1 BA 187 – International Trade Increasing Returns to Scale, Imperfect Competition & Trade.
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Transcript of 1 BA 187 – International Trade Increasing Returns to Scale, Imperfect Competition & Trade.
1
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.