product quality or variety differences enter most CGE models is by distinguishing between a product’s country of origin. This is done using so-called Armington elasticities which can ensure domestically produced goods are imperfect substitutes for imported goods in aggregate, and imports from one country are an imperfect substitute for goods imported from any other country (Armington 1969).

In the real world, however, there is an ever-increasing array of qualities and varieties available for any product from each supplying country. It appears consumers (including producers using those products as intermediate inputs) are willing to pay for a greater variety of different quality products, even though that product differentiation may be costly in terms of shorter production runs and more advertising. Hummels and Klenow (2005) suggest that these improvements in quality are sufficiently rapid that the prices received by countries for the products that they continue to export—as distinct from their new exports—actually rise by 0.09 percent for each increase of 1 percent in national income. This result is strikingly at variance with traditional Armington models, which generate a reduction in export prices when economies grow and exports expand.

Feenstra, Markusen and Zeile (1992) suggest the welfare cost of tariff protection can be underestimated by as much as a factor of ten when this consideration is not included in the analysis. Further evidence of the importance of this issue is provided by Broda and Weinstein (2006). In a study of US import data from 1972 to 2001, they find that the upward bias in the conventional import price index, because of not accounting for the growth in varieties of products, is approximately 1.2 percent per year, and estimate that the welfare gain from variety growth in US imports is 2.8 percent of GDP. Both computational capability and data improvements are needed before this can issue can be dealt with comprehensively in global CGE models.

# **_The emergence of new products_**

Standard models used to assess the implications of trade reforms are based on the assumption that expansion of exports following liberalization involves increasing the volume of the products initially being exported, but not of any other products. The Armington assumption also rules out expanding the markets to which goods are being supplied: if exports to a particular country are initially zero, then in most CGE models they remain zero following reform.

Recent research, however, highlights the key role of the “extensive” margin, where export expansion involves increases in the range of products exported (Hummels and Klenow 2005) and expansion in the range of markets supplied (Evenett and Venables 2002). Hummels and Klenow conclude that only about onethird of the export expansion associated with economic growth comes from the “intensive margin” where greater quantities of the same products are exported. And Evenett and Venables find that about one-third of the expansion of exports from developing countries was obtained by exporting products to countries to which they had not previously exported.

In a world where importers exhibit a preference for variety in the goods they purchase, these observations on the importance of extensive-margin growth have major implications. Increasing the volumes of the same products, as under the Armington assumption, has the inevitable consequence of driving down the price of exports and causing income losses to the exporter from deterioration in the terms of trade. Where exports are characterized by an expansion in the range of products 36