1 International Economy Week 4 Prepared by Shi Young Lee* (Chung-Ang University)

Contents  Increasing Returns & Trade 1. Economies of Scale and Krugman Model 2. Gravity Model & Strategy

Economies of Scale: An Example OutputTotal Labor inputAverage Labor Input / /3

Economies of Scale & Trade  International Trade and Economies of Scale: An Example - 2 countries (A & B) /2 outputs (X and Y) - Population (Labor force) fixed: 20 - Assume that technologies and labor productivities are identical between two countries - Country A produces and consumes 5 units of output X with 10 labor inputs and produces and consumes 5 units of output Y without trade - Instead, Country A can produce 15 units of output X with 20 labor inputs if it can concentrate on the production of X

Economies of Scale & Trade - Also Country B can produce 15 units of output Y with 20 labor inputs with the possibility of international trade - If two countries engage in trade, then they would produce and consume more than the autarky and achieve higher social welfare - But this story cannot explain the pattern of trade - Specialization and spill-over of knowledge may give the rise of economies of scale and trade

Two Types of Economies of Scale  External Economies of Scale: Cost per unit (average cost) depends on the size of the industry but not necessarily on the size of one firm  Internal Economies of Scale: Cost per unit depends on the size of a single firm but not the size of industry  Two types may co-exist with each other but intrinsic characteristics may distinguish one type over the other

External Economies of Scale  Because of external economies of scale, a country that has large production in some industry will tend to have low cost of producing that good  Phenomenon: clustering or agglomeration of industry via geographical proximity (located in a single region), not necessarily imperfectly competitive  Examples: Milan as "fashion" center; Silicon Valley as a semiconductor industry; London as a financial center

External Economies of Scale  Backbone of external economies of scale: - Cluster via geographical proximity  spill-over of knowledge (positive externality) via learning from others - Abundance of input suppliers due to cluster  How is knowledge created? - Two sources of knowledge: either from diverse (and related) fields (diversity) and specialization - Example: invention of bras (Mrs. Rosenthal)

External Economies of Scale via Lock-in  Lock-in - Localization, concentration, and clustering of industry - After the size of industry becomes large, it becomes the predominant industry: historical lock-in  once established, tend to be self-perpetuating - Historical accident may persist even if new producer may be potentially more efficient  In this case, lock- in determines the pattern of trade

External Economies of Scale & Catch-Up  Catch-up - Even though it is difficult for others to catch up, there are some cases of leap-frogging - Dynamics of external economies of scale: Learning curve - Catch-up process - Catch-up process indicates that the follower must stay in the market for some time to catch up

Infant Industry Protection Argument  Infant industry protection - Once lock-in, it is difficult to catch up - Even if a potential competitor (follower) is more efficient, it would be impossible to enter into the market in the first place - Infant-industry protection argument: Protection may be justified on the ground that the follower is potentially more efficient than the incumbent

Problems with Infant Industry Protection Argument 1. It is difficult to figure out future cost schedule ex-ante  it is difficult to claim who is more potentially efficient than others 2. Time-inconsistency problem: - After protection is given, hold-up problem may arise - Once protection is given, political process is unable to stop protection since it can be too costly to stop possibly due to employment effect (capture theory)

Application: Why Cluster?  What Determine Industry Cluster (Historical lock-in)? - Unknown yet but there can be some plausible guesses - What are the advantages and disadvantages of clustering? - Specify the conditions that clustering may occur - Which industries are more likely to be clustered? - Role of transport cost or government policy in determining clustering  How about natural resources abundance & geographical advantages - How about coordination cost among the firms?

