Imperfect Competition and International Trade Dianna DaSilva- Glasgow

outline The theory of imperfect competition 5/22/2018 The theory of imperfect competition Monopolistic competition as a formal model of intra- industry trade International Trade Theory- ECN 4202, 2016/2017

THE THEORY OF IMPERFECT COMPETITION 5/22/2018 H-O trade is trade between different industries, inter- industry trade. However, about half of the trade in manufactured goods among industrialized nations is based on product differentiation and economies of scale, which are not easily reconciled with the H-O factor-endowment model. International Trade Theory- ECN 4202, 2016/2017

THE THEORY OF IMPERFECT COMPETITION 5/22/2018 The fact that this type of trade is occurring between countries that are similar (i.e. among the countries of the North rather than among countries with different factor endowments as in the H-O model) has two implications : There may be no pre-trade difference in costs across nations and hence no comparative advantage. However, comparative advantage arise as countries specialize (acquired comparative advantage), due to scale advantages. In the H-O model comparative advantage exist prior to trade and specialization (natural comparative advantage). International Trade Theory- ECN 4202, 2016/2017

THE THEORY OF IMPERFECT COMPETITION 5/22/2018 Because intra- industry trade means each nation produces similar products, most likely with similar factor intensities, it is not necessary for one factor to gain and another to lose. Labour and capital displaced in one industry are not a decrease in another, as in the H-O model. Consequently, it is easier for intra-industry trade to expand without significant resistance by labour unions. International Trade Theory- ECN 4202, 2016/2017

THE THEORY OF IMPERFECT COMPETITION 5/22/2018 What is intra- industry trade? Intra- industry trade occurs when a nation both imports and exports goods in the same industry. The exports are slightly different than imports, but occur in the same general industry classification. International Trade Theory- ECN 4202, 2016/2017

THE THEORY OF IMPERFECT COMPETITION 5/22/2018 How does intra-industry trade occur? Through product differentiation (exports of differentiated rather than homogeneous products) Through economies of scale in production. International Trade Theory- ECN 4202, 2016/2017

THE THEORY OF IMPERFECT COMPETITION 5/22/2018 How does economies of scale lead to imperfect competition and intra-industry trade? Intra- industry trade is based on international competition. The need to be internationally competitive forces firms to produce one or a few varieties and styles of the same products to keep unit costs low. For example, the US exports mid-sized automobiles while Germany exports luxury automobiles. International Trade Theory- ECN 4202, 2016/2017

THE THEORY OF IMPERFECT COMPETITION 5/22/2018 To competitively export a differentiated product, firms need to benefit from economies of scale. With economies of scale the optimal size firm will be large relative to the market, so markets will not be competitive. Markets will take the form of monopolistic competition, oligopoly, or in the extreme, monopoly. International Trade Theory- ECN 4202, 2016/2017

THE THEORY OF IMPERFECT COMPETITION 5/22/2018 Products within an industry are strongly differentiated from those of rival firms. Product differentiation arises where each nation specializes in a segment of the industry, producing a product that is differentiated in some way. Under each scenario firms are able to set the price for their products rather than take the price set by the market. International Trade Theory- ECN 4202, 2016/2017

MONOPOLISTIC COMPETITION 5/22/2018 Monopolistic competition addresses the pricing interdependence of firms that characterize oligopolies because of two assumptions: Firms can differentiate their products from rivals and can therefore charge a different price (monopoly in differentiated product). Firms ignore the impact of their own price on rivals price. Example: automobile industry in Europe International Trade Theory- ECN 4202, 2016/2017

MONOPOLISTIC COMPETITION 5/22/2018 International Trade Theory- ECN 4202, 2016/2017

MONOPOLISTIC COMPETITION 5/22/2018 MR < P because to sell more firm have to lower their price MC curve < AC curve because AC falls as output increases Pforit maximizing point (break even) where MR = MC International Trade Theory- ECN 4202, 2016/2017

MONOPOLISTIC COMPETITION 5/22/2018 Demand for one firm’s product is based on industry demand and prices set by rivals The relationship between the number of firms and the price each firm charges is downward sloping :the more firms, the greater is competition and the lower the price charged When price exceeds AC more firms will enter the industry. The more firms in the industry the higher is AC International Trade Theory- ECN 4202, 2016/2017

MONOPOLISTIC COMPETITION 5/22/2018 Limitations: Monopolistic competition excludes: collusive behaviour through coordination strategies or a price leader Strategic behaviour, for example building extra capacity not to be used but to deter future rivals. International Trade Theory- ECN 4202, 2016/2017

MONOPOLISTIC COMPETITION 5/22/2018 Monopolistic comp. and trade In industries where there are economies of scale, both the variety of goods that a country can produce and the scale of its production are constrained by size of the domestic market Trade increases market size and therefore loosens these constraints International Trade Theory- ECN 4202, 2016/2017

MONOPOLISTIC COMPETITION and intra-industry trade 5/22/2018 International Trade Theory- ECN 4202, 2016/2017

MONOPOLISTIC COMPETITION 5/22/2018 The larger the number of firms in the industry the lower the price The larger the number of firms in the industry the higher is AC International Trade Theory- ECN 4202, 2016/2017

MEASURING INTRA-INDUSTRY TRADE 5/22/2018 The extent of intra-industry trade is measured by an intra-industry trade index:   T= 1 - ‌ ‌ [X – IM] ‌ / (X + M) ‌ If exports equal imports in an industry, then T= 1. if there are only exports, or only imports, then T= O. For both industrial and developing countries, the share of intra- industry trade has increased considerably since 1970, currently accounting for approximately one- half of world trade. International Trade Theory- ECN 4202, 2016/2017

DUMPING 5/22/2018 One consequence of imperfect competition is dumping where firms charge different prices for the same good sold domestically or exported. Price discrimination Dumping is the most typical form of price discrimination in international trade and is controversial in trade policy because it is regarded as an unfair practice. International Trade Theory- ECN 4202, 2016/2017

DUMPING Dumping relies on two conditions: 5/22/2018 Dumping relies on two conditions: The industry is imperfectly competitive such that it is a price maker Markets must be segmented so that domestic consumers cannot easily purchase goods meant for the export market. International Trade Theory- ECN 4202, 2016/2017

Further reading Salvatore (2007) , Chapter 1 5/22/2018 Salvatore (2007) , Chapter 1 Krugman and Obstfeld (2009), Chapters 1 and 2 International Trade Theory- ECN 4202, 2016/2017