Economic Modelling 92 (2020) 230–238

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Economic Modelling
journal homepage: www.journals.elsevier.com/economic-modelling

Export, FDI and the welfare gains from trade liberalization☆

Puyang Sun a , Yong Tan b, ∗ , Guang Yang a
a Department of Economics, Nankai University, China
b
School of International Economics & Trade, Nanjing University of Finance and Economics, China

A R T I C L E I N F O A B S T R A C T

JEL classification: This paper extends Melitz and Redding (2015) to analyze the welfare gains from trade liberalization by adding
F12 foreign direct investment(FDI). Our model predicts that with FDI activities, welfare gains from trade liberaliza-
F13 tion will be strictly lower than those in a model without FDI, but only takes exports into account. In addition, the
F41
calibrated model indicates that with FDI activities, aggregate welfare reaches its maximum when the fixed export
costs are positive rather than 0. Furthermore, we decompose the welfare gains induced by trade liberalization
Keywords: from continuing exporters, and switchers. The results show that in any case, with or without FDI, continuing
FDI exporters contribute a larger share to welfare gains than status switching firms.
Welfare gains
Trade liberalization

1. Introduction
In the last three decades, a central element of economic global-
ization has been the growth in multinational production (henceforth,
MP). From 1990 to 2006, the annual growth rate of global foreign
direct investment (henceforth, FDI) was 17%; during the same period,
world exports grew by only 8% (Irarrazabal et al., 2013). According
to the World Investment Report, by 2006, 10% of the world’s GDP
was comprised of value added from MP. The remarkable growth of
FDI and its interaction with exports has drawn considerable attention
from researchers (e.g. Helpman et al., 2004; Irarrazabal et al., 2013;
Ramondo and Rodriguez-Clare, 2013).
Further, the question of how much a country gains from trade
liberalization, a decrease in the variable trade cost, lies at the core
of research in international trade. Arkolakis et al. (2012) and Melitz
and Redding (2015) evaluate the gains from trade liberalization in
economies with homogeneous and heterogeneous firms, respectively.
However, FDI is prohibited in their works, which leaves the gains
unclear when firms face FDI options. Ethier (1986) finds a substitu-
tion relationship between FDI and exports. Firms that are engaged in
FDI are not necessarily affected by trade liberalization.1 As such, gains
from trade liberalization are overestimated if firm-level FDI activities
are not considered. Given the rapid growth of FDI and its influence on
welfare gains during trade liberalization, how to correctly measure wel-
fare gains from trade liberalization is not only of academic interest; it
is also of policy importance.
Pioneer research documents welfare gains from trade liberalization
from different perspectives: consumers gain from more variety (Broda
and Weinstein, 2006; Goldberg et al., 2009); productivity gains from
exporting a large variety of goods (Feenstra and Kee, 2008) and welfare
gains from reduced markups (Feenstra and Weinstein, 2009; Edmond et
al., 2015). In contrast, Arkolakis et al. (2012) (henceforth, ACR) intro-
duce a way to measure the aggregate welfare gains from trade liberal-
ization.2
However, Melitz and Redding (2015) show that ACR underesti-
mate gains from trade liberalization by focusing on an economy with

☆
We are grateful to Lorenzo Caliendo, Yi Lu, Larry Qiu, Joel Rodrigue for their invaluable comments and feedback. We are also grateful to the editor and two
anonymous referees for providing valuable comments. We would like to thank participants at CCER Summer Conference in Yantai (2016), and CTRG conference in
Nanjing (2016). Yong Tan acknowledges the financial support from the Natural Science Foundation of China (71703067), National (Major) Social Science Foundation
of China (18VSJ017). Guang Yang acknowledges the financial support from Social Science Foundation of China (18CJL013). All authors have equal contribution in
this paper. If you have any questions, please contact Yong Tan, who is the corresponding author.
∗
Corresponding author.
E-mail addresses: puyangsun@163.com (P. Sun), yongtan_econ@163.com (Y. Tan), yangg@nankai.edu.cn (G. Yang).
1
Trade liberalization only affects a firm that is engaged in FDI if it switches its status from FDI to exporting due to variable trade cost reductions.
2 ACR (2012) extend the idea of Eaton and Kortum (2002) to show that when certain conditions are satisfied, the aggregate welfare gains from trade liberalization

can be measured using a country’s domestic trade share and its elasticity of trade with respect to variable trade costs.

