1. 1 BA 187 – International Trade Increasing Returns to Scale, Imperfect Competition & Trade

2. 2 Economies of Scale & Market Structure F Increasing Returns to Scale (IRS) F Increasing Returns to Scale (IRS) means that equal proportionate increase in inputs to production results in a more than equal proportionate change in output. cost per unit for output falls as output rises –This implies cost per unit for output falls as output rises. F Two ways for this to occur: F External Economies to Scale –When cost per unit for output depends on size of the industry but not on the size of any one firm. (Think knowledge spillovers.) –Typically results in industry of many small firms acting as perfect competitors. (Think Silicon Valley, Multi-media Gulch, etc.) F Internal Economies of Scale –When cost per unit for output depends on the size of the individual firm but not necessarily on the size of the industry. (Think Natural Monopoly) –Typically results in advantage to few, large firms acting in imperfectly competitive manner. (Think Regulated Utilities, Microsoft, etc)

3. 3 PPF & Gains to Trade with RS Good Y PPF with IRS Good X A U Aut 2. In autarky, nations produce & consume at point A. 1. Assume PPF same for both nations & exhibits Increasing Returns to Scale. This means PPF is bowed inward towards origin. QYQY QXQX E U Trade 3. If each nation specializes in one of the goods and then trades to reach pt. E, both achieve higher utility. 4. Pattern of trade is indeterminate, either nation can specialize in either good.

4. 4 Strategic Trade with IRS Good Y PPF Good X 1. Assume PPF same for both nations & exhibits IRS. 2. Assume that international terms of trade given. QYQY QXQX 3. Pattern of trade is technologically indeterminate, either nation can specialize in either good. E1E1 U 1 Trade 4. Nation is not indifferent between which good it produces. Will want to specialize in Good Y, as this results in highest utility. E2E2 5. Still mutual gains from trade but now strategic. U 2 Trade

5. 5 Older Approaches to Trade Patterns Product Cycle and Linder Demand Theories

6. 6 Product Cycle Models temporary F Based on presumption that introduction of new product conveys temporary monopoly in market. –New product requires highly skilled labor to produce –As product matures, it becomes standardized or can be imitated. –Comparative advantage shifts from innovating nation to nations with cheap labor. F Technological Gap model F Technological Gap model emphasizes time lag in imitation. Product Cycle model F Product Cycle model emphasizes standardization process. Stage I: New Product Phase – Produced/consumed in innovating country only. Stage II: Product Growth Phase – Rising demand at home & abroad leads to exports from innovating country. Stage III: Product Maturity Phase – Product standardized, prod’n licensed to others. Stage IV: Imitation I Phase – Imitating country undersells originator in ROW. Stage V: Imitation II Phase – Imitating country undersells in originator’s market.

7. 7 The Product Cycle Model Consump. Innovating Country Prod’n Consump. Prod’n Imitating Country Stage IStage IVStage IIIStage VStage II Quantity Time Exports Imports Exports

8. 8 Dates of Product Introduction & Characteristics of Industry 1970-1979 Characteristic Prior to 1930 1930- 1949 1950- 1954 1955- 1959 1960- 1964 1965- 1969 After 1969 Real Market Growth % 0.5%3.0%5.0%6.9%7.7%10.8%18.1% R&D Expenses as % of Revenue 1.32.23.22.63.84.35.4 Marketing Expenses as % of Revenue 6.87.48.57.99.410.5 Industry Exports as % of Industry sales 8.77.99.610.0 8.513.0 Industry Imports as % of Industry sales 7.05.33.74.24.53.94.0 Source: Thorelli & Burnett, “The Nature of Product Life Cycle for Industrial Goods Business” Date of Product Introduction

9. 9 Linder Demand Theory F Linder Theory focuses on role of demand, rather than supply, on trade patterns. –Assumes consumers’ tastes depend on their income levels. –A nation’s income level yields pattern of demand for goods. –The nation’s produce types of goods demanded within country, hence nation’s production reflects its income level. overlapping demand F Trade between countries occurs in goods for which there is overlapping demand, i.e. consumers in both countries have a demand for these particular items. –Implies that trade in certain goods should be more intense between countries with similar per capita income than between countries with dissimilar per capita incomes. –Consistent with product cycle model. –Consistent with empirical evidence generally & for manufactures in particular.