Internal Economies of Scale  Review of Monopoly  Assumptions of Monopolistic Competition - product differentiation (horizontal differentiation): differentiate from its rival firms - each firm takes other firms' prices as given. - free entry & exit - identical demand and cost functions - In the long run, P=AC

Krugman Model  Will be presented in class  Two Applications (1) Effect of open-up for new market (New Market) (2) Effect of technological progress

Relationship between Intra-Industry and Inter-Industry Trade Manufactures Food [Home]__________________________________ [Foreign]__ ______________________________

Relationship between Intra-Industry and Inter-Industry Trade - Inter-industry trade is based upon comparative advantage - Intra-industry trade is not based on comparative advantage  trade pattern cannot be easily predicted - Intra-industry trade often generates negligent income redistribution effects (i.e. EC) - The rise of intra-industry trade among industrialized countries during the period of is due to no political and social problems associated with such trade

Application: Prospect for Trade between Two Koreas  Objective: Provide the prospects for trade between the two Koreas if they were allowed to trade (in absence of any trade barrier)  Methodology: Estimate trade volume via industry (SITC code) between the North and OECD over 3 years  Do the same between the South and OECD, then match the industry code

Application: Prospect for Trade between Two Koreas  Results: - Intra-industry trade between the two Koreas would be negligible - For inter-industry trade, the North would be better off to trade with other advanced nations such as the US or Japan than with the South

Rationales  Rationale for Intra-industry Trade: - Utilize Linder's hypothesis: tastes and the levels of incomes are correlated with each other - Suppose that a country is endowed with high (low) level of human capital  When the level of human capital is high (low), they tend to produce high (low) quality goods - With the production of high (low) quality goods, they earn high (low) level of incomes  Since their income level is high (low), they demand high (low) quality goods - In fact, after 1990s, the East-West European countries’ trade volume has been so low, i.e., Germany with high level of human capital could not export its quality goods such as BMWs to the East - At the same time, the East could not export low quality goods to high income countries in the West

Rationales  Rationales for Inter-industry trade - The essence of Heckscher-Ohlin model lies on the difference of factor endowments ratios - Factor endowments ratios are relatively similar between the two Koreas - The North would be better off if it engages in trade with the U.S. or Japan than with the South mainly due to the wider difference of factor endowments ratios

Caveat Emptor  Processed trade & Outsourcing - This study did not examine processed trade & outsourcing due to lack of sufficient data - If we consider processed and outsourcing, it is possible that sufficient trade volume may arise between the North and South - Moreover, appropriate institutions and infrastructures are required for processed and outsourcing

Business Application  Product Differentiation and Trade - Product differentiation induces inelastic response from price change  it is important to determine the price range that does not affect its demand - Product positioning is the main determinant of that range  Determine the price range via product positioning that can maximize its profits given the strategy by competitors - What happen in case of currency appreciation or depreciation?

Gravity Model & Strategy  Some Backgrounds - Trade dependency tends to increase over time for many countries - For example, Korea has reached 80% by indicates top 10 trading partners for Korea  China, Japan, and the US are top 3 trading partners for Korea - Why does Korea trade more with these countries than others? - indicates that the size of economy is positively related to the trade volume

Top 10 Trading Partners for Korea

Gravity Model & Strategy  Logics of Gravity Model - As the size of economy increases, its income level also is high  If the income level is high, it can produce and demand a wide range of goods  Trade volume may increase - High GDP levels imply high consumption level of goods and services  High demand for imports for each other

Gravity Model & Strategy Estimate gravity equation: Take log to the above

Gravity Model & Strategy  Some Rationales - Trade patterns generally follow gravity model - But some countries trade more or less than the gravity model indicates - The US tends to trade more with some European countries possibly due to cultural proximity and low transport cost compared to Asia - Canada and Mexico trade more with the US than some European countries  NAFTA (absence of trade barriers) and close distance (low transport cost) may be responsible for high trade volume among these countries - FTA member countries tend to trade more with each other

Gravity Model & Strategy  Factors Affecting Trade Volume (To be included in Gravity Model) - Trade cost (search cost and cultural distance like communication cost) - Home bias: a djacency and border effect (local relationship over long time) - Purchasing Power - Common and historical background - Differences of national institutions  What strategy should be employed under gravity model?