https://doi.org/10.1016/j.econmod.2020.01.003
Received 1 March 2019; Received in revised form 25 October 2019; Accepted 3 January 2020
Available online 9 January 2020
0264-9993/© 2020 Elsevier B.V. All rights reserved.
P. Sun et al.
homogeneous firms. Specifically, Melitz and Redding (2015) demon-
strate that the aggregate welfare level can be measured by real income,
i.e., the nominal income divided by the price index. Moving from an
economy with homogeneous firms to one with heterogeneous firms,
the trade induced welfare gains will increase. Intuitively, in equilib-
rium, nominal income is determined by aggregate output, and the price
index depends on the revenue-weighted average firm-level productiv-
ity.3 Trade liberalization, on the one hand increases aggregate output
by encouraging firm-level exporting participation; on the other hand, it
leads to a disproportionately faster growth of more productive firms.4
Therefore, as nominal income increases, and the price index decreases.
The aggregate welfare level, in turn increases.
In this paper, we attempt to measure the gains from trade similar
to Melitz and Redding (2015) by allowing firm-level FDI activities. Fol-
lowing Helpman et al. (2004), when an economy moves from autarky to
free trade, the most productive firms choose to conduct FDI, followed by
firms engaged in exporting, and those that only serve the domestic mar-
ket, while the least productive firms exit. The FDI activities change the
trade elasticity measured in Melitz and Redding (2015), in which trade
elasticity with respect to variable trade costs is determined only by the
export productivity cutoff, 𝜙x . In contrast, with the FDI option, this
elasticity is jointly determined by the productivity cutoffs of exporting,
𝜙x , and FDI, 𝜙I .5 This implies that the aggregate output and average
productivity growth induced by trade liberalization are smaller in cases
with FDI activities. As such, the welfare gains from trade liberalization
are overestimated by Melitz and Redding (2015).
Further, in this paper we estimate the trajectory of welfare gains
by gradually lowering the variable trade cost, 𝜏 . The results show that
although the welfare level is always higher in the case with FDI than
that without FDI, the welfare gains from trade liberalization are smaller
in the case with FDI. Specifically, our calibration results show that
when the variable trade cost, 𝜏 , decreases from 3 to 1.25, the welfare
gains in the case with FDI are 3 percentage points lower than those
in the case with exporting only. We further decompose the welfare
gains into different group of firms in order to investigate the source
of gains. The results demonstrate that with FDI activities, gains from
continuing exporters contribute 57% of the aggregate welfare gains,
and status-switching firms contribute the remaining 43% of welfare
gains (of which 78% is from the switching of non-exporting firms to
exporting firms, and 21% from the switching of FDI firms to exporting
firms). By comparison, when FDI is prohibited, continuing exporters
contribute 74% of the aggregate welfare gains. These findings are not
only of research interest; they are also of policy importance. Since FDI
revenue varies across economies, an economy with a higher FDI share
would expect lower welfare gains from trade liberalization. In addition,
FDI activities exhibit heterogeneities across industries, i.e., FDI is more
popular in some industries, e.g., textile and cloths, leather, and min-
ing industries than in others. To maximize social welfare, policymakers
may want to decrease the variable export cost, 𝜏 , more in industries
with fewer FDI activities.6
After understanding the source of welfare gains, we conduct fur-
ther counterfactual experiments by gradually changing the fixed export
costs, variable trade costs, and fixed FDI costs. The calibration results
demonstrate that when gradually increasing the fixed export costs in an
economy with heterogeneous firms, welfare reaches its maximum at a
positive fixed export cost. This is because a positive fixed export cost
3 Nominal income increases in the aggregate output and price index decreases
with average firm-level productivity.
4 invariant to economies with heterogeneous and homogeneous firms.
Throughout this paper, trade liberalization refers to reductions in variable
trade cost, 𝜏 .
5 their productivity draw, low productivity firms serve the domestic market only,
This is because a decrease in variable trade costs would decrease the export
productivity cutoff, 𝜙x , and increase the FDI productivity cutoff, 𝜙I .
6 market, and the most efficient firms serve the foreign market through FDI.
Since FDI firms will not be affected by trade liberalization, the reduction in
variable export costs will generate fewer welfare gains in industries in which
more firms are engaged in FDI activities.
231
Economic Modelling 92 (2020) 230–238
drives more firms to conduct FDI instead of exporting.7 More FDI firms
increase the aggregate output and average productivity. This, in turn,
raises the social welfare level.
This work is related to a number of papers which empirically or
numerically quantify the gains from trade through different channels
(Broda et al., 2006; Broda and Weinstein, 2006; Goldberg et al., 2009;
Feenstra and Weinstein, 2009; Edmond et al., 2015; Fajgelbaum and
Khandelwal, 2014). In contrast to these works, our study evaluates the
aggregate welfare gains from trade liberalization. This feature makes
our paper closely related to Melitz and Redding (2015). However, our
work differs from Melitz and Redding (2015) in three respects. First,
we examine the aggregate welfare gains from trade liberalization in a
framework with FDI activities, which are the central elements of the
economic globalization. Second, we decompose the welfare gains into
different groups of firms to clarify the source of the gains; Third, we
calibrate the model to detect optimal export fixed costs. We find that in
the case with FDI activities, the optimal export fixed costs are strictly
positive.
Our work is also distinct from Irarrazabal et al. (2013) and Ramondo
and Rodriguez-Clare (2013) in two respects. First, we do not discuss FDI
geography gravity; instead we focus on the welfare effects of the substi-
tutability between FDI and exports. Second, in a more general setting
with FDI activities, we find that economies consisting of heterogeneous
and homogeneous firms benefit differently from trade liberalization.8
This paper proceeds as follows: In section 2 we introduce the model
with FDI. Section 3 outlines the welfare gains in response to trade lib-
eralization when FDI activities are allowed. Section 4 decomposes the
welfare gains from different firms to clarify where the gains come from.
In section 5, we calibrate the welfare gains from variable trade cost
reductions, fixed trade cost reductions, and fixed FDI cost reductions.
Section 6 concludes.
2. Model
2.1. A model with heterogeneous firms and FDI
Following Helpman et al. (2004), we assume that there are two
countries, the home country, H, and the foreign country, F. The two
countries are assumed to be symmetric, i.e. identical in size, labor sup-
ply, etc. After paying a sunk entry cost, fe , firms draw their productivity
from a Pareto distribution, G(·). Based on a productivity draw, each firm
decides to either stay in the market or exit. If a firm chooses to stay in
the market, it will further decide whether to serve the foreign market
and, if so, whether to do so through exporting or FDI.9
Each firm produces a differentiated variety, and preferences in both
the home and foreign country have the standard CES form, with an elas-
ticity of substitution, 𝜎 = 1∕(1 − 𝜌) > 1. These preferences generate
a demand function Ap−𝜎 for every firm. A is a demand shifter in the
home and foreign countries.10 Since the home and foreign countries
are identical, we focus our discussion on the home country, H, even
though all results are equally applicable to the foreign country, F.
7
In the case with FDI activities, zero fixed export costs will lead to excessive
entry into exporting, i.e., some FDI firms will switch to exporting, and some
nonexporters will start exporting. This lowers firm-level output. Suzumura and
Kiyono (1987) show that the excessive entry will decrease firm-level output,
and hence, lower social welfare. Our result is in line with Suzumura and Kiyono
(1987), and we thank an anonymous referee for pointing out this issue.
8
In Ramondo and Rodriguez-Clare (2013), the gains from openness are
9
Intuitively, the least productive firms exit the market immediately after
firms with a relatively high level of productivity draw export to the foreign
10
In particular, A = 𝜔PL P𝜎 , where 𝜔 is the wage level, L is the aggregate labor
supply, and P denotes the price index.
P. Sun et al. Economic Modelling 92 (2020) 230–238

