Network Effects, Trade, and Productivity

We consider network effects in the monopolistically competitive model of trade developed by Melitz and Ottaviano (2008). We show that a larger network effect intensifies competition by allowing more-productive firms to raise prices and earn higher profits, but forcing less-productive firms to reduce prices and earn lower profits. As a result, low-productivity firms are driven out of the market. We also show that when network effects are asymmetric, it may be difficult for firms from a country with a small network effect to compete with firms from a country with a large network effect.