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BA 187 – International Trade

Increasing Returns to Scale, Imperfect Competition & Trade

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Economies of Scale & Market Structure

Increasing Returns to Scale (IRS)Increasing Returns to Scale (IRS) means that equal proportionate increase in inputs to production results in a more than equal proportionate change in output. – This implies cost per unit for output falls as output risescost per unit for output falls as output rises.

Two ways for this to occur:

External Economies to ScaleExternal Economies to Scale– When cost per unit for output depends on size of the industry but not on

the size of any one firm. (Think knowledge spillovers.)

– Typically results in industry of many small firms acting as perfect competitors. (Think Silicon Valley, Multi-media Gulch, etc.)

Internal Economies of ScaleInternal Economies of Scale– When cost per unit for output depends on the size of the individual firm

but not necessarily on the size of the industry. (Think Natural Monopoly)

– Typically results in advantage to few, large firms acting in imperfectly competitive manner. (Think Regulated Utilities, Microsoft, etc)

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PPF & Gains to Trade with RS

Good Y

PPF with IRS

Good X

A

UAut

2. In autarky, nations produce & consume at point A.

1. Assume PPF same for both nations & exhibits Increasing Returns to Scale. This means PPF is bowed inward towards origin.

QY

QX

E

UTrade

3. If each nation specializes in one of the goods and then trades to reach pt. E, both achieve higher utility.

4. Pattern of trade is indeterminate, either nation can specialize in either good.

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Strategic Trade with IRS

Good Y

PPF

Good X

1. Assume PPF same for both nations & exhibits IRS.2. Assume that international terms of trade given.

QY

QX

3. Pattern of trade is technologically indeterminate, either nation can specialize in either good.

E1

U1Trade

4. Nation is not indifferent between which good it produces. Will want to specialize in Good Y, as this results in highest utility.

E2

5. Still mutual gains from trade but now strategic.

U2Trade

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Older Approaches to Trade Patterns

Product Cycle and Linder Demand Theories

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Product Cycle Models Based on presumption that introduction of new product conveys

temporarytemporary monopoly in market.– New product requires highly skilled labor to produce

– As product matures, it becomes standardized or can be imitated.

– Comparative advantage shifts from innovating nation to nations with cheap labor.

Technological Gap modelTechnological Gap model emphasizes time lag in imitation.

Product Cycle modelProduct Cycle model emphasizes standardization process.Stage I: New Product Phase – Produced/consumed in innovating country only.

Stage II: Product Growth Phase – Rising demand at home & abroad leads to exports from innovating country.

Stage III: Product Maturity Phase – Product standardized, prod’n licensed to others.

Stage IV: Imitation I Phase – Imitating country undersells originator in ROW.

Stage V: Imitation II Phase – Imitating country undersells in originator’s market.

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The Product Cycle Model

Consump.InnovatingCountry

Prod’n

Consump.

Prod’nImitatingCountry

Stage I Stage IVStage III Stage VStage II

Quantity

Time

Exports

Imports

Imports

Exports

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Dates of Product Introduction & Characteristics of Industry 1970-1979

CharacteristicPrior to

19301930-1949

1950-1954

1955-1959

1960-1964

1965-1969

After 1969

Real Market Growth % 0.5%0.5% 3.0%3.0% 5.0%5.0% 6.9%6.9% 7.7%7.7% 10.8%10.8% 18.1%18.1%

R&D Expenses as % of Revenue 1.3 2.2 3.2 2.6 3.8 4.3 5.4

Marketing Expenses as % of Revenue

6.8 7.4 8.5 7.9 9.4 10.5 10.5

Industry Exports as % of Industry sales 8.7 7.9 9.6 10.0 10.0 8.5 13.0

Industry Imports as % of Industry sales 7.07.0 5.35.3 3.73.7 4.24.2 4.54.5 3.93.9 4.04.0

Source: Thorelli & Burnett, “The Nature of Product Life Cycle for Industrial Goods Business”

Date of Product Introduction

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Linder Demand Theory Linder Theory focuses on role of demand, rather than

supply, on trade patterns.– Assumes consumers’ tastes depend on their income levels.– A nation’s income level yields pattern of demand for goods.– The nation’s produce types of goods demanded within country,

hence nation’s production reflects its income level. Trade between countries occurs in goods for which there is

overlapping demandoverlapping demand, i.e. consumers in both countries have a demand for these particular items.– Implies that trade in certain goods should be more intense between

countries with similar per capita income than between countries with dissimilar per capita incomes.

– Consistent with product cycle model.– Consistent with empirical evidence generally & for manufactures

in particular.

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Per-Capita Income Demand PatternsFood Clothing

Rent & Power

Medical Care Education

Transport & Commun

Other Consumer

High-IncomeHigh-Income

U.S. 13% 6% 18% 14% 8% 14% 27%

Japan 16 6 17 10 8 9 34

Upper Upper Middle Inc.Middle Inc.