Denote 𝜙Td,𝜏 , 𝜙Ts,𝜏 and 𝜙TI,𝜏 as the productivity cutoffs for serving the two models, the number of active firms will be smaller in the model
domestic market, exporting, and FDI, at trade costs, 𝜏 , respectively. with FDI than in the model without FDI. By allowing FDI, the expected
The zero profit conditions for serving the domestic market, exporting profit for potential entrants is higher than that in a setting where firms
and FDI are as follows: can only export. Higher profits encourage entry and hence intensify the
( ) ( )𝜎−1 competition.12 Second, the welfare gains will be smaller in the case
rd 𝜙Td,𝜏 R 𝜎 − 1 P𝜙d,𝜏
T
= = wfd (1) with FDI activities than those in Melitz and Redding (2015). This is
𝜎 𝜎 𝜎 w because a portion of firms with the highest levels of productivity are
( ) ( )𝜎−1 engaged in FDI, and some of them are not affected by trade liberaliza-
rx 𝜙Tx,𝜏 R 𝜎 − 1 P𝜙x,𝜏
T
tion (a decrease in variable trade cost, 𝜏 ) if they do not switch from
= = wfx (2)
𝜎 𝜎 𝜎 𝜏w FDI to exporting. Third, moving from an autarkic economy to an open
( ) ( ) economy, the model with FDI will imply greater welfare gains.13
rI 𝜙TI,𝜏 rx 𝜙TI,𝜏
− wfI = − wfx (3)
𝜎 𝜎 3. Welfare analysis
( )
where rd 𝜙Tx,𝜏
denotes the revenue of firms with the cutoff produc- In this section, we investigate the welfare gains from trade liberal-
( )
tivity 𝜙Td,𝜏
in the home country; rx 𝜙Tx,𝜏 denotes the export revenue ization. Similar to Melitz and Redding (2015), we represent the aggre-
( ) gate welfare in a setting with FDI as follows:
in foreign market with productivity 𝜙Tx,𝜏 ; and rI 𝜙TI,𝜏 measures the
1
FDI revenue in the foreign market with productivity, 𝜙TI,𝜏 . fd , fx , and ⎧ ⎫ 𝜎−1
fI are the fixed production costs in the domestic market, export, and ⎪ ( ) ⎪
w 𝜎 − 1 ⎪ L(1 + 𝜒x,𝜏 + 𝜒I ,𝜏 ) ̃T 𝜎− 1 ⎪
T
𝜙
𝜎 ⎨ ⎬
FDI, respectively. w is the wage level. Equations (1)–(3) define the pro- WHet ,FDI = = t ,𝜏 (7)
P 𝜎 F T
⎪⏟⏞⏞⏞⏞⏞⏞⏞⏞⏞⏟⏞⏞⏞⏞⏞⏞⏞⏞⏞⏟ ⏟⏞⏞⏟⏞⏞⏟ ⎪
ductivity cutoffs of staying in the market, starting exporting and FDI,
⎪ ⎪
respectively.11 ⎩ Γ1 Γ2 ⎭
[( )𝜎−1 ( )𝜎−1 ( ]
T )𝜎−1
For potential entrants, the expected profit is equal to the entry cost,
1
which gives the free entry condition as follows: 𝜙̃Tt,𝜏 = 𝜙̃Td,𝜏 + 𝜒x,𝜏 𝜏 −1 𝜙̃Tx,𝜏 + 𝜒I ,𝜏 𝜙̃I ,𝜏
( ) ( ) ( ) 1 + 𝜒x,𝜏 + 𝜒I ,𝜏
fd J 𝜙Td,𝜏 + fx J 𝜙Tx,𝜏 + fI J 𝜙TI,𝜏 = fe (4) T
where, WHet ,FDI
denotes aggregate welfare in the home (foreign) coun-
( )𝜎−1 try when firms can choose to conduct FDI.14 𝜙 ̃T is the weighted aver-
( ) 𝜙max ⎡ ⎤ t ,𝜏
where, fd J 𝜙Td,𝜏 = ⎢ 𝜙 − 1⎥ dG(𝜙) age of 𝜙̃T , 𝜙̃T and 𝜙̃T , which are the average productivity of all
x,𝜏 I ,𝜏
∫𝜙 T ⎢ 𝜙 T ⎥ d,𝜏
d,𝜏 ⎣ d,𝜏 ⎦ active firms, firms serving foreign markets (through exporting and FDI),
( )𝜎−1 and firms engaged in FDI, respectively. In particular,
( ) 𝜙max ⎡ ⎤
fx J 𝜙Tx,𝜏 = ⎢ 𝜙 − 1 ⎥ dG(𝜙) 1
∫𝜙 T ⎢ 𝜙Tx,𝜏 ⎥ 𝜙max ⎡ ⎤ 𝜎−1
dG(𝜙)
x,𝜏 ⎣ ⎦ 𝜙̃Td,𝜏 = ⎢𝜙𝜎−1 ( )⎥ (7.1)
∫𝜙 T ⎢ 1 − G 𝜙Td,𝜏 ⎥⎦
( )𝜎−1 d,𝜏 ⎣
( ) 𝜙max ⎡ ⎤
fI J 𝜙TI,𝜏 = ⎢ 𝜙 − 1⎥ dG(𝜙) [ ] 1
∫𝜙 T ⎢ 𝜙T ⎥ 𝜙max 𝜎−1
I ,𝜏 ⎣ I ,𝜏 ⎦ 𝜙̃Tx,𝜏 = 𝜙𝜎−1
dG(𝜙)
( ) (7.2)
∫𝜙T 1 − G 𝜙Tx,𝜏
Similar to Melitz and Redding (2015), with all the notations intro- x,𝜏

duced above, the number of active firms can be expressed as: 1

𝜙max ⎡ ⎤ 𝜎−1
[ ( )] dG(𝜙)
M = 1 − G 𝜙Td,𝜏 Me =
R L 𝜙̃TI,𝜏 = ⎢𝜙𝜎−1 ( )⎥ (7.3)
= (5) ∫𝜙 T ⎢ 1 − G 𝜙TI,𝜏 ⎥⎦
r 𝜎FT I ,𝜏 ⎣
where, M is the number of active firms, and Me is the number of poten-
Equation (7) indicates a difference from Melitz and Redding (2015);
tial entrants. L is the total labor supply in the home country. r and
two new terms appear in the aggregate welfare expression, 𝜒 I,𝜏 , and
FT denote the average revenue earned by active firms and the average
𝜙TI,𝜏 . A decrease in variable trade costs, 𝜏 , will change the share of firms
fixed costs paid by all firms, respectively. In particular,
that are engaged in FDI and the FDI productivity cutoff. Similarly, we
fe can rewrite the aggregate welfare calculation when FDI is prohibited:
FT = ( ) + fd + 𝜒x,𝜏 fx + 𝜒I ,𝜏 fI (6)
1 − G 𝜙Td,𝜏 { } 1
w 𝜎 − 1 L(1 + 𝜒x,𝜏 ) ( ̃T )𝜎−1 𝜎−1
( ) ( )
T
WHet ,EXP = = 𝜙 t ,𝜏 (8)
P 𝜎 𝜎FT
G 𝜙TI,𝜏 − G 𝜙Tx,𝜏
𝜒x,𝜏 = ( ) [( )𝜎−1 ( )𝜎−1 ]
1
1 − G 𝜙Td,𝜏 𝜙̃Tt,𝜏 = 𝜙̃Td,𝜏 + 𝜒x,𝜏 𝜏 −1 𝜙̃Tx,𝜏
1 + 𝜒x,𝜏
( )
1 − G 𝜙TI,𝜏 It is easy to show that aggregate welfare is higher in the case with
𝜒I ,𝜏 = ( ) FDI than without FDI:
1 − G 𝜙Td,𝜏

