1. The “New Trade Theory” + some other post-HO-models Appleyard & Field (& Cobb): Chapter 10 Krugman & Obstfeld: Chapter 6

2. 2 Today’s Lecture 1. Economies of scale and the Krugman model 2. Some other post-HO-models 1. Imitation Lag 2. The Product Cycle Theory 3. Gravity Models 4. New Economic Geography 5. Heterogeneous Firms

3. 3 The “Krugman Model”: Assumptions 1. Internal economies of scale 2. Monopolistic competition (non-homogeneous goods) 3. One factor of production (labour) 4. Identical preferences 5. Large number of goods produced with the same technology 6. Full employment Paul R. Krugman (1979): Increasing returns, monopolistic competition, and international trade. Journal of International Economics, Vol. 9(4): 469-479

4. 4 Key assumption 1: Economies of Scale External: cost per unit depends on the size of the industry, not the firm (Silicon Valley, Hollywood...) Internal: cost per unit depends on the size of the firm, not industry (Nokia, Phillips, GE...) o Krugman models technology as L = a + b*Q  Q = 1/b*L – a/b o the amount of labour required (L) to produce amount of input (Q) depends on b and constant a (fixed cost) → Doubling the inputs more than doubles the output (increasing internal economies of scale)

5. 5 Production Possibilities Frontier with Economies of Scale Good Y Good X

6. 6 Key assumption 2: Monopolistic Competition Each firm produces a different brand of the good (goods that are not exactly the same, but that are substitutes for one another) Each firm takes prices of rivals as given (=no strategic pricing) → Each firm behaves as if it were a monopolist However, we assume easy entry and exit → zero-profits in the long run o as long as (average cost < price) more firms enter the market

7. 7 Long-Run Market Equilibrium of Monopolistically Competitive Market The more firms there are: 1. the less each firm produces → higher average cost (due to increasing returns to scale) → upward sloping cost curve 2. the harder the competition → decreasing price → downward sloping price curve Price Number of firms AC P n* p*

8. 8 Introducing Trade to the Monopolistic Competition Model Trade increases market size → firms exploit more of the returns to scale → average cost decreases → price decreases → number of firms increases i.e. a larger variety of products is available for smaller price everybody are better off even if the countries are identical Price Number of firms AC A P nAnA pApA n FT p FT AC FT

9. 9 Intra- and Inter-industry Trade Inter-industry trade: countries export goods of one product category and imports goods of other product category as in the Ricardian and the Heckscher- Ohlin models o Basis for trade: Comparative Advantage due to differences in productivity (Ricardian model) or in factor endowments (HO-model) Intra-industry trade: countries export and import products of the same products category as in the Krugman model o Basis for trade: Internal economies of scale

10. 10 Impact of Trade Ricardian Model o complete specialization (linear PPF) o increase of country’s consumption possibilities Heckscher-Ohlin Model o shift of production towards commodity that uses intensively country’s abundant factor of production o real income of the abundant factor increases and the real income of scarce factor decrease o increase of country’s consumption possibilities Krugman Model o more firms and more varieties of goods o lower cost of production → lower price

11. 11 The “integrated” framework integrating HO-style and ”Krugman” style models o endowment-based comparative advantage + o horizontal product differentiation and increasing returns to scale allows for technology differences, factor price inequality, and trade costs Something of a current standard paradigm Helpman, Elhanan, and Paul Krugman (1985): Market Structure and Foreign Trade: Increasing Returns, Imperfect Competition and the International Economy. Cambridge, MA: MIT Press.

12. 12 Other Explanations of Intra-Industry Trade Transport costs in large countries (e.g. a buyer in Maine buys the Canadian rather than the Californian product) Dynamic economies of scale: product differentiation + learning-by-doing Problems with statistics o Aggregation: the categories are too wide (e.g. “beverages and tobacco”) o Different quality of goods inside a product category

13. 13 Imitation Lag Assume that it takes time for new technology to spread Imitation lag: the time between product’s introduction in country 1 and appearance of a version of that product produced in country 2 Demand lag: time between products appearance in country 1 and its acceptance in country 2 Net lag: imitation – demand lag → Trade focuses on new products

14. 14 The Product Cycle Theory The product cycle consists of three stages (new, maturing, standardized) 1. A new product is introduced in a rich country o High-income demands, labour-saving production technique o The firms operate only in the domestic markets and learn production techniques and consumer responses 2. Maturing product o Economies of scale start to realize o Demand in other rich countries starts to emerge o Part of the production may be shifted to these countries and they might even start exporting to the original country

15. 15 The Product Cycle Theory 3. Standardized product o Product is well know to consumers and producer o Production may shift to the developing counties time Production, consumption (in the developed country) exports imports new product stage maturing product stage standardized product stage Consumption 1 Production 1 Vernon (1966): International Investment And International Trade in the Product Cycle. Quarterly Journal of Economics 80(2).

16. 16 Gravity Models Focus to explain the volume of trade between countries Popular framework in empirical work: Typically the volume of exports and imports is modelled as a function of countries national incomes, distance and other observable characteristics such as population size and institutional dummies (e.g. free trade area)

17. 17 New Economic Geography Firms decide the location of production in the presence of o economies of scale → rationale for concentrating production, imperfect competition o transportation cost → rationale for decentralizing production Dynamic comparative advantage may be based on coincidence that has set off a cumulative process Trade may take place as a result of “arbitrary specialization based on increased returns” Policies may influence the beginning of such an cumulative process P. Krugman (1991): Geography and Trade. MIT Press.

18. 18 Models with Heterogeneous Firms Melitz (2003, Econometrica) model Extension of the “Krugman model” firms can enter an industry by paying a fixed entry cost, they then learn their productivity (profitability) and leave if this is too low There are fixed and variable costs also for exporting → only the most productive firms export reductions in barriers to trade → increase profits of exporters and reduce the export productivity cutoff → labor demand within the industry rises → increase in wages → profits of nonexporter decrease → less productive firms bankrupt A new source of gains from trade: Increase in productivity See Bernard, Jensen, Redding and Schott (2007): Firms in International Trade, Journal of Economic Perspectives, 21(3), 105–130