.947***
Agreement
(0.0378)
Observations 20313 20313
R2 0.660 0.676
Adjusted R2 0.659 0.676
Standard errors in parentheses
*
p < 0.05, ** p < 0.01, *** p < 0.001

We can see that including origin and destination fixed effects increases the R2. Variables such as
common border, colonial relationship, common currency and regional trade agreement all seem to
have a smaller effect on trade.
Regression output - Fixed effects
(1) (2)
log_value log_value
 log_dist -1.678*** -1.440***
(0.0192) (0.0227)
Common Border 0.758***
(0.0940)
Common Language 0.791***
(0.0441)
Colonial Relationship 1.072***
(0.123)
Common Currency 0.0252
(0.0967)
Regional Trade 0.429***
Agreement
(0.0389)
Observations 24379 24379
R2 0.757 0.764
Adjusted R2 0.753 0.760
Standard errors in parentheses
*
p < 0.05, ** p < 0.01, *** p < 0.001
The EU is an institution that promotes economic integration of its members via the free movement
of goods and services, capital, and labor. Focusing on trade in goods and services, the EU promotes
trade by reducing the costs associated with exporting to another EU member. This statement is
supported by the gravity model of trade, whereby trade between countries declines in the bilateral
trade costs. The EU reduces bilateral trade costs as 1) there are no tariffs between EU members and
2) regulations on product standards are harmonized across countries. The increase in trade flows
between Denmark and other EU members is beneficial for welfare. First, let us consider the trade
flows between Denmark and countries of similar level of development (Germany, Netherlands,
etc...). Applying the Krugman model, we can claim that trade has increased the number of varieties
available for consumption in Denmark and in the other countries, and prices of differentiated goods
have likely fallen. Second, let us focus on countries within the EU that have not the same level of
development of Denmark (Poland, Bulgaria, etc...). It is likely that these countries exhibit
technological differences or different endowments of high-skilled and low-skilled workers than
Denmark. Therefore, by the Ricardian model or the Heckscher-Ohlin model, we can claim that the
EU allowed these countries to specialize in their comparative advantage industries, thus, improving
welfare. Finally, one can speculate that the news coverage of Brexit has highlighted the benefits of
the EU and the costs associated with 21 exiting the EU to Danish citizens. However, since we do
not have a model nor conclusive evidence, we can leave this line of thought to other researchers or
journalists.