Introducing Melitz-Style Firm Heterogeneity in CGE Models: Technical Aspects and Implications

This paper discusses which changes in the architecture of a standard CGE model are needed in order to introduce effects of trade and firm het- erogeneity à la Melitz. Starting from a simple specification with partial equilibrium, one primary production factor and one industry, the frame- work is progressively enriched by including multiple factors, intermedi- ate inputs, multiple industries (with a mixture of differentiated and non- differentiated products), and a real general equilibrium closure. There- fore, the model structure is gradually made similar to a full-fledged CGE. Calibration techniques are discussed, and a number of changes from the original Melitz’s assumptions are also proposed. It is argued that the in- clusion of industries with heterogeneous firms in a CGE framework does not simply make the Melitz model “operational”, but allows accounting for structural effects that may significantly affect the nature, meaning and implications of the model results.