where 𝜒 x,𝜏 and 𝜒 I,𝜏 denote the share of firms that are engaged in export
and FDI, respectively.
Before we proceed further, it is worthwhile to note three differences
between the model with FDI and the model without FDI (e.g. Melitz
and Redding, 2015). First, given that all parameters are identical in the
11
These cutoffs are also depicted in Fig. A1 in the online Appendix.
12
The higher expected profit shifts up the free entry curve, which increases
the zero profit cutoff 𝜙Td,𝜏 .
13 The second and third points can be seen in Fig. A2 in the online Appendix.
14
Similar to Melitz and Redding (2015), Γ1 and Γ2 measure the nominal
income and price index, respectively. The only difference is that in Melitz and
L(1+𝜒 )
Redding (2015), Γ1 = 𝜎F Tx,𝜏 . Notice that Γ1 is a measure of the aggregate out-
put, which equals to the total expenditure in each country. As such, the welfare
measured in equation (7) takes into account of both import and export tariffs.

232
P. Sun et al. Economic Modelling 92 (2020) 230–238

Table 1 Second, the economy gains from increasing foreign sales from continu-
Welfare gains from trade liberalization. ing exporters. Third, the switching of a fraction of firms from conduct-
ing FDI to exporting also increases the welfare level. In this section, we
Trade Cost WelfareEXP ∕WelfareA WelfareOFDI ∕WelfareA
(without OFDI) (with OFDI) decompose the aggregate welfare gains from trade liberalization to the
three groups of firms: 1. nonexporters; 2. exporters; 3. firms engaged in
𝜏 → inf 1 1.06
𝜏 = 3 1 1.06 FDI.
𝜏 = 1.25 1.10 1.14 According to equation (7), when the variable trade costs decrease
Welfare Change (10%) 10% 8% from a particular level, 𝜏 1 , to 𝜏 2 (𝜏 2 < 𝜏 1 ), the ratio of aggregate
welfare under these two different variable trade costs can be written as:

[ [ ] 1
⎧ ( )𝜎−1 ( )𝜎−1 ( )𝜎−1 ] ⎫ 𝜎−1
⎪ ̃
𝜙T + 𝜒 x,𝜏 𝜏 −1 𝜙̃T + 𝜒 I ,𝜏 𝜏 ̃
−1 𝜙 T fe
( ) + f + 𝜒 x,𝜏 x ⎪
f
T d,𝜏 x,𝜏 I ,𝜏 1−G 𝜙 T d
WHet ,FDI ⎪ d,𝜏 ⎪
=⎨ [( [ ] ⎬ >1 (9)
T
WHet )𝜎−1 ( )𝜎−1 ]
,EXP ⎪ ̃T ̃ (fe
⎪
⎪ 𝜙d,𝜏
+ 𝜒 x,𝜏 𝜏 −1 𝜙T
x,𝜏
) +f +𝜒 f +𝜒 f
d x,𝜏 x I ,𝜏 I ⎪
1−G 𝜙T
⎩ d,𝜏 ⎭

Inequality (9) implies that in moving from autarky to an open econ-

omy, welfare gains are smaller when FDI is prohibited.

⎡ ( )𝜎−1 ⎤ 𝜎−1 1
T
𝜒 𝜒 T 𝜙̃T
3.1. Welfare gains from trade liberalization WHet (𝜏 )
,FDI 2 ⎢ 1 + x,𝜏2 + F
I ,𝜏2 𝜏1 t ,𝜏2 ⎥
=⎢ ( ) ⎥ (10)
T
WHet (𝜏 ) ⎢ 1 + 𝜒x,𝜏1 + 𝜒I ,𝜏1 F𝜏T2 𝜙̃T 𝜎−1 ⎥
,FDI 1
Now we are ready to evaluate the gains from trade liberalization. We ⎣ t ,𝜏 1 ⎦
set all parameters identical to Melitz and Redding (2015). That is, we
Our decomposition procedures are straightforward. First, we assume
set the elasticity of substitution rate, 𝜎 = 4, the wage rate, 𝜔 = 1, the
that nonexporters and FDI firms do not switch to exporting when the
labor force, L = 153.889, the Pareto distribution parameter, 𝜙min = 1,
variable trade costs decrease from 𝜏 1 to 𝜏 2 , and calculate the gains
and k = 4.25.15 In addition, the fixed cost of entry, fe , domestic pro-
for continuing exporters in response to trade liberalization. Second, we
duction, fd , export, fx , are set to be 1, 1, and 0.545, respectively. Finally,
compute the new survival, export and FDI productivity cutoffs under
we set the fixed cost of FDI as 20.16 Using equations (1)–(6), we can
the trade costs 𝜏 2 . With these new cutoffs, we can calculate the welfare
compute the share of exporting firms, FDI firms, and the correspond-
gains from switchers: (1) nonexporters that start exporting (2) nonex-
ing productivity cutoffs. We gradually decrease variable trade costs, 𝜏 ,
porters that exit (3) FDI firms switch to exporting. Mathematically, the
to measure the welfare gains from trade liberalization. The results are
welfare gains are written as
presented in Table 1:
T
WHet (𝜏 ) T
WHet (𝜏 ) T
WHet (𝜏 )
In Table 1, WelfareA , WelfareEXP and WelfareFDI denote the wel- ,FDI 2 ,FDI 2,keep ,FDI 2
fare level in autarky, with exporting only and with exporting and FDI, T
= T T
(11)
WHet (𝜏 )
,FDI 1
WHet (𝜏 )
,FDI 1
WHet (𝜏
,FDI 2,keep
)
respectively. The results in the first row show that when the variable
trade costs, 𝜏 , converge to infinity, WelfareEXP = WelfareA , and the wel- T
where WHet (𝜏
,FDI 2,keep
) is the welfare level at the trade cost level, 𝜏 2 ,
fare with FDI is 6% higher than that in the autarky.17 This relationship without any switching. In comparison, WHet T (𝜏 ) denotes the welfare
,FDI 2
continues to hold when the trade costs decrease to 3 (𝜏 = 3). The third level at the trade cost, 𝜏 2 , after accounting for all possible switching.
row of Table 1 implies that when the trade costs further decrease to As such, the first component in the RHS of equation (11) measures the
𝜏 = 1.25, the welfare levels in the case without FDI and in the case welfare gains for continuing exporters, while the second term captures
with FDI are 10% and 14% higher than that in autarky, respectively. In the welfare gains generated by switchers. Later, the second term will
sum, Table 1 delivers two pieces of information. First, the welfare level be further decomposed into the gains from nonexporters and FDI firms,
is always higher when FDI is not prohibited than that in the case with respectively.
exports only; Second, trade liberalization brings larger welfare gains for
the economy with export only ((1.10 − 1)∕1 = 10% higher) than in
⎡ ( ̃T )𝜎−1 ⎤ 𝜎−1
1