10. 10 Per-Capita Income Demand Patterns FoodClothing Rent & Power Medical CareEducation Transport & Commun Other Consumer High-Income U.S. 13%6%18%14%8%14%27% Japan 16617108934 Upper Middle Inc. Argentina 3569461326 Korea 3561159925 Lower Middle Inc. Thailand 30167551324 Cote d’Ivoire 4010594 23 Low-Income Pakistan 54915331 Zaire 55101131614 Source: World Bank, World Bank Development Report, 1990

11. 11 Linder & Intra-Industry Trade F Linder theory does not identify the direction in which any good flows. –In fact, a good might be traded in both directions. –This was not possible in previous models. F Intra-Industry trade F Intra-Industry trade: –Occurs when country imports and exports items in the same product classification. –Linder predicts this trade should be greatest between countries with similar per capita income levels. –Why Intra-industry trade? u Product DifferentiationIRS u Product Differentiation plus IRS can lead to each country specializing in particular variants for the joint “mass market”.

12. 12 Intra-Industry Trade F Index of Intra-Industry Trade I IIT = 1 – |X-M|/(X+M) –No IIT then I IIT = 0, All IIT then I IIT = 1.0 F Why Intra-Industry Trade in an Industry? –Product Differentiation. –Transport Costs and Geographical Location. –Dynamic Economies of Scale (2+ versions of product). –Mismeasurement due to degree of product aggregation. –Differing Income Distributions within Countries.

13. 13 New Approaches to Trade I IRS, Imperfect Competition and Intra-Industry Trade

14. 14 Imperfect Competition F Pure Monopoly F Pure Monopoly: –Firm faces no competition, faces downward-sloping Demand Curve. –Maximizes profit by setting Quantity to ensure: Marginal Revenue = MR = MC = Marginal Cost F Monopolistic Competition F Monopolistic Competition: –A-1: –A-1: Each firm differentiates its product from that of rival firms. –A-2: –A-2: Each firm takes rivals’ prices as given in setting own price. –Result: –Result: Each firm acts like a monopolist in pricing (MR = MC), even though each faces competition from many rivals. oligopoly –Special case of oligopoly: interdependent u Market structures where firms have interdependent pricing decisions. collusive –Ignoring opportunities for collusive behavior between firms. strategic –Also ignoring opportunities for strategic behavior between firms.

15. 15 P Q MC SR AC SR Monopolistic Competition MC Cost, C and Price, P Quantity, Q AC D SR 2. In SR number of firms fixed, each with produces differentiated product. 1. Fixed Costs generate IRS for each firm. MR SR 3. Each sets MR=MC to determine output level. Profit SR 4. In SR all firms earn positive economic profits. Implies will have entry into industry.

16. 16 LR Monopolistic Competition MC Cost, C and Price, P Quantity, Q AC Q MC LR P=AC 3. In LR equilibrium, each firm earns zero economic profits. More firms & more types of goods. 2. Entry continues until pushes D LR tangent to AC. D LR MR LR D SR MR SR 1. Entry by new firms pushes down Demand Curve for each firm to D LR.

17. 17 The Krugman Model - Details F IRS at firm level due to fixed costs. C = F + cQAC = F/Q + c u Firm-level costs: C = F + cQ or AC = F/Q + c F Firms produce differentiated goods with market structure that of monopolistic competition. Q = S[1/n – b(P-P bar )] u Firm-level Demand: Q = S[1/n – b(P-P bar )] u Where S = Industry sales, P bar = Competitor’s Price, n = #firms. F Industry-level costs (CC Curve): –AC = F/Q + c = F/(S/n) + c = n x F/S + c –More firms in the industry, the higher is the average cost. F Industry-level Price (PP Curve): MR = P – Q/(S x b) = cP = c + 1/(b x n) –Set MR = P – Q/(S x b) = c or P = c + 1/(b x n) –More firms in the industry, the lower the price each firm charges. F Equilibrium: –CC and PP Curves intersect at zero-profit # of firms in industry

18. 18 The Krugman Model - Diagram Cost, C and Price, P Number of Firms, n CC 1. Fixed Costs imply upward- sloping CC Curve. PP 2. Monopolistic competition implies downward-sloping PP Curve. n1n1 P1P1 AC 1 3. With n 1 in industry, each firm makes +ve profits, entry occurs. AC 2 P2P2 n2n2 4. With n 2 in industry, each firm makes -ve profits, exit occurs. P* =AC n* 5. Only at n* firms in the industry does each firm make zero profits, no entry or exit occurs.

19. 19 Trade & the Krugman Model PP Cost, C and Price, P Number of Firms, n CC P 0 =AC 0 n 0 1. Introduction of trade increases size of market. Result is lower CC Curve for any given level of n. CC Trade n1n1 2. More firms in market after trade, i.e. greater variety of goods. P 1 =AC 1 3. In addition, lower AC and so Price for goods after trade.

