A Solution to the Melitz-Trefler Puzzle

An empirical finding by Trefler (2004) and others that industrial productivity rises more strongly in liberalized industries than in non-liberalized industries has been widely accepted as evidence for the Melitz (2003, Econometrica) model. However, our recent paper shows that under fairly general assumptions, a multi-industry version of the Melitz model predicts the exact opposite relationship. In this paper, we present a simple solution to this "Melitz-Trefler" puzzle: introducing decreasing returns to scale in entry costs into an otherwise standard Melitz model. The model predicts the Trefler finding and removes other counter-intuitive predictions.

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