Micro to Macro: Optimal Trade Policy with Firm Heterogeneity

The empirical observation that “large firms tend to export, whereas small firms do not” has transformed the way economists think about the determinants of international trade. Yet, it has had surprisingly little impact about how economists think about trade policy. In this paper, we characterize optimal trade policy in a generalized version of the trade model with monopolistic competition and firm-level heterogeneity developed by Melitz (2003). At the micro-level, we find that optimal import taxes discriminate against the most profitable foreign exporters, while optimal export taxes are uniform across domestic exporters. At the macro-level, we demonstrate that the selection of heterogeneous firms into exporting tends to create aggregate nonconvexities that dampen the incentives for terms-of-trade manipulation, and in turn, the overall level of trade protection.