© 2007 Pearson Addison-Wesley. All rights reserved Chapter 7 Imperfect Competition, Increasing Returns, and Product Variety

7-2 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Difference Ricardian Model: Technological difference Heckscher-Ohlin Model: Endowment different, identical tech. Specific Factor Model: Endowment different, factor immobile. But all assume market structure is perfect competitive Imperfect competition matters –International competition between large firms. –The role of government: it will pass on a strategic advantage to domestic firms

7-3 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Index to measure intra-industry trade Previous models based on comparative advantage imply that a traded good is either importer or exported, but not both. Index=1-(|X-M|)/(X+M) The index ranges from zero, in which no intra-industry trade occurs, to one when exports and imports are balanced and intra-industry trade is at its maximum.

7-4 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Table 7.1 Average Levels of Intra-Industry Trade, All Commodities, Selected Countries, (percentages)

7-5 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Stylized Facts of Intra-industry Trade Low for simple, undifferentiated products in which the U.S. has either a strong comparative advantage (corn) or disadvantage (crude petroleum). High for nearly all complex, differentiated goods (photographic equipment) whatever the apparent state of the comparative advantage of the U.S. High for some simple goods (fertilizers, inorganic chemicals) for which the U.S. seems to neither have a strong comparative or disadvantage.

7-6 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Love of Variety Individuals may exhibit a love for variety. Demand side Each country’s variety is distinct from that in the other country. Individuals consume a given amount of clothing and have available two variety of food. The indifference curve for these two varieties hits the axes, showing that individuals can survive consuming only quantity C or D– An Ideal Variety If restricted to consuming only one variety, and if the relative price of the first variety is higher than that of the second one, then individuals consume only the second variety.

7-7 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Figure 7.2 Love of Variety

7-8 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Love of Variety However, for given prices of the two varieties, a mixture of varieties shown by A or by B could be obtained more cheaply and yield the same level of utility. Intra-industry trade could improve real incomes even in the absence of any inter-industry trade. There need to be no losers with trade – everyone benefits by having a wider selection of each type of commodity.

7-9 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Increasing Returns to Scale Internal IRS the scale of a firm increases. Accordingly, the fixed cost of each product decreases. Fixed cost could include management cost, designing cost, R&D. External IRS It happens within an industry. The number of firms increases, which cause the scale of an industry expand.

7-10 Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

7-11 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Production and Trade under IRS

7-12 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Production and Trade under External IRS Industry: demand and supply curves are regular. LRAC is downward sloping due to the external IRS. MC1 and AC1 in the right figure denotes firm’s case in Autarky. Since external IRS, more firms enter the industry. Market supply increases to S’ Due to the decrease AC and MC of each firm, the industry’s AC and MC will decrease as well. S’ shift right to S2. The cost advantages cause trade.

7-13 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Production and Trade under External IRS The increased foreign demand shift aggregate demand right from D1 to D2. New equilibrium at a lower price Firms earn zero profit in the long run. Consumers’ welfare increase due to a lower price. Therefore, it exists gains from trade.

7-14 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Production and Trade under Internal IRS Internal IRS  Monopolistic Competition The demand curve is downward sloping Firms produce differentiated products Firms also face competition Free Entry MR=MC

7-15 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Monopolistic Competition

7-16 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Monopolistic Competition with Trade

7-17 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Monopolistic Competition with Trade Before trade: demand is D1 and price is P1. AC is higher than MC due to the fixed cost Optimal quantity to produce is Q1. After trade: MR1  MR2, D1  D2 Excess Profit exists in the short run as the shaded area. In the long run, excess profit disappears. Demand curve D3 is more elastic than that before trade, D1. Because same fall in price leads to more quantity demanded under trade.

7-18 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Monopolistic Competition with Trade

7-19 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Monopolistic Competition with Trade P3=LAC3, zero profit. Effects of trade in the short run –Output up, –AC down –SR positive profit. –Price could down (as shown), consumers better off –Price could up, consumers worse off. Effects of trade in the long run –Output up (but not necessarily higher than that in the SR) –AC=P down –Consumers better off –Firms zero profit –The whole society gains from trade.

© 2007 Pearson Addison-Wesley. All rights reserved Krugman (1979) Internal IRS

7-21 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Assumptions Supply Side Firms face monopolistic competition Production input requirement: Labor is the only input, no capital Assume each firm is symmetric L i =a +by i C=Lw=w(a+by)=aw + bwy AC=aw/y+bw MC=bw

7-22 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Cost Curve AC MC y

7-23 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Increasing Returns in Production Assume that each variety entails two different types of costs: a fixed-cost and constant marginal production costs. Therefore, to produce each variety, the average costs of production decline. Monopolistic competition Free Entry, zero profit MR=MC Assumptions: each firm produces a separate variety in which the cost structure is the same for all firms. Demand is identical for all varieties.

