1 ECONOMICS 3150C Lecture 7 November 18

2 Monopolistic Competition Model Large number of competitors (large undefined) producing different, yet similar products (product differentiation) Problems: –Competitive advantage and creation and introduction of different varieties of product – why does one firm produce a particular brand/variety? –Defining industry boundaries –Stability – tendency for consolidation if there is value in brand names – imperfect information and brand names as signal for quality –First mover advantages – distribution channels, brand name reputation, market pre-emption Linear model Circular model –Full price to consumers of variety j: Pj + disutility of variety j differing from desired variety {t[abs(Zj – Z*)]}

3 Monopolistic Competition Model Entry/exit process in circular model –Pre-emption –Fighting brands –Distribution channels – economies of scale, transactions costs If Y1 characterized by monopolistic competition and Y2 is homogeneous product with constant returns to scale –Intra-industry trade –Inter-industry trade based on comparative advantage –Trade will lead to lower prices, lower unit costs and more varieties  gains from trade greater than in standard trade model with constant returns to scale

4 Monopolistic Competition Model Standard m.c. model –Equilibrium: no. of firms, economies of scale, production point relative to MES –No. of firms and no. of varieties –Who created first variety? Competitive advantage Effects of entry  resulting from increase in D –P, output, production efficiency, profits, no. of firms and varieties In industries with economies of scale, variety of goods and scale of production constrained by size of country’s market

5 Monopolistic Competition Model Trade results from economies of scale and multiple varieties of product –Trade expands size of market  each country can specialize in narrow range of products/varieties Gains from trade: lower per unit costs and prices (increased production per firm); less excess capacity; more varieties thus wider range of choices –More firms serving combined markets, more output per firm  closer to most efficient scale of production, less excess capacity Internal economies of scale and comparative advantage –What country produces what varieties? –Intra-industry trade

6 Monopolistic Competition Model Extension of H-O model with internal economies of scale and monopolistic competition –Assumptions: Two countries Two products: Y1– heterogeneous product subject to economies of scale; Y2 – homogeneous product with constant returns to scale Two factors of production Y1 uses X1 relatively more intensively A has relative abundance of X1 Outcomes: –A: net exporter of Y1, net importer of Y2 –Both intra-industry (Y1) and inter-industry trade (Y1, Y2) B will produce and export some varieties of Y1, but be a net importer

7 Monopolistic Competition Model Outcomes (cont’d): –No income distribution effects from intra-industry trade –Pattern of intra-industry trade cannot be predicted A will produce more varieties, but cannot predict which ones Adjustment costs as some producers of Y1 disappear in both countries Relative importance of intra and inter-industry trade depends on how similar are the two countries – the more similar the more important intra-industry trade If B larger country, no differences in relative availabilities of factors of production and no differences if factor intensity of production –B: net exporter of Y1 – more firms and varieties pre-trade

8 Brand Names Imperfect information Re. product quality/safety: lemons model – consumers believe all suppliers produce lowest quality and so bad drive out good suppliers Re. risks: adverse selection (insurance markets) – only bad risks buy insurance, good risks squeezed out (experience rating); credit crunch because of inability to quantify credit risks (credit risks improperly priced); magnitude of liabilities stemming from terrorist attack (following 9-11, insurance companies tried to terminate insurance for terrorist attacks) Re. quality, motivation of workers: statistical discrimination (do not hire from among certain groups of job applicants)

9 Brand Names Brand names a signal for quality – quality difficult to measure without repeated use of product; brand name developed over time provides some assurance to consumers about quality of product Developing a brand name Consumers willing to pay price premium for established brand name products –Travel abroad, willing to purchase brands recognized from home (hotels, consumer goods, financial institutions, entertainment) –Example of products from China

10 Brand Names –Value of brand name – Apple, Armani, BMW, Canali, Coach, Coca Cola, Disney, Ferrari, Goldman Sachs, GE, Google, Harvard, H&M, IBM, Ikea, McKinsey, Mercedes, Miele, Nike, Prada, Starbucks, Tata, Toyota, Trump, Virgin Group, Wynn, etc. –Transferable to other markets? – geographic, product