20. 20 Intra-Industry Trade Year Total (All Areas) U.K.EEC All W. Europe Canada Latin America Japan Imports 196519318507211317 19701,464391592071,08019152 19753,235733254332,033207528 19796,9652111,0591,3373,7495691,084 Exports 19658671832716221164 19702,23732741491,60227517 19754,993561603143,52164835 19798,4461653766675,3171,53053 U.S. Imports/Exports of Auto Parts, Engines, & Bodies (Millions of $) Source: R.B. Cohen, Trade Policy in the 1980’s, IIE

21. 21 Product Differentiation & Trade F With IRS technologies, trade & gains from trade can arise even if both economies identical. (Non-comparative advantage trade) F Several sources for gains from trade. Expansion of IRS sector leads to pro-competitive gains: profit effect and decreasing average cost effect. F Gains from trade may be captured as increased product diversity or lower average costs or both. Krugman model is example of where both occur together. F Trade based on scale economies may drive factor prices farther apart in the two countries. Also make it more likely, however, that all factors gain from trade.

22. 22 New Approaches to Trade II Price-Discriminating Monopolists and Dumping

23. 23 Monopoly and “Dumping” Cost, C and Price, P Quantity, Q MR Home MC D Home P0P0 Q0Q0 1. Domestic Monopolist produces at MR=MC, (P 0, Q 0 ). D Int = MR Int P Int 2. Assume can export output as price-taker at P int =MR Int Q Exports Q Home Total Q 3. Monopolist will equate MR across markets to allocate total output so as to maximize profits. P Home 4. Result is that P Home higher than P Int, i.e. firm is “unfairly” dumping output in foreign market.

24. 24 Price Discriminating Monopolist Cost, C and Price, P Quantity, Q MC Quantity, Q MC Market 1 Market 2 Cost, C and Price, P 1. Assume Price-discriminating Monopolist with constant MC across markets. MR 1 D1D1 MR 2 D2D2 Q2Q2 Q1Q1 2. Will determine price/quantity in each market as MC =MR 1 = MR 2. P1P1 P2P2 3. Result will be different prices in each market depending on demand conditions.

25. 25 New Approaches to Trade III External Economies of Scale and Trade

26. 26 Sources of External Economies F External Economies to Scale occur at the level of the industry, rather than the individual firm. F Sources of External Economies –Clustering of Specialized Suppliers. u Localized industrial cluster of firms collectively create market large enough to support specialized equipment or support. –Pool for Specialized Labor. u Localized industrial cluster collectively create & support market for specialized labor. Benefits both labor & firms. –Knowledge Spillovers. u Localized industrial cluster of firms create informal exchange of ideas and knowledge for innovation.

27. 27 External Economies & Specialization D World Cost, C and Price, P Quantity, Q 1. Strong External Economies tend to reinforce existing patterns of IIT regardless of initial source. AC DC PWPW Q 0 2. Developed Country (DC) initial producer of Good at Q 0 and P w = AC DC. C0C0 AC LDC 3. Less Developed Country (LDC) tries to enter with lower AC Curve. Unable to because cannot compete when denied scale effects of prod’n (Cost = C 0 > P w ).

28. 28 Infant Industry Argument D World Cost, C and Price, P Quantity, Q AC DC 1. LDC may try to protect its industry from ROW exports to gain scale effects in prod’n. PWPW C0C0 AC LDC Q 0 D LDC 2. Prohibitive tariff or quota closes LDC market. LDC producers face D LDC, produce to meet demand. P LDC 3. Domestic producers reach AC LDC = P LDC < P w. Can now undersell DC producers on world market.

29. 29 Dynamic Scale Economies D World Cost, C and Price, P Quantity, Q 1. Strong Dynamic Learning effects reinforce existing patterns of IIT. LC DC PWPW Q 0 2. Learning Curves, LC, reflect cost saving from cumulative output learning effects. C0C0 LC LDC 3. Again, if DC is first in industry, cost savings from learning will dominate lower LC LDC.

30. 30 Summary of Scale Effects on Trade Patterns

31. 31 Empirical Summary of IRS Models F Gains from IRS occur in addition to gains from comparative advantage. Theories are thus complementary to Standard Trade model results. F Pattern of specialization, and thus trade patterns, inherently arbitrary. Possibly dependent on historical factors, open to strategic interventions (first mover advantage) to capture highest welfare effects. F IRS models offer more possibilities for gains from trade. F Empirical evidence indicates IRS important determinant of trade flows for countries size of Canada or Western European nations. Primarily rationalization of manufacturing. F Increased mobility of factors of prod’n (mostly capital) suggests comparative advantage models increasingly less important.