The Impact of Institutional Quality on Intra-Industry Resource Allocation

Melitz (2003) embedded heterogeneous firms in monopolistic competition to examine how trade liberalization induces intra-industry reallocation, leading to improvement of aggregate industry productivity. From our perspective, firm productivity results from using heterogeneous inputs. As technology uses more inputs, entry will be harder. In our model, marginal products of inputs are randomly distributed. Choice of inputs incurs additional transaction cost in case of imperfect institution according to Acemenglu et al. (2007). In Melitz (2003), all aggregate variables depend on mass of firms, which is mainly determined by the factor endowment of labor. If the endowment is same over countries under same condition, all aggregates should be equal. However, the transaction cost behind input choices can affect all the aggregates and affect the pattern of trade. The transaction cost can be reduced by a choice of institution. As an extension to the work of Melitz (2003), we will incorporate input choices and institution into the Melitz’s model to show how the distributions of factor inputs affect firm dynamics of entries and exits. Factor endowments determine comparative advantages or patterns of trade. Our paper aims to show that distribution of factors is a determinant as well.