11 Intra-Industry Trade 25% of world trade –Most significant in “sophisticated” manufactured products (machinery, chemicals, pharmaceuticals, telecommunications equipment, autos, aerospace) and trade among industrialized countries Intra-industry trade often takes the form of production of specialized, skill or technology- intensive components in one country and assembly in another country –Nokia develops a technology – manufactured by an EMS company, perhaps in Canada or in some other country (costs and productive/technology capacity) then sold as part of system or network by Nokia

12 Intra-Industry Trade Competitive advantage and introduction of new product/variety –Caters to domestic demand (tastes, income levels) –Uses familiar technology –PLC: growth in domestic demand  entry; expansion of demand in other markets –Small size initially of foreign markets  with economies of scale, supply foreign markets from domestic plants –Growth in foreign markets  expansion of production, creation of subsidiaries as consolidation reduces number of competitors –Companies with foreign subsidiaries will transfer production more quickly

13 Canada-US FTA Gains from trade –Traditional: comparative advantage, new products –Larger markets: economies of scale, plant economies (specialization), learning curves –Increased competition: new products, higher quality, lower prices, efficiency –Minimize trade disputes – less likely to be side-swiped when trading partner initiates trade dispute against other countries; dispute resolution mechanism fairer and quicker in resolving trade disputes Consider softwood lumber under NAFTA, subsidies for regional jets Losses –Income losses for owners of relatively abundant resources –Adjustment to new trade patterns – unemployment during transition

14 Canada-US FTA Argument in favour of FTA with US based on Canada exploiting economies of scale and gaining secure access to US market (required to encourage investment in Canada and restructuring) –Productivity levels in Canada 25% below US because Canadian branch plant replica of US Same number of varieties and shorter production runs; Less competition thus X-inefficiency and less incentive to innovate –Plant economies of scale Standard internal economies of scale and per unit costs decrease with reduction in number of products produced in each plant

15 Canada-US FTA Problems with argument: –If economies of scale so important why did some firms not specialize and drive competitors out of the market? –Tariff barriers had been declining since 1947 – what if management a problem? –Security of access limited incentives to restructure

16 FTA, NAFTA Objectives –Eliminate barriers to trade in goods and services –Expand liberalization of conditions for cross-border investments –Dispute resolutions – more binding, more effective enforcement –Facilitate conditions for fair competition (labor and environment codes) –Rules of origin: 50% of value added (62.5% for autos) must originate in free trade area –Eliminates import and export restrictions on energy products, no price discrimination between domestic and foreign consumers of energy products –National treatment Trade in services – subject to regulation (professional services); labor mobility; foreign ownership restrictions (financial services, broadcasting, transportation)

17 FTA, NAFTA Security of access not achieved – trade remedy laws and trade disputes (S. 301 cases); dispute resolution – enforcement mechanisms, effectiveness (incentives to abide by decisions); no list of exempt policies  Canadian government policies at risk –Ambiguous enforcement susceptible to political pressures; ambiguous interpretation of laws (damage, source of damage); harassment potential; asymmetric costs of fighting complaints; uncertainty for customers (countervailing duties) Options for Canada –Fight complaints in US courts and build up case law –Go to WTO –Case-by-case negotiations (example of softwood lumber)

18 GATT GATT/WTO [General Agreement on Tariffs and Trade/World Trade Organization] –3 basic principles Nondiscrimination (MFN) – preferential trading arrangements violate this principle; NAFTA an example of preferential trading arrangement Elimination of quotas (except for balance of payments problems) – international system of quotas in textiles, proliferation of VERs, exploitation of escape clause Consultation to solve trade disputes – weak enforcement mechanism; US domestic laws supercede GATT, NAFTA –As Tariffs , NTMs  because D for protection constant –NTMs higher cost form of protection –Canada essentially bystander in MTNs – EU, US and Japan dictated outlines of agreements