the economy with both export and FDI ((1.14 − 1.06)∕1.06 = 8%).
⎢ 𝜙t ,𝜏
T
WHet (𝜏
,OFDI 2,keep
) ⎥
T
= ⎢ ( 2 )𝜎−1 ⎥
WHet (𝜏 )
,OFDI 1 ⎢ 𝜙 ̃T ⎥
4. Decomposition of welfare gains ⎣ t ,𝜏1 ⎦
⎡ ( ̃T )𝜎−1 (
̃
)𝜎−1 (
̃
)𝜎−1 ⎤ 𝜎−1 1
In an economy with FDI, welfare gains from trade liberalization can 𝜙
⎢ d,𝜏1 + 𝜒 x,𝜏1 𝜏 −1 𝜙
2
T
x,𝜏1 + 𝜒 I ,𝜏1 𝜙 T
I ,𝜏1 ⎥
be attributed to three sources. First, the economy benefits from a por- = ⎢( )𝜎−1 ( )𝜎−1 ( )𝜎−1 ⎥
⎢ 𝜙 ̃T + 𝜒x,𝜏1 𝜏1 𝜙x,𝜏1
− 1 ̃T ̃
+ 𝜒I ,𝜏1 𝜙I ,𝜏
T ⎥
tion of nonexporters (with relative high productivity) start to export. ⎣ d,𝜏1 1 ⎦
(12)
̃T , 𝜙̃T , and 𝜙̃T , i = 1, 2, are productivity cutoffs as defined
where 𝜙d,𝜏 ix,𝜏 it ,𝜏 i
( )−k in equations (7.1)–(7.3). Note that in equation (12), we assume switch-
15 𝜙
The Pareto distribution function is given by G(𝜙) = 1 − 𝜙min
, where
ing is not possible, and hence there is no change in productivity cutoffs.
𝜙min denotes the minimum productivity and k is the Pareto distribution param-
Similarly, the welfare gains from switchers can be written as follows:
eter, which governs the shape of the distribution.
16 This value is not picked randomly. It cannot be too large or too small rela-

tive to fixed export costs. If it is too large, no firms will choose to conduct FDI,
and if it is too small no firms will choose to export.
17
Notice that the fixed FDI costs, fI , is fixed at 20 during the decrease of the
variable trade costs. This implies that the most productive firms can always
choose to conduct FDI.

233
P. Sun et al. Economic Modelling 92 (2020) 230–238

⎡ ( )𝜎−1 ( )𝜎−1 ( ) ⎤ 𝜎−1 1

T
𝜒 𝜒 T 𝜙̃T + 𝜒 𝜏 −1 𝜙̃T + 𝜒 𝜙̃T
WHet (𝜏 )
,OFDI 2 ⎢ 1 + x,𝜏2 + F
I ,𝜏2 𝜏1 d,𝜏2 x ,𝜏 2 2 x,𝜏2 I ,𝜏 2 I ,𝜏2 ⎥
=⎢ ( ) ( )𝜎−1 ( )⎥ + (13)
T
WHet (𝜏
,OFDI 2,keep
) ⎢ 1 + 𝜒x,𝜏1 + 𝜒I ,𝜏1 F𝜏T2 𝜙̃T 𝜎−1 + 𝜒 𝜏 − 1 ̃
𝜙T + 𝜒 𝜙̃T ⎥
⎣ d,𝜏1 x ,𝜏 2 2 x ,𝜏 1 I ,𝜏 2 I ,𝜏 1 ⎦

After some cumbersome algebra,18 we write the welfare gains as

follows: 5.1. Welfare gains from fixed export cost reductions
T
WHet (𝜏 ) T
WHet (𝜏 ) T
WHet (𝜏 )
,FDI 2 ,FDI 2,keep ,FDI 2 We first calibrate the influence of fixed export cost reductions on
ln T
= ln T
+ ln T
(14)
WHet (𝜏 )
,FDI 1
WHet (𝜏 )
,FDI 1
WHet (𝜏
,FDI 2,keep
) welfare. We are interested in two questions. First, in the model with

[ ]
𝜒x,𝜏1 ( −1 T )𝜎−1 ( −1 T )𝜎−1
= 𝜏2 𝜙̃x,𝜏 − 𝜏1 𝜙̃x,𝜏
𝜎−1 2 1
⏟⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏟⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏟
Gains of continuing Exporters
[ ( )𝜎−1 ( )𝜎−1 ]
1
+ 𝜒 − 𝜒x,𝜏 1 + 𝜒x,𝜏1 fx − 𝜒x,𝜏 2 fx + 𝜒x,𝜏2 𝜏2−1 𝜙̃Tx,𝜏2 − 𝜒x,𝜏1 𝜏2−1 𝜙̃Tx,𝜏2
𝜎 − 1 x,𝜏2
⏟⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏟⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏟
Gains from swithing (nonexport to export)
[ ( )𝜎−1 ( )𝜎−1 ]
1
𝜒 − 𝜒I ,𝜏 1 + 𝜒I ,𝜏1 fI − 𝜒I ,𝜏 2 fI + 𝜒I ,𝜏2 𝜏2−1 𝜙̃TI,𝜏 − 𝜒I ,𝜏1 𝜏2−1 𝜙̃TI,𝜏
𝜎 − 1 I ,𝜏2 2 2
⏟⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏟⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏟
Gains from swithing (FDI to exporters)
( )𝜎−1
1
+ Δ 𝜙̃Td
𝜎−1
⏟⏞⏞⏞⏞⏞⏞⏞⏞⏟⏞⏞⏞⏞⏞⏞⏞⏞⏟
Gainsfromswitching(exit)

