McGraw-Hill/Irwin © 2012 The McGraw-Hill Companies, All Rights Reserved Chapter 6: Scale Economies, Imperfect Competition, and Trade

This chapter surveys several theories of international trade that are alternatives to the standard theory based on perfectly competitive markets with constant or increasing costs. These alternative theories are based on some form of increasing returns to scale, so that unit costs tend to decline as output increases.

Several trade facts indicate the need for alternative theories. First, much trade, especially trade in manufactured goods among industrialized countries, is intra- industry trade—two-way trade in the same or very similar goods. Second, some industries are global oligopolies—a few firms account for most of global sales. While there may be a number of explanations of intra-industry trade, product differentiation seems to be the major one. The market structure of monopolistic competition is useful for analyzing the role of product differentiation.

Copyright  2012 by The McGraw-Hill Companies, Inc. All rights reserved. 6-4 Figure 6.1 Scale Economies

Copyright  2012 by The McGraw-Hill Companies, Inc. All rights reserved. 6-5 Exports Plus Imports as a Percentage of GDP Figure 6.2 Intra-Industry Trade for the United States, Selected Products, 2009

Copyright  2012 by The McGraw-Hill Companies, Inc. All rights reserved. 6-6 Figure 6.3 Average Percentage Shares of Intra-Industry Trade in the Country’s Total Trade in Nonfood Manufactured Products

Copyright  2012 by The McGraw-Hill Companies, Inc. All rights reserved. 6-7 Figure 2.2 The Market for Motorbikes: Demand and Supply Figure 6.4 The U.S. Market for Compact Cars, No Trade

Copyright  2012 by The McGraw-Hill Companies, Inc. All rights reserved. 6-8 Figure 6.5 Market for Compact Cars, No Trade and Free Trade

Copyright  2012 by The McGraw-Hill Companies, Inc. All rights reserved. 6-9 The Individual Firm in Monopolistic Competition

Copyright  2012 by The McGraw-Hill Companies, Inc. All rights reserved No Trade to Free Trade

Copyright  2012 by The McGraw-Hill Companies, Inc. All rights reserved Figure 6.6 Net Trade and Intra- Industry Trade

In some industries, a few large firms account for most global sales, perhaps because internal scale economies are large. In such an oligopoly each firm should recognize interdependence with the other large firms—its actions and decisions are likely to elicit responses from the other firms. Competition then resembles a game, but it is still not clear how the firms should play the game. If they compete aggressively, then they may earn only normal profits. If instead they restrain their competitive thrusts, then they may be able to earn high profits. However, they may be caught in the prisoners dilemma of competing aggressively, unless they can find some way to cooperate.

Although we do not have a single dominant full theory of oligopoly, we can make several observations about oligopoly and trade.  First, scale economies tend to concentrate production in a few production sites. When they were chosen by the firms, these may have been the lowest-cost sites. Over time production tends to continue in these sites, even though they may not remain the lowest cost sites if all sites could achieve the same production scale.  Second, the fact that oligopoly firms can earn high profits means that it matters where these firms are located (or who owns them). The high profit earned on export sales creates another source of national gains from trade for the exporting country, in the form of better terms of trade, but at the expense of foreign buyers of the imports.

A third alternative theory is based on scale economies that are external to the individual firm but arise from advantages of having a high level of production in a geographic area. With external economies of scale (also called agglomeration economies), an expansion of demand (such as that caused by increased exports) can result in a lower unit cost for all producers in the area and a lower product price.

Copyright  2012 by The McGraw-Hill Companies, Inc. All rights reserved Figure 6.7 External Economies Magnify an Expansion in a Competitive Industry

Copyright  2012 by The McGraw-Hill Companies, Inc. All rights reserved Figure 6.8 Summary of Gains and Losses from Opening Up Trade in Three Cases