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In one of the central papers of "new new" trade theory , Melitz proposes a framework in which the effect of trade on firm productivity at the aggregate industry level can be analyzed. Productivity at the firm level is drawn from a distribution that determines the variable cost of production. (Following , the Pareto distribution is used in this Demonstration.) The model endogenously determines cut-off productivity levels (the ... *): in autarky, only firms with productivity ... , where ... is the cut-off productivity level in an autarky, serve the domestic market. In the open economy, firms with productivity ... , where ... * is the open-economy cut-off productivity level, sell goods in the domestic market, while firms with ... export as well. Firms with productivity ... are forced to exit the market when moving from a closed to an open economy. To summarize, as low-productivity firms exit and the most productive firms gain market share, trade increases firm productivity at the aggregate level.
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