Argentina 35 6 9 4 6 13 26

Korea 35 6 11 5 9 9 25

Lower Lower Middle Inc.Middle Inc.

Thailand 30 16 7 5 5 13 24

Cote d’Ivoire 40 10 5 9 4 10 23

Low-IncomeLow-Income

Pakistan 54 9 15 3 3 1 15

Zaire 55 10 11 3 1 6 14Source: World Bank, World Bank Development Report, 1990

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Linder & Intra-Industry Trade Linder theory does not identify the direction in

which any good flows.– In fact, a good might be traded in both directions.

– This was not possible in previous models.

Intra-Industry tradeIntra-Industry trade:– Occurs when country imports and exports items in the

same product classification.

– Linder predicts this trade should be greatest between countries with similar per capita income levels.

– Why Intra-industry trade? Product DifferentiationProduct Differentiation plus IRSIRS can lead to each country

specializing in particular variants for the joint “mass market”.

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Intra-Industry Trade

Index of Intra-Industry Trade

IIIITIIT = 1 – |X-M|/(X+M) = 1 – |X-M|/(X+M)

– No IIT then IIIT = 0, All IIT then IIIT = 1.0

Why Intra-Industry Trade in an Industry?– Product Differentiation.

– Transport Costs and Geographical Location.

– Dynamic Economies of Scale (2+ versions of product).

– Mismeasurement due to degree of product aggregation.

– Differing Income Distributions within Countries.

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New Approaches to Trade I

IRS, Imperfect Competition and Intra-Industry Trade

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Imperfect Competition Pure MonopolyPure Monopoly:

– Firm faces no competition, faces downward-sloping Demand Curve.

– Maximizes profit by setting Quantity to ensure:

Marginal Revenue = MR = MC = Marginal CostMarginal Revenue = MR = MC = Marginal Cost

Monopolistic CompetitionMonopolistic Competition:– A-1:A-1: Each firm differentiates its product from that of rival firms.

– A-2:A-2: Each firm takes rivals’ prices as given in setting own price.

– Result:Result: Each firm acts like a monopolist in pricing (MR = MC), even though each faces competition from many rivals.

– Special case of oligopolyoligopoly: Market structures where firms have interdependentinterdependent pricing decisions.

– Ignoring opportunities for collusivecollusive behavior between firms.

– Also ignoring opportunities for strategicstrategic behavior between firms.

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P

QMCSR

AC

SR Monopolistic Competition

MC

Cost, C and Price, P

Quantity, Q

AC

DSR

2. In SR number of firms fixed, each with produces differentiated product.

1. Fixed Costs generate IRS for each firm.

MRSR

3. Each sets MR=MC to determine output level.

ProfitSR

4. In SR all firms earn positive economic profits. Implies will have entry into industry.

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LR Monopolistic Competition

MC

Cost, C and Price, P

Quantity, Q

AC

QMCLR

P=AC

3. In LR equilibrium, each firm earns zero economic profits. More firms & more types of goods.

2. Entry continues until pushes DLR tangent to AC.

DLR

MRLR

DSRMRSR

1. Entry by new firms pushes down Demand Curve for each firm to DLR.

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The Krugman Model - Details IRS at firm level due to fixed costs.

Firm-level costs: C = F + cQC = F + cQ or AC = F/Q + cAC = F/Q + c Firms produce differentiated goods with market structure

that of monopolistic competition. Firm-level Demand: Q = S[1/n – b(P-PQ = S[1/n – b(P-Pbarbar)])] Where S = Industry sales, Pbar= Competitor’s Price, n = #firms.

Industry-level costs (Industry-level costs (CC CurveCC Curve):):– AC = F/Q + c = F/(S/n) + c = n AC = F/Q + c = F/(S/n) + c = n xx F/S + cF/S + c– More firms in the industry, the higher is the average cost.

Industry-level Price (PP Curve):Industry-level Price (PP Curve):– Set MR = P – Q/(S MR = P – Q/(S xx b) = c b) = c or P = c + 1/(b P = c + 1/(b xx n) n)– More firms in the industry, the lower the price each firm charges.

Equilibrium:Equilibrium:– CC and PP Curves intersect at zero-profit # of firms in industry

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The Krugman Model - Diagram

Cost, C and Price, P

Number of Firms, n

CC

1. Fixed Costs imply upward- sloping CC Curve.

PP

2. Monopolistic competition implies downward-sloping PP Curve.

n1

P1

AC1

3. With n1 in industry, each firm makes +ve profits, entry occurs.

AC2

P2

n2

4. With n2 in industry, each firm makes -ve profits, exit occurs.

P* =AC

n*

5. Only at n* firms in the industry does each firm make zero profits, no entry or exit occurs.

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Trade & the Krugman Model

PP

Cost, C and Price, P

Number of Firms, n

CC

P0 =AC0

n0

1. Introduction of trade increases size of market. Result is lower CC Curve for any given level of n.

CCTrade

n1

2. More firms in market after trade, i.e. greater variety of goods.

P1 =AC13. In addition, lower AC and so Price for goods after trade.

