ba 187 – international trade increasing returns to scale, imperfect competition & trade
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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
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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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
Types of Industry Structure – A Review
Perfect Competition, Monopoly, and Monopolistic Competition
Perfect Competition
“Price-taker” Markets
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Price Takers & Perfect CompetitionGeneral Condition for Maximizing Profits
• Choose level of output so that Marginal Revenue = Marginal CostMarginal Revenue = Marginal Cost
Price-Takers: • Firms that take market price as given when selling their product.
Each is small relative to market, cannot affect price.
Purely Competitive (or Price-taker) Markets• Markets characterized by large number of small firms producing
identical products in industry with complete freedom or entry/exit.
Price-Taker Behavior to Maximize Profits• Marginal Revenue of each unit of output sold = Market Price.
• Price-taking firm sets output so Marginal Cost of last unit of output produced equals market price.
• In LR equilibrium, firms earn zero economic profits as entry or exit occurs.
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SR Equilibrium: Price-Taker Market
MC = SR Supply above PMin
AVC
ATC
Quantity, q
Price, p
pmin
SR Profits
SR Lossesp2
q2
p2
p1
q1
p1
pLR = MRLR
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Perfect Competition & Supply CurvesSR Supply for Individual Firm = Marginal Cost curve above AVCMarginal Cost curve above AVC.
SR Supply for Market = horizontal sum of all the marginal cost curves of horizontal sum of all the marginal cost curves of firms in the industry.firms in the industry.
LR Supply for Market: shows minimum price that firms will supply any level of market output, given sufficient time to adjust all factors of production & allow for any entry/exit from the industry.
– Economies of Scale determine Shape of LR Supply• Constant Returns to Scale (i.e. Constant cost) industry will have
horizontal LR Supply Curve.• Increasing Returns to Scale (i.e. Declining cost) industry will have
downward-sloping LR Supply Curve.• Decreasing Returns to Scale (i.e. Increasing cost) industry will have
upward-sloping LR Supply Curve.– LR Supply Curve is more elastic than SR Supply Curve
• One or more factors fixed in SR, limits supply response to any change in demand. More flexibility in LR to adjust.
Monopolistic Competition
“Price-searcher” Markets with Low Barriers to Entry
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Price Searcher Markets with Low Entry Barriers
Competitive Price-Searcher Markets (Monopolistic Competition)• Each firm faces a downward-sloping demand curve for their output.
• Firms produce differentiated products. Output of other firms close substitutes, so individual firm’s demand curve is highly elastic.
• Low entry barriers allow entry or exit of firms if existing firms earn non-zero economic profits. Each firm faces competition from existing firms in industry & potential new entrants.
Profit-maximizing Behavior for a Firm in Price Searcher Market• Set output level so that Marginal Cost equal to Marginal Revenue.• Marginal Revenue is related to shape of the firm’s Demand Curve.
• Intuition for two factors at work to sell additional unit of output.
• (+) In the long run, competition along with free entry and exit will drive prices down to level of average costs.
• (-) LR equilibrium is not efficient, however, because firms produce less than the minimum ATC level of output.
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SR Monopolistic Competition
MC
ATC
Quantity, q
Price, p1. Each firm has set of cost curves
Demand
MR, Marginal Revenue
2. Each firm has demand curve for its own product. Also has MR.
pMC
qMC
3. Each firm sets output so that MR =MC to max. profits
SR Profits
4. In SR, firms may have positive or negative profits.
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LR Monopolistic Competition
MC
ATC
Quantity, q
Price, p1. In SR, firm has positive profits.
DSR
MRSR
pLR
qLR
3. In LR, zero economic profits at profit max. MR = MC
2. New firms enter. Lowers each firm’s demand & MR curves.
DLRMRLR
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Markets with Low Entry BarriersCompetition is an important disciplinary force in a price-
searcher market where barriers to entry are low.• Competition places pressure on producers to operate efficiently and
cater to preferences of customers.• Competition provides firms with strong incentive to develop improved
products and discover lower-cost production methods. (entrepreneurs & innovation)
• Competition causes firms to discover the type of business structure and size that best keep per unit costs of production low.
Monopoly
“Price-searcher” Markets with High Barriers to Entry
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Price Searcher Markets with High Entry Barriers
Monopoly is a market characterized by:1. Single seller of a well-defined product with no good substitutes.2. High barriers to entry of any other firms into market for the product.
Oligopoly is a market characterized by:1. Small number of rival firms in industry.2. Interdependence among sellers as each is large relative to market.3. Substantial economies of scale in production of the good.4. High barriers to entry firms into market.
Profit-maximizing Behavior for a Monopolist• Sets output level so that Marginal Cost = Marginal RevenueMarginal Cost = Marginal Revenue.
• Marginal Revenue is related to shape of the Demand Curve. Intuition for two factors at work to sell additional unit of output.
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Profit-Maximizing MonopolistCost, C and Price, p
Quantity, q
MR Curve
Demand
MC = Supply
qMonop
pMonop
qComp
pComp
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OligopolyOligopolists have a strong incentive to collude;
– By colluding, i.e. acting as a cartel, oligopolists can coordinate supply decisions to maximize the joint profits of all the firms. Cartel seeks to create a monopoly in market.
Obstacles to collusion among oligopolistic firms;
– Incentive for any firm to cheat on cartel agreement to increase its profits. Obstacles to success of collusion:
1. Increase in number of firms making up oligolpoly.
2. If price cuts by individual firms difficult to detect & prevent.
3. Low barriers to entry. Successful collusion induces new entrants.
4. Unstable demand conditions lower likelihood collusion successful.
5. Vigorous antitrust actions increase cost of collusion.
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DemandMR
Problems with Natural Monopoly
Cost, C and Price, p
Quantity, p
ATC
pReg
qReg
MC
qMonop
pMonop
New Approaches to Trade I
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.
New Approaches to Trade II
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.
New Approaches to Trade III
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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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.
Summary of Scale Effects on Trade Patterns
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Empirical Summary of IRS Models1. Gains from IRS occur in addition to gains from comparative
advantage. Theories are thus complementary to Standard Trade model results.
2. 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.
3. IRS models offer more possibilities for gains from trade.4. Empirical evidence indicates IRS important determinant of
trade flows for countries size of Canada or Western European nations. Primarily rationalization of manufacturing.
5. Increased mobility of factors of prod’n (mostly capital) suggests comparative advantage models may become increasingly less important.