Strategies for Global Value Added: Gains Product variety and economies of scale © Professor Daniel F. Spulber

2 Why are goods traded within the same industry? Why are branded goods traded? How do customer preferences and production costs interact in international trade? How do companies compete when products are differentiated and there are scale economies? Inter-country connections Gains from trade

3 Historical role of product variety in international trade Prosciutto Di Parma China’ silk road Spice islands

4 Love of Variety and Economies of Scale If consumers prefer variety and there are economies of scale, there is a basis for trade between countries International trade increases demand – companies benefit from demand for variety of goods International trade provides economies of scale from increased sales in multiple countries Managers of international business need to take advantage of both these forces

5 D(P) Red cars Blue cars P P Q Q QQ Cadillac SLR BMW Z4 Roadster Demand for variety: Market demand for red cars only or the market demand for blue cars only

6 D(P) P Q Q Consumer benefit: Diminishing marginal utility implies preference for variety B(Q) + B(Q) > B(2Q) 2Q Demand for variety: Market demand for red cars only or the market demand for blue cars only B(Q)

7 Economies of Scale International trade generates greater demand Greater economies of scale available at global demand levels Examples: Aircraft, cars, cell phones, computers

8 Economies of scale AC(Q) Average Cost: AC(Q) = C(Q)/Q AC(Q) Q Diminishing average cost implies that C(Q) + C(Q) > C(2Q) Q C(Q) 2Q

9 Economies of scale and variety AC(Q) International trade grows the market so that there can be both greater scale and variety Shaded area: Consumer benefit minus total cost AC QQ AC(Q) D(P)2D(P)

10 Love of Variety and Economies of Scale International trade is equivalent to combining total demands and total supplies of the two countries A total increase in demands allows each country to do more of what it does best Each country trades its increased production with the other Manager’s strategic task: discover what types of variety are demanded and ways to get economies of scale in production

11 Example: Love of variety: RED and BLUE cars Unit production cost of cars: $ 30/unit at 10 units $18/unitat 20 units Consumer value per car: $80/unit if one type available $90/unit if variety available Economies of Scale Love of Variety

12 Example: Love of variety in autarky Will a country produce both types of cars of just one type? Value per car of producing 20 cars of one type: = 62 Value per car of producing 10 cars of each type: = 60 People in the country are better off if only one type of car is produced

13 Example: Love of variety with free trade Each country produces 20 of one type of car, One produces 20 red cars One produces 20 blue cars Countries trade 10 blue cars for ten red cars Value per car : = 72 Gains from trade are realized Compared to autarky:72 – 62 = 10 per car

14 Monopolistic competition and the international product mix Firms: There are N firms Each firm produces a distinct product so N is variety. Output Q is the firm’s scale. Each firm has marginal cost C and fixed cost F. Total cost:C(Q) = CQ + F Average cost: AC = C + F/Q

15 Monopolistic competition and the international product mix Each firm maximizes profit – taking prices of other firms as given: 1.Profit maximization Marginal revenue equals marginal cost: P(1 − 1/E) = C. 2,Free entry condition Entry of firms continues until each firm earns zero profit: PQ − CQ − F = 0.

16 Monopolistic competition and the international product mix AC(Q) Q DMR P Q P = AC C Monopolistic competition (Chamberlin tangency) Entry of new firms producing differentiated products continues until profit of each firm is zero 1. 2.

17 Monopolistic competition and the international product mix Combine the profit max condition with the zero- profit condition P(1 − 1/E) = C. PQ − CQ − F = 0. Solve for the output (scale) of the firm: Q = (E − 1)F/C.

18 Monopolistic competition and the international product mix With many products, elasticity depends on the number of products N and substitution parameter S: E = SN Put into the output condition: Q = (NS − 1)F/C Q N Scale and variety at competitive market outcomes: positive slope shows market effects Q = (NS − 1)F/C

19 Monopolistic competition and the international product mix The number of products at the competitive market outcome depends on national income (GDP) NPQ = I Or since profits are zero: N(CQ + F) = I Solve for scale: Q = I/NC − F/C Q N Scale and variety combinations that are feasible given national income I: negative slope shows tradeoff Q = I/NC − F/C

20 Monopolistic competition and the international product mix Q N Domestic market outcome: Scale and variety if national income is I* Q* N* Q = I*/NC − F/C Q = (NS − 1)F/C

21 Monopolistic competition and the international product mix Q N International trade increases total income which increases both scale and variety Q = I*/NC − F/C Q* N* Q = I**/NC − F/C Q** N**

22 Monopolistic competition and the international product mix Q N SPAIN EU Q** N**

23 Monopolistic competition and the international product mix AC(Q) Q P Q P = AC C International trade yields greater scale for every firm, more variety in the market, and lower prices. MR P = AC Q

24 Summary and take-away points Intra-industry trade takes advantage of buyers’ love of variety and suppliers’ economies of scale. Managers should design international transactions to realize these types of gains from trade Managers of the international business should coordinate multiple-country production and sales to realize both benefits of variety and economies of scale