The Melitz Model – A Darwinian Commerce

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When Charles Darwin sat in his study in 1838 to write one of the most fascinating scientific cornerstones in the history of mankind, little did he know the repercussions of his findings would transcend the realm of natural science to exert a tremendous influence in the functioning of unrelated fields, most notably the study of international economics. In his classical volume, aptly titled – On the Origin of Species – Darwin argues that the process of evolution is devoid of any randomness as nature possesses a rather strange proclivity to mechanically purge itself of undesirable species through a sadistic procedure commonly known as ‘natural selection.’ Darwin believed that species less suited to an environment are less likely to survive and thus less likely to reproduce as well. On the other end, species more suited to an environment are more likely to survive and more likely to reproduce, thus transferring their heritable traits to future generations. Over time, the surviving species adapt to the environment and accumulate, while the less suited are wiped out of the biological map through natural selection. Darwin had stirred quite a rapturous debate over his postulations, which in turn had caused tidal ripples that provided the framework upon which economists came to understand the intrinsic behaviour of firms participating in intra-industry trade at the export market.

It wasn’t until recently that the connection between Darwinism and international economics was inadvertently established by Marc Melitz – a Harvard professor of economics as well as one of the pioneering contributors to a contemporary branch of international economics formally referred to as New Trade Theory, alongside Paul Krugman and Avinash Dixit. Melitz devised an ingenious model to explain the impact of trade on intra-industry reallocations and aggregate productivity in domestic firms. Melitz explained that a competitive fringe of potential firms can enter an industry by paying a fixed sunk cost. Once the sunk cost is paid, firms draw productivity from a fixed distribution. Productivity remains fixed thereafter but firms face a constant exogenous probability of death or exit. Needless to say, firms produce horizontally differentiated varieties within the industry under conditions of monopolistic competition. The existence of fixed productivity costs imply that firms drawing a productivity level below the zero-productivity threshold would make negative profits if they produced, therefore these firms choose to exit the industry. Fixed and variable costs of exporting ensure that, of the active firms in the industry, only those drawing productivity above a higher threshold, the export productivity cut-off, find it profitable to export in equilibrium.

The demand of labour within the industry rises, with it the price of labour (wages), due both to expansion by existing firms and new firms beginning to export. The increase in labour demand bids up factor prices and drastically reduces the profits of non-exporters. This reduction in profits of firms in the domestic market induces some low-productivity firms who were previously marginal to exit the industry. As low-productivity firms exit, and as output and employment are reallocated towards higher-productivity firms, average industry productivity and efficiency rises. In other words – if I may borrow a phrase from Darwin’s lexicon – it’s the survival of the fittest, the incentive for natural selection; cruel but necessary for the greater good.

The Melitz model’s applicability is not only confined to multinational conglomerates, of course. It can be applied to a vast array of fields, most importantly the agricultural industry. The competitiveness of South Africa’s agricultural exports can be enhanced by pruning low productivity domestic farms, restricting their activities to the domestic market, while increasing subsidies and other aids to high productivity farms so they may expand and amass considerate profits in international trade. The expansion of farms exporting their produce to overseas markets will increase aggregate employment and production efficiency as they adapt to the exceedingly competitive international market. In the end, average agricultural productivity, efficiency, and employment will rise as inefficient farms exit the industry and are replaced by emerging production efficient farms. Thus the aggregate agricultural industry, through natural selection, is made better off.

The international market, quite like nature, is ferocious to firms not suited to its volatile environment. For the most part, it has been known to render entire countries’ industries obsolete, not because all the participating firms in those countries were operating below the zero-productivity threshold, but because policy makers failed to heed the Melitz model in ensuring the survival of such industries by reallocating resources to high productivity firms, and banishing average productivity firms back to the domestic market or as I like to call it, ‘the commercial naughty corner,’ until they get their output act together. Perhaps the Melitz model is indeed quite harsh, but then again if there is anything we have learned from Charles Darwin’s natural selection, it is that sometimes things need to get messy to make room for the perfection, or in our context – immense revenue – that lies beyond.