Introduction

Most of the theories of international trade show that a larger economy exports more in absolute terms than a smaller economy. However, trade theories differ in analyzing the fact as to how larger economies export more. Models that assume Armington's (1969) kind of national differentiation emphasize on the concept of intensive margin. It implies that an economy, when twice the size of another economy, exports twice that of the other economy, it does not export a wider variety of goods. Models based on monopolistic competition similar to the work of Krugman (1981) stress on the extensive margin, that is, economies twice the size of another country produce and export twice the range of goods of the other economy. Vertical differentiation models, such as those proposed by Flam and Helpman (1987) and Grossman and Helpman (1991), feature a quality margin, namely that richer countries produce and export higher-quality goods. The large extensive margins are inconsistent with Armington's (1969) type of models, which have no extensive margin and imply that larger economies face lower export prices. In contrast, Krugman's (1981) style of models with firm-level product differentiation predict that larger economies will produce and export more varieties, consistent with the observed large extensive margins (assuming a strictly increasing relationship between varieties produced and varieties exported). However, these models predict that variety will expand in proportion to an exporter's size, which overstates the size of the observable extensive margin in the data.

It is a very commonly held view among trade theoretician that the gains from trade are larger than what quantitative general equilibrium models of trade can explain. A recurring goal in the trade literature has been to find new channels through which trade models can generate larger gains. A prominent example is suggested by Romer (1994), who stated that trade allows for the consumption of a large variety of goods, and this generates additional benefits not included in standard general equilibrium trade models. Furthermore, Romer (1994) has also performed a numerical exercise to show in terms of Harberger Triangles, in response to higher tariffs, that welfare losses operating through reduced variety may be larger than losses in standard trade analysis.