Trade Costs, Generalized Demand, and Firm Selection (CES Working Paper version available here)
Abstract: This paper extends the canonical Melitz-Chaney framework beyond the CES to characterize the selection effect à la Melitz (2003) under generalized demand. It uses a Gorman-Pollak demand system that nests direct and indirect separability and keeps demand curvature unrestricted. The selection effect is always operative and remains the dominant welfare channel. This gravity-consistent model generalizes the ACR formula in Arkolakis et al. (2012) and reveals that by shaping export participation patterns, demand curvature governs the intensity of the competitive pressure trade exerts on domestic firms forcing them to exit. Super-convex demand yields an upper bound for the probability of exporting and the average export productivity and thus magnifies trade-induced firm exit and welfare gains from trade. This result reverses under sub-convex demand, with CES demand delivering an intermediate outcome. This paper thus uncovers new implications of demand curvature previously unexplored in the trade literature.