The components on the RHS of equation (14) give the welfare con-
tributions of each group. In particular, when the variable trade costs,
𝜏 , decrease from 3 to 1, we calculate the associated welfare gains from
each group of firms. The results are reported in Panel A of Table 2:
The results indicate that the aggregate welfare with FDI will increase
by 16%. Continuing exporters contribute 57% of the total welfare gains,
while switchers contribute 43% of welfare gains. Further, within the
6.88% (=43% × 16%) welfare gains, most are caused by firms switch-
ing from nonexporting to exporting, which accounts for 78% of the
gains, while the firms switching from FDI to exporting only contribute
21% of the gains.19
For comparison purposes, we repeat the exercise for the model with-
out FDI in Panel B of Table 2. The results indicate that when FDI is pro-
hibited, the aggregate welfare gains are larger, 19% compared to 16%
– in response to a variable trade cost decrease. This is because more
continuing firms directly benefit from the variable cost reduction.
The above results convey an important piece of information: com-
pared with continuing exporters, the switching of FDI firms contributes
a relatively trivial share to welfare gains.
5. Calibrating the influence of trade liberalization
In this section, we calibrate the model with FDI to numerically
evaluate the influence of trade liberalization on an economy. We first
increase the fixed exporting costs from 0 to 1 and compare the wel-
fare changes in economies with homogeneous and heterogeneous firms.
Next, we increase the variable export costs, 𝜏 , to compare the welfare
changes in the homogeneous and heterogeneous economies. Finally,
we increase the fixed FDI investment costs to evaluate the influence
of investment liberalization on welfare.
18
The details are in Appendix.
19
Exit firms account for 1% of the welfare gains among all switchers. The
results are consistent with our intuition: switching from nonexporting to export-
ing contributes more to welfare gains than switching from FDI to exporting. The
former increases foreign sales more (decreases the domestic trade share more)
than the latter and, hence, according to Arkolakis et al. (2012) the former con-
tributes more to welfare gains.
FDI, how different do the economies with homogeneous and heteroge-
neous firms respond to fixed export cost reductions? Second, how do
the gains differ from those reported in Melitz and Redding (2015)?
In the calibration, we set all parameters identical to those in Melitz
and Redding (2015), and increase the fixed export costs from 0 to 1.20
Fig. 1 depicts the changes in welfare gains, export probability, average
productivity and the domestic trade share in response to a fixed cost
increase.
In Panels A − Panel D of Fig. 1, the solid and dashed curves depict
the patterns of different variables across heterogeneous and homoge-
neous economies, respectively. Fig. 1 first indicates that the welfare
gains and weighted average productivity are always higher in the econ-
omy with heterogeneous firms than in the economy with homogeneous
firms when facing different levels of fixed export cost (Panel A and
C). Second, the export probability decreases in both economies when
facing an increase in fixed export costs (Panel B). Third, the domes-
tic trade share, which is calculated as domestic sales divided by total
sales, increases with fixed export costs in both economies in both
economies.21
When we focus on trends in the economy composed of heteroge-
neous firms, we find some patterns that are in striking contrast to those
in Melitz and Redding (2015).22 Panel A, for instance, indicates that
when facing an increase in the fixed export cost, welfare first increases
and then decreases. The average weighted productivity also manifests a
similar inverted-U shape (Panel C). The intuition is that when the fixed
exporting costs gradually increase from 0, some productive exporters
with sufficiently high productivity will switch to FDI. After these firms
20
Notice that the fixed cost for FDI is much higher than that associated with
exporting. This setting is consistent with the fact that FDI activities require a
higher fixed cost relative to exporting. Secondly, we need to set the fixed FDI
cost higher to guarantee that not every firm serves the foreign markets through
FDI.
21
The domestic trade share initially decreases in the economy with heteroge-
neous firms when fixed export costs increase.
22
The corresponding results for an economy without FDI are shown in Fig. A3
in the Appendix.

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P. Sun et al. Economic Modelling 92 (2020) 230–238

Table 2
Welfare decomposition.
Panel A: With FDI
Welfare Gains Continuing Exporters Switchers
16% 57% 43%
Exit Nonexport to Export FDI to Export
1% 78% 21%
Panel B: Without FDI
Welfare Gains Continuing Exporters Switchers
19% 74% 26%
Exit Nonexport to Export FDI to Export
3% 97% 0%

Fig. 1. The influence of export fixed cost reductions.

switch from exporting to FDI, they sell more in foreign markets,23 which
has two direct consequences: it decreases the domestic trade share (the
decreasing part in Panel D), and increases the aggregate income as
consumers earn more income from foreign sales.24 Both effects result
in a welfare increase. When the fixed export cost increases even fur-
ther, more firms stop exporting, which decreases foreign sales and
drives both average productivity and welfare down. Therefore, aggre-
gate welfare eventually declines in response to further fixed export cost
increases.
An implication of Fig. 1 is that in order to maximize welfare in
an economy with heterogeneous firms, moderate positive fixed export
costs are necessary when FDI is not prohibited.
23
This switching prevents excessive entry into the foreign market, which
would otherwise lead to lower foreign sales (see, Suzumura and Kiyono, 1987).
24
This is also consistent with Arkolakis et al. (2012) that given the trade
elasticity, the welfare is decreasing in domestic trade share.
5.2. The influence of export variable cost reductions
We next calibrate the model to evaluate the influence of variable
export cost reductions on economies with heterogeneous and homoge-
neous firms, respectively. In this numerical exercise, we again set all
parameters equal to those values in the previous section, except that
fixed export costs are set to fx = 0.76 (rather than varying between
0 and 1), and the variable export costs will increase from 1 to 3 as in
Melitz and Redding (2015). The influence of variable export costs based
on aggregate welfare, export probability, weighted average productiv-
ity, and domestic trade share are depicted in Fig. 2.25
In contrast to the influence of fixed export cost on these aggregate
variables, increasing variable trade costs cause a steady decline in wel-
fare, export probability, weighted average productivity, and increase
the domestic trade share for both economies. The only exception is
weighted average productivity, which only declines in the economy
with heterogeneous firms. Although these results seem to contradict
the patterns exhibited in Fig. 1, we have good explanations for these
25
We depict the results without FDI in Fig. A4 of the Appendix.

235
P. Sun et al. Economic Modelling 92 (2020) 230–238

Fig. 2. The influence of export variable cost reductions.

