Dundee Discussion Papers in Economics 090: Efficiency gaps, love of variety and international trade

This paper develops a general equilibrium model of trade with technical heterogeneity amongst monopolistically competitive firms and countries. With free-entry, the existence of technical asymmetries between firms leads to the endogenous determination of the equilibrium average efficiency of the industry. It is shown that trade reduces (increases) the minimum efficiency required to survive in the more (less) efficient country. This has important welfare implications: (1) contrary to the constant elasticity of substitution homogeneous firms model, through its effects on the efficiency composition of the industry, trade affects welfare even when there is no love of variety, and (2) there are circumstances in which trade liberalisation leads to a loss of consumer welfare.