Trade and domestic policies under monopolistic competition

Should trade agreements constrain domestic policies? We analyse this question using a model with monopolistic competition (MC) and CES demand. We develop a welfare decomposition to show that welfare changes induced by trade and domestic policies can be decomposed into consumption- and production-efficiency, and terms-of-trade effects. We analyse the reasons to sign trade agreements and compare shallow and deep trade agreements, modelled according to GATT-WTO rules. Under MC, unlike deep trade agreements, shallow agreements with market access commitments may not achieve efficiency because terms-of-trade can be improved without reducing market access by increasing the set of foreign firms selling domestically.