Fig. 3. The influence of FDI fixed cost reductions.

observed trends. When variable export costs increase from 1, some pro-
ductive firms switch from export to FDI. However, this switching does
not largely change firm-level sales in foreign markets, as FDI variable
costs, which take a value of 1, are only slightly lower than that associ-
ated with exporting. Therefore, foreign sales decrease because less pro-
ductive firms stop exporting, and these firms dominate those switching
from export to FDI.
The results indicate that in order to maximize welfare and
weighted average productivity in an economy with heteroge-
neous firms, variable trade costs should be reduced to 1.

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P. Sun et al. Economic Modelling 92 (2020) 230–238

5.3. The influence of FDI fixed cost reductions
Finally, we assess the influence of FDI fixed cost reductions on
aggregate welfare, weighted average productivity, average FDI propen-
sity, and domestic sales. In this calibration, all parameters are set to the
same values as those in the previous section, while fixed FDI costs, fI ,
increase from 15 to 200. The calibrated results are depicted in Fig. 3
with the solid and dashed curves denoting economies with heteroge-
neous and homogeneous firms, respectively:
The figure shows that firm-level productivity in the homogeneous
economy has been set to equalize the weighted average productivity of
firms in the heterogeneous economy in autarky. No firms will conduct
FDI in the homogeneous economy, as firm-level productivity is not suf-
ficiently high to overcome the high FDI fixed costs.26 As such, changes
in FDI fixed cost have a trivial impact on the homogeneous economy.
In contrast, in the economy with heterogeneous firms, the most produc-
tive firms will conduct FDI instead of exporting. Changes in the fixed
FDI costs will thus significantly affect the heterogeneous economy. For
instance, Panel A shows that the aggregate welfare level declines as
FDI fixed costs increase. This is because weighted average productiv-
ity also decreases with FDI fixed costs (shown in Panel C). Meanwhile,
Panel B indicates the probability that FDI is also decreasing as FDI fixed
costs increase, and hence the domestic trade share increases with FDI
fixed costs (Panel D). Intuitively, when FDI fixed costs rise, a portion
of firms will switch from FDI to exporting. This switching reduces firm-
level sales in foreign markets, and hence decreases weighted average
productivity, as well as the foreign share. All of these facts predict a
decline in aggregate welfare.
6. Conclusions
In this paper, we investigate the welfare gains from trade liberal-
ization when FDI activities are allowed. The results indicate that wel-
fare gains are lower with FDI than those without FDI when considering
marginal changes in variable trade costs. This implies that the welfare
gains from trade liberalization have been overestimated if they do not
take FDI into account. We further decompose the welfare gains into dif-
ferent groups of firms. The results indicate that the continuing exporters
contribute the most to welfare gains in response to trade liberalization.
In contrast, firms that switches to FDI only contribute a trivial share of
the welfare gains. This explains why the welfare gains are lower with
FDI activities.
This finding show that economies benefit differently from trade lib-
eralization, i.e., those with a larger share of FDI benefit less. In addition,
the welfare gains are disproportionately large for industries with a small
share of FDI.
Meanwhile, we compare the welfare gains in an economy with
homogeneous firms vs. heterogeneous firms. The results show that the
welfare gains from trade liberalization are always higher in the econ-
omy with heterogeneous firms. However, when FDI is not prohibited,
the welfare difference between the two economies narrows. This sug-
gests that Melitz and Redding (2015) overestimate the gains from a
heterogeneous economy.
In addition, the calibrated results demonstrate that zero fixed export
costs do not maximize aggregate welfare in an economy with FDI activ-
ities. Instead, slightly positive fixed export costs will maximize the
aggregate welfare by driving some firms to switch from exporting to
FDI. This finding has important policy implications: to increase foreign
sales by encouraging firm-level FDI activities, policymakers can either
decease fixed FDI costs or slightly increase the fixed export costs. This
finding implies that a certain low level of export/import clearance cost
is optimal for social welfare.
Lastly, aggregate welfare is monotonically decreases with variable
trade costs and fixed FDI costs. Therefore, policymakers may want to
lower both types of costs jointly to maximize social welfare.

Appendix A. Supplementary data

Supplementary data to this article can be found online at https://doi.org/10.1016/j.econmod.2020.01.003.

Proofs
The Decomposition

With FDI option, the aggregate welfare can be written as:

[ ]
𝜎 − 1 L(1 + 𝜒x,𝜏 + 𝜒I ,𝜏 ) ( ̃T )𝜎−1
1
𝜎−1
T
WHet ,OFDI (𝜏) = 𝜙t,𝜏 (A1)
𝜎 𝜎FT
where 𝜒 x,𝜏 and 𝜒 I,𝜏 are defined as the proportion of firms engaging in export and FDI under the trade cost level, 𝜏 , respectively.
The welfare increase caused by variable trade cost, 𝜏 , decreases from 𝜏 1 to 𝜏 2 is

⎡ ( )𝜎−1 ⎤ 𝜎−1 1
T
𝜒 𝜒 T 𝜙̃T
WHet (𝜏 )
,OFDI 2 ⎢ 1 + x,𝜏2 + F
I ,𝜏2 𝜏1 t ,𝜏2 ⎥
=⎢ ( ) ⎥ (A2)
T
WHet (𝜏 ) ⎢ 1 + 𝜒x,𝜏1 + 𝜒I ,𝜏1 F𝜏T2 𝜙̃T 𝜎−1 ⎥
,OFDI 1
⎣ t ,𝜏 1 ⎦

where 𝜙 ̃T denotes the weighted average of the three productivity cutoffs, 𝜙̃T , 𝜙̃T and 𝜙̃T , (write the expressions of the average.) under trade
t ,𝜏 d,𝜏 x,𝜏 I ,𝜏
cost, 𝜏 as in equation (2).
T
WHet (𝜏 ) T
WHet (𝜏 ) T
WHet (𝜏 )
,OFDI 2 ,OFDI 2 ,OFDI 2,keep
T
= T T
WHet (𝜏 )
,OFDI 1
WHet (𝜏
,OFDI 2,keep
) WHet (𝜏 )
,OFDI 1

⎡ ( ̃T )𝜎−1 ⎤ 𝜎−1
1

⎢ 𝜙t ,𝜏
T
WHet (𝜏
,OFDI 2,keep
) ⎥
T
= ⎢ ( 2 )𝜎−1 ⎥ (A3)
WHet (𝜏
,OFDI 1
) ⎢ 𝜙 ̃T ⎥
⎣ t ,𝜏1 ⎦

26
In the homogeneous economy, firm-level productivity is not sufficiently
high to allow firms to conduct FDI. If we change some parameters, such as
fI = fx , all firms will conduct FDI after investment liberalization.

