Krugman Model
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Transcript of Krugman Model
The Krugman Model
Saurabh Batra(559)
Tuhina Dubey(572)
Objective
Overview of Krugman Model
Main characteristics with graph
Two country instance(Auto Pact)
Potential result
What Krugman Model is?
Krugman Model is a model of trade Under monopolistic competition. With economies of scale in production.
Krugman model shows that trade can be beneficial to consumers even with this form of market.
Monopolistic Competition
Each firm acts like a monopolist
Presence of many substitutes (not a homogeneous product)
Product Differentiation –Advertising and Sales promotion
Encouragement of Brand Loyalty
Start in Autarky
There are number of firms in each country
Labor assumed to be the only factor of production
Production exhibits Economies of scale , scale limited to home market
Countries start to trade
With larger world market some firms try to expand their production Firms realize their economies of scale hence
average cost falls so does the price of the good
Some firms fade out and exit
There are fewer firms in the world with trade; but there are MORE FIRMS SELLING IN EACH MARKET
Hence with trade, consumers get more selection and lower prices than without trade
Krugman Model
Market is characterized by monopolistic competition with increasing returns to scale.
Average cost of production falls for each firm falls as output increases. (Marginal cost is constant)
Returns to scale : Labour is only factor of production
L= a + b Q ; b > 1, a > 0.
Example, b = 2, a = 30
If Q = 50, L = 130,
If Q = 100, L = 230 < 260
-production exhibits increasing returns to scale
Krugman Diagram
This diagram analyzes relationship between per capita consumption of a product, c (horizontal axis) and real cost to purchaser (relative to wage), P/W (vertical axis)
Basic Krugman Diagram
First: PP curve
as consumption of a company’s good increases (demand increases … shift outward in a
demand/supply)
P/W for the good also increases because demand becomes less elastic as Q increases. elasticity of demandΔQ/Q/ΔP/Por (Q2-Q1)/(Q1+Q2) /(P2-P1)/(P1+P2)
The ZZ curve
As per capita consumption (c) rises, output rises and brings scale economies. P falls relative to W as c rises
reductions in unit cost lead to lower prices and zero economic profit
above ZZ curve profits are greater than zero
below ZZ curve profits are less than zero
Trade in the Krugman Model
International trade allows economies of scale to be realized, more so than with limited or no trade
Total production of each good increases as more people buy it
The ZZ curve moves down, P/W falls (meaning real wage W/P rises) because goods become cheaper.
Also, c drops for each good per capita consumption decreases as more choice is
available
Two Firms instance Suppose this firm exists in
country 1.
Let country 2 be identical to country 1 on both the demand and the supply sides of the economy.
Traditional trade theory posits that these countries would not trade.
However, because trade effectively increases the market size in each country, economies of scale are realized in the Krugman model.
Trade effectively shifts the ZZ curve to the left
Z΄
Z
P
P
Z΄
Z
(P/W)1
(P/W)2
cc1c2
The Canada—United States Automotive Products Agreement
It removed tariffs on cars, trucks, buses, tires, and automotive parts between the two countries (greatly benefitted the large American car makers)
GM,Ford,Chrysler,Volvo agreed for a stagnant level of production- sales ratio
Reduction in production costs in Canada ,more efficient production of a smaller range of vehicles and components, and lower vehicle prices for consumers
Initially Canada exported $ 16 million worth of automotive parts to US and imported parts worth $519 million. But after this pact the number increased to $ 2.4 billion within a decade.
The agreement is said to have benefitted Canadian workers and consumers by lowered prices and increased production creating thousands of jobs and increasing wages.
The Auto Pact was though abolished in 2001 after a World Trade Organization ruling declared it illegal.
We conclude..
Although trade causes per capita consumption (c) to fall, total consumption of the firm’s output has risen.
P/W has decreased because of trade; this also means that its reciprocal (W/P) rises.
This suggests that trade causes the real wage of workers to rise.
Thank You..
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