19 GATT 9 Rounds of multilateral trade negotiations – Kennedy, Tokyo, Uruguay and Doha rounds addressed NTMs as first 5 focused on tariffs only –Tokyo, Uruguay and Doha also attempted to extend trade rules to services and establish investment rules –WTO created to replace GATT secretariat Responsible for enforcement of agreement and dispute resolution More formal procedures with tighter deadlines –GATS (General Agreement on Trade in Services) –TRIPS (Agreement on Trade-Related Aspects of Intellectual Property

20 GATT Difficulties in reducing NTMs –Definition of subsidies –Escape clause provisions –Dispute settlement mechanism with effective enforcement – market power of different countries –Trade-offs: Problems in measuring concessions –North-South issues: need to develop economies –Agriculture sector and political importance of farmers Major problem for Doha Round

21 Agriculture Support Government support, 2007: % of gross farm receipts Canada: 19.4% Australia: 6.7% Brazil: 5.0% China: 8.6% EU27: 25.5% Japan: 47.5% Russia: 10.8% S. Korea: 65.1% Mexico: 13.6% South Africa: 3.3% Turkey: 18.9% US: 10.2%

22 GATT GATT includes articles on anti-dumping (Article 6), countervail (Article 16) and escape clause (Article 19) –Dumping: export price below domestic market price (below cost of production or normal home market price) –Escape clause: temporary protection to limit imports causing serious injury to domestic producers –Countervail: tariffs to offset effects of subsidies –Problems: defining subsidies, determining existence of dumping, measuring degree of dumping, measuring injury, determining causation

23 GATT and US Trade Laws US contingency protection legislation – countervail, anti-dumping, escape clause and unfair trade (S. 301) –First three deal with imports, unfair trade deals with exports as well –US definitions of injury and causation differ from spirit and letter of GATT –Unfair trade not part of GATT – trade panel has found S. 301 to violate GATT Issue of sovereignty for US

24 GHG Caps Canada’s position at Bali conference on climate change: –All countries must agree to carbon emission limits, not just developed countries –No trade advantage because of different rules –Longer time frame to achieve significant GHG reduction targets

25 GHG Caps Options –Carbon tax Magnitude Unilateral, multilateral Use of proceeds –Regulations Energy efficiency standards – autos Emission limits Unilateral, multilateral Monitoring and enforcement –Cap and trade systems Specific industries or general system Setting limits each year – whose responsibility? Unilateral, multilateral Monitoring, enforcement Gaming of system for competitive advantage

26 GHG Caps U.S. –Companies reducing emissions to prevent class action law suits along the lines of those in the tobacco industry –Lieberman-Warner Climate Security Act: Cap U.S. carbon consumption through tradable permit plan Criticisms: What level of emission reductions is realistic? Damage competitiveness of U.S. based companies without parallel commitments from trading partners

27 Dumping Requirements: –Imperfect competition – price setters rather than price takers –Segmented markets – no arbitrage By firms in A into B: –Price in B below price in A –P(B) < AC(A) –P(B) < AVC(A) Price discrimination –Elasticity of demand differs between A and B –Prevent arbitrage Warranties Price discrimination model: –MC(A) = MR(A) = MR(B) –P(A) > P(B)

28 P1 Y1 D(B) D(A) MR(B) MR(A) MC(A) P1(A) P1(B)

29 Dumping P(B) < AVC(A) –Beach-head strategy –Price in short run < price in long run Improved competitive position in future and ability to charge higher price P(B) < AVC(A) –Learning curve –AVC in short run > AVC in long run Pricing to move down learning curve and develop cost-based competitive advantage Lower price increases demand and production per period of time

30 Dumping P(B) < AVC(A) –Objective: drive competitors out of market to monopolize market –How to distinguish predatory dumping from dumping based on competitive behaviour not aimed at monopolization? –Substitute domestic competition law for anti-dumping provisions in trade agreements  companies may be driven out of market before case is resolved