237
P. Sun et al. Economic Modelling 92 (2020) 230–238

⎡ ( ̃T )𝜎−1 ( )𝜎−1 ( )𝜎−1 ⎤ 𝜎−1 1

⎢ 𝜙d,𝜏1 + 𝜒x,𝜏1 𝜏2−1 𝜙̃Tx,𝜏 + 𝜒I ,𝜏1 𝜙̃TI,𝜏 ⎥

1 1
= ⎢( )𝜎−1 ( )𝜎−1 ( )𝜎−1 ⎥
⎢ 𝜙 ̃T + 𝜒x,𝜏1 𝜏1 𝜙x,𝜏1
− 1 ̃ T ̃
+ 𝜒I ,𝜏1 𝜙I ,𝜏
T ⎥
⎣ d,𝜏1 1 ⎦
( )𝜎−1 ( )𝜎−1 ( )
⎡ ̃T ⎤
T
WHet (𝜏 ) ⎢ 1 + 𝜒x,𝜏2 + 𝜒I ,𝜏2 F𝜏1 𝜙d,𝜏2
T + 𝜒x,𝜏2 𝜏2−1 𝜙̃Tx,𝜏2 + 𝜒I ,𝜏2 𝜙̃TI,𝜏 ⎥
,OFDI 2 2
= ⎢ ( ) ( ) ( ) ⎥ (A4)
T
WHet (𝜏
,OFDI 2,keep
) ⎢ 1 + 𝜒x,𝜏1 + 𝜒I ,𝜏1 F𝜏T 𝜙̃T 𝜎−1 + 𝜒 𝜏 ̃Tx,𝜏
−1 𝜙
𝜎−1
+ 𝜒 𝜙̃T ⎥
⎣ 2
d,𝜏1 x ,𝜏 2 2 1 I ,𝜏 2 I ,𝜏 1 ⎦

We can further decompose equation (A4) into two parts: one is welfare gains from nonexport switching firms, the other is welfare gains from
FDI swiching firms. In particular:
T
WHet (𝜏 )
,OFDI 2
ln T
WHet (𝜏
,OFDI 2,keep
)
( )𝜎−1 ( )𝜎−1 ( )
⎡ ( ) ⎤
1 ⎢ 1 + 𝜒x,𝜏2 + 𝜒I ,𝜏2 F𝜏T 𝜙̃Td,𝜏 + 𝜒x,𝜏2 𝜏2−1 𝜙̃Tx,𝜏2 + 𝜒I ,𝜏2 𝜙̃TI,𝜏 ⎥
1 2 2
+ ln T + ln ( )𝜎−1 ( )𝜎−1 ( )⎥
𝜎 − 1 ⎢⎢
= ln
1 + 𝜒x,𝜏1 + 𝜒I ,𝜏1 (A5)
⎣
F𝜏
2 𝜙̃Td,𝜏 + 𝜒x,𝜏2 𝜏2−1 𝜙̃Tx,𝜏1 + 𝜒I ,𝜏2 𝜙̃TI,𝜏 ⎥⎦
1 1
1
≈ [Δ𝜙̃Td,𝜏 + 𝜒x,𝜏2 + 𝜒I ,𝜏2 − 𝜒x,𝜏1 − 𝜒I ,𝜏1 + F𝜏T1 − F𝜏T2
𝜎 − (1 2
)𝜎−1 ( ) ( )𝜎−1 ( )
+𝜒x,𝜏2 𝜏2−1 𝜙̃Tx,𝜏2 + 𝜒I ,𝜏2 𝜙̃TI,𝜏 − 𝜒x,𝜏2 𝜏2−1 𝜙̃Tx,𝜏1 − 𝜒I ,𝜏2 𝜙̃TI,𝜏 ]
2 1

fe
Substitute F𝜏T =
1−G(𝜙T )
+ fd + 𝜒x,𝜏 fx + 𝜒x,𝜏 fI into equation (A5) and obtain:
d,𝜏

fe
F𝜏T − F𝜏T = + fd + 𝜒x,𝜏1 fx + 𝜒x,𝜏1 fI
1 2 1 − G(𝜙Td,𝜏 )
1
( )
fe
− + fd + 𝜒x,𝜏2 fx + 𝜒x,𝜏2 fI
1 − G(𝜙Td,𝜏 )
2

We can rewrite equation (A5) as

T
WHet (𝜏 )
,OFDI 2 1
ln ≈ [Δ𝜙̃Td,𝜏 + 𝜒x,𝜏2 + 𝜒I ,𝜏2 − 𝜒x,𝜏1 − 𝜒I ,𝜏1
T
WHet (𝜏
,OFDI 2,keep
) 𝜎−1 2

(A6)
+𝜒x,𝜏1 fx + 𝜒I ,𝜏1 fI − 𝜒x,𝜏2 fx − 𝜒I ,𝜏2 fI
( )𝜎−1 ( ) ( )𝜎−1 ( )
+𝜒x,𝜏2 𝜏2−1 𝜙̃Tx,𝜏 + 𝜒I ,𝜏2 𝜙̃TI,𝜏 − 𝜒x,𝜏2 𝜏2−1 𝜙̃Tx,𝜏 − 𝜒I ,𝜏2 𝜙̃TI,𝜏 ]
2 2 1 1

( )𝜎−1 ( )𝜎−1
Within equation (A6), the component 𝜎− 1
[Δ ̃T + 𝜒x,𝜏 − 𝜒x,𝜏 + 𝜒x,𝜏 fx − 𝜒x,𝜏 fx + 𝜒x,𝜏 𝜏 −1 𝜙̃T
𝜙 − 𝜒 ,𝜏 𝜏 ̃T
−1 𝜙 ] is the welfare
1 d,𝜏2 2 1 1 2 2 2 x ,𝜏 2 x 2 2 x ,𝜏 1
increase caused by the switching of nonexport firms: a( portion
) of nonexport
( ) firms exit, and another portion of nonexport firms switch to export. The
component: 𝜎−1
1
[𝜒I ,𝜏2 − 𝜒I ,𝜏1 + 𝜒I ,𝜏1 fI − 𝜒I ,𝜏2 fI + 𝜒I ,𝜏2 𝜙̃TI,𝜏 − 𝜒I ,𝜏2 𝜙̃TI,𝜏 ], is the welfare increase caused by the switching of FDI firms: a portion
2 1
of FDI firms switch to export in response to a variable trade cost decrease.

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