7-24 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Firms maximize their profits MR=MC It implies p(1-1/e)=bw TR=P(Q)*Q MR=P’(Q)*Q+P=P[(dP/dQ)*Q/P+1] Elasticity of demand=-(dQ/dp)*(P/Q) p/w=b*e/(e-1)=b*[1+1/(e-1)] Assumption: the elasticity of demand is decreasing in consumption. Consumption up  e down  p/w up

7-25 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Firms maximize their profits P=AC P=aw/y+bw Market clear condition for product market: Y=Lc where c is consumption per capita P/w=a/y+b P/w=a/(Lc)+b When labor increases, the inverse of real wages decrease. i.e., the real wages increase.

7-26 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Diagram Analysis p/w MR=MC P=AC c

7-27 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Example: a linear demand curve p a b d o e f elasticity =(ef/de)*(de/oe)=ef/oe=df/ad

7-28 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. From Autarky to Trade In the H-O model, there is no reason for two identical countries to trade. However, now suppose two countries produce different varieties, then they could trade. But the key point is: what is the economic consequence? Labor increases due to international trade P=AC shift to the left due to the increase of labor

7-29 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Implications Trade causes the consumption of each variety decrease. This raises the elasticity of demand, reducing the equilibrium price and therefore raising real wages. This is a source of gains for consumers. But output of each variety increases This is because the drop of output price makes the output necessarily increase as moving on the average cost curve. Any firm that produces both in autarky and under free trade will be selling more with trade.

7-30 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Number of Varieties Market clear condition of the labor market: L=N*L i =N*(a+by)=N*(a+bLc) N=L/(a+bLc)=1/[(a/L)+bc)] Both the increase of labor endowment and the decrease of the consumption lead to the increase of the number of varieties. Consumer enjoy more varieties but consume less on each variety!

7-31 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. The Scale Effect v.s. Selection Effect Scale effect: output of each variety increases Selection Effect: Recall L=N*(a+by) Labor is fixed for each country, but output increases Number of variety in each country reduces! Opening trade between countries indeed implies that some firms must exit in each, while the remaining firms expand their output and take advantage of scale economics.

7-32 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Figure 7.4 Size and Number of Firms

7-33 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Size and Number of Firms Assume same technology, same tastes. Foreign is a large market (the U.S.) and devotes more resources to the clothing sectors. Its firm in autarky will not resemble exactly the firms at home. The RC curve shows how in each country sharing a common technology, large firm size goes hand in hand with the production of a greater number of varieties. In autarky, the smaller home market is served by firms (at H) that are fewer in number and smaller in size than in the larger foreign market (F).

7-34 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Size and Number of Firms With trade, if the same resources are devoted to clothing as in autarky, producers concentrate (at H’ and F’), all firms are the same (larger) size, and a larger number of varieties is available for consumers (at W). A move toward the southeast represents, for each country a cutback in the number of varieties produced but an increase in the scale of operation for each variety.

7-35 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Inter-industry Trade According to the Heckscher-Ohlin model or Ricardian model, countries specialize in production. –Trade occurs only between industries: inter-industry trade In a Heckscher-Ohlin model suppose that: –The capital abundant domestic economy specializes in the production of capital intensive cloth, which is imported by the foreign economy. –The labor abundant foreign economy specializes in the production of labor intensive food, which is imported by the domestic economy.

7-36 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Inter-industry Trade (cont.)

7-37 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Intra-industry Trade Suppose now that the global cloth industry is described by the monopolistic competition model. Because of product differentiation, suppose that each country produces different types of cloth. Because of economies of scale, large markets are desirable: the foreign country exports some cloth and the domestic country exports some cloth. –Trade occurs within the cloth industry: intra-industry trade

7-38 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Intra-industry Trade (cont.) If domestic country is capital abundant, it still has a comparative advantage in cloth. –It should therefore export more cloth than it imports. Suppose that the trade in the food industry continues to be determined by comparative advantage.

7-39 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Intra-industry Trade (cont.)

7-40 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Inter-industry and Intra-industry Trade 1.Gains from inter-industry trade reflect comparative advantage. 2.Gains from intra-industry trade reflect economies of scale (lower costs) and wider consumer choices. 3.The monopolistic competition model does not predict in which country firms locate, but a comparative advantage in producing the differentiated good will likely cause a country to export more of that good than it imports.

7-41 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Inter-industry and Intra-industry Trade (cont.) 4.The relative importance of intra-industry trade depend on how similar countries are. –Countries with similar relative amounts of factors of production are predicted to have intra-industry trade. –Countries with different relative amounts of factors of production are predicted to have inter-industry trade. 5.Unlike inter-industry trade in the Heckscher-Ohlin model, income distribution effects are not predicted to occur with intra-industry trade.

7-42 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Inter-industry and Intra-industry Trade (cont.) About 25% of world trade is intra-industry trade according to standard industrial classifications. –But some industries have more intra-industry trade than others: those industries requiring relatively large amounts of skilled labor, technology and physical capital exhibit intra-industry trade for the US. –Countries with similar relative amounts of skilled labor, technology and physical capital engage in a large amount of intra-industry trade with the US.

7-43 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Inter-industry and Intra-industry Trade (cont.) Note: an index of 1 means that all trade is intra-industry trade. An index of 0 means that all trade is inter-industry trade.