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Intra-Industry Trade

YearYearTotal Total

(All Areas)(All Areas) U.K.U.K. EECEECAll W. All W. EuropeEurope CanadaCanada

Latin Latin AmericaAmerica JapanJapan

Imports

1965 193 18 50 72 113113 1 7

1970 1,464 39 159 207 1,0801,080 19 152

1975 3,235 73 325 433 2,0332,033 207 528

1979 6,965 211 1,059 1,337 3,7493,749 569 1,084

Exports

1965 867 18 32 71 622622 116 4

1970 2,237 32 74 149 1,6021,602 275 17

1975 4,993 56 160 314 3,5213,521 648 35

1979 8,446 165 376 667 5,3175,317 1,530 53

U.S. Imports/Exports of Auto Parts, Engines, & Bodies(Millions of $)

Source: R.B. Cohen, Trade Policy in the 1980’s, IIE

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Product Differentiation & Trade

With IRS technologies, trade & gains from trade can arise even if both economies identical. (Non-comparative advantage trade)

Several sources for gains from trade. Expansion of IRS sector leads to pro-competitive gains: profit effect and decreasing average cost effect.

Gains from trade may be captured as increased product diversity or lower average costs or both. Krugman model is example of where both occur together.

Trade based on scale economies may drive factor prices farther apart in the two countries. Also make it more likely, however, that all factors gain from trade.

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New Approaches to Trade II

Price-Discriminating Monopolists and Dumping

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Monopoly and “Dumping”Cost, C and Price, P

Quantity, Q

MRHome

MC

DHome

P0

Q0

1. Domestic Monopolist produces at MR=MC, (P0, Q0).

DInt = MRInt

PInt

2. Assume can export output as price-taker at Pint =MRInt

QExportsQHome

Total Q

3. Monopolist will equate MR across markets to allocate total output so as to maximize profits.

PHome

4. Result is that PHome higher than PInt, i.e. firm is “unfairly” dumping output in foreign market.

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Price Discriminating Monopolist

Cost, C and Price, P

Quantity, Q

MC

Quantity, Q

MC

Market 1 Market 2Cost, C and Price, P

1. Assume Price-discriminating Monopolist with constant MC across markets.

MR1

D1

MR2

D2

Q2Q1

2. Will determine price/quantity in each market as MC =MR1 = MR2.

P1

P2

3. Result will be different prices in each market depending on demand conditions.

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New Approaches to Trade III

External Economies of Scale and Trade

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Sources of External Economies

External Economies to Scale occur at the level of the industry, rather than the individual firm.

Sources of External Economies– Clustering of Specialized Suppliers.

Localized industrial cluster of firms collectively create market large enough to support specialized equipment or support.

– Pool for Specialized Labor. Localized industrial cluster collectively create & support

market for specialized labor. Benefits both labor & firms.

– Knowledge Spillovers. Localized industrial cluster of firms create informal exchange

of ideas and knowledge for innovation.

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External Economies & Specialization

DWorld

Cost, C and Price, P

Quantity, Q

1. Strong External Economies tend to reinforce existing patterns of IIT regardless of initial source.

ACDC

PW

Q0

2. Developed Country (DC) initial producer of Good at Q0 and Pw = ACDC.

C0

ACLDC

3. Less Developed Country (LDC) tries to enter with lower AC Curve. Unable to because cannot compete when denied scale effects of prod’n (Cost = C0 > Pw).

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Infant Industry Argument

DWorld

Cost, C and Price, P

Quantity, Q

ACDC

1. LDC may try to protect its industry from ROW exports to gain scale effects in prod’n.

PW

C0

ACLDC

Q0

DLDC

2. Prohibitive tariff or quota closes LDC market. LDC producers face DLDC , produce to meet demand.

PLDC

3. Domestic producers reach ACLDC = PLDC < Pw. Can now undersell DC producers on world market.

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Dynamic Scale Economies

DWorld

Cost, C and Price, P

Quantity, Q

1. Strong Dynamic Learning effects reinforce existing patterns of IIT.

LCDC

PW

Q0

2. Learning Curves, LC, reflect cost saving from cumulative output learning effects.

C0

LCLDC

3. Again, if DC is first in industry, cost savings from learning will dominate lower LCLDC.

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Summary of Scale Effects on Trade Patterns

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Empirical Summary of IRS Models Gains from IRS occur in addition to gains from comparative

advantage. Theories are thus complementary to Standard Trade model results.

Pattern of specialization, and thus trade patterns, inherently arbitrary. Possibly dependent on historical factors, open to strategic interventions (first mover advantage) to capture highest welfare effects.

IRS models offer more possibilities for gains from trade. Empirical evidence indicates IRS important determinant of

trade flows for countries size of Canada or Western European nations. Primarily rationalization of manufacturing.

Increased mobility of factors of prod’n (mostly capital) suggests comparative advantage models increasingly less important.