trade flows arising from this selection process. The volume of trade flows will be determined by the volume of exports by each individual exporting firm (the intensive margin) as well as the fraction of firms actually exporting (the extensive margin). The subsequent section will provide a brief introduction to the original model<sup>10</sup> and develop an extension to the theory so as to formalize regional TBT liberalization initiatives.

As a general set-up for his model, Melitz (2003) uses the framework first introduced by Krugman (1980), in that he assumes a 2-country, 2-good, single factor-ofproduction setting (the only factor being labour). One of the goods is homogeneous and is produced in the A-sector under Walrasian conditions. Trade for this good is costless. The other good is produced in a Dixit-Stiglitz monopolistic competition setting with increasing returns to scale and ice-berg trade costs<sup>11</sup> , τ ≥1. Consumer preferences are represented by a two-tier utility function. The upper tier is CobbDouglas and determines the relative expenditure shares on A- and M-sector goods respectively, while the second tier defines preferences over the differentiated M- sector varieties.

CM represents consumption of the composite of all differentiated varieties of goods M and CA is consumption of the homogeneous good A, μ and 1-μ are the respective expenditure shares, N is the mass of varieties and σ is the constant elasticity of substitution between any two manufactured varieties.

In the M-sector, firms face 4 types of cost: constant marginal cost of production as well as 3 types of fixed cost: F has to be paid in order to acquire a patent for a unique variety so that production is possible at all. Further, market entry costs FD and FX have to be paid for both the domestic and the foreign market respectively. These elements of the model will be of particular relevance for subsequent analysis. We will assume FX > FD, where FX can be interpreted as fixed costs arising from adaptation to standards and technical regulations abroad. It should be noted that previous models have considered TBTs to affect both fixed and variable costs. Since the analytical results for variable cost TBTs are straight-forward and the larger part of the costs is hypothesized to come from fixed costs, I will ultimately focus on the effects of changes in fixed costs following regional liberalization.

Variable costs in the domestic and foreign market can be expressed as follows: ci ai w and ci* ai τ w (2) where ci are sales in market i, ai is the unit input coefficient (or the firm’s level of inefficiency), w is the wage and τ the ice-berg trade-cost. The model departs from standard new trade theory in that it assumes M-sector firms to be heterogeneous in their productivity levels ai. In Melitz’s model, each firm draws their own ai from a Pareto distribution (this part of the model is crucial and will be developed further below).

> 10 Based on Baldwin and Robert-Nicoud (2004)

> 11 The concept of iceberg trade costs is due to Samuelson (1954), who modeled transport costs as using up part of the good that is being transported. It is a very convenient way of modeling trade costs as it affects no other market.

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