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

2. Economies of Scale & Market Structure
Increasing Returns to Scale (IRS) means that equal proportionate increase in inputs to production results in a more than equal proportionate change in output.
This implies cost per unit for output falls as output rises.
Two ways for this to occur:
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.)
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. PPF & Gains to Trade with RS
1. Assume PPF same for both nations & exhibits Increasing
Returns to Scale. This means PPF is bowed inward towards origin.
Good Y A
UAut
2. In autarky, nations produce & consume at point A. QY QX E
UTrade
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.
PPF
with IRS
Good X

4. Strategic Trade with IRS
1. Assume PPF same for both nations & exhibits IRS.
Good Y
2. Assume that international terms of trade given.
3. Pattern of trade is technologically indeterminate,
either nation can specialize in either good. QY E1
U1Trade
4. Nation is not indifferent between which good it
produces. Will want to specialize in Good Y, as
this results in highest utility. E2
5. Still mutual gains from trade but now strategic.
U2Trade
PPF QX
Good X

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

6. Product Cycle Models
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.
Technological Gap model emphasizes time lag in imitation.
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. The Product Cycle Model
Quantity
Stage I
Stage II
Stage III
Stage IV
Stage V
Consump.
Innovating
Country
Prod’n
Imports
Exports
Exports
Imports
Consump.
Prod’n
Imitating
Country
Time

8. Dates of Product Introduction & Characteristics of Industry 1970-1979
Date of Product Introduction
Characteristic
Prior to 1930
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
1.3
2.2
3.2
2.6
3.8
4.3
5.4
Marketing Expenses as % of Revenue
6.8
7.4
8.5
7.9
9.4
10.5
Industry Exports as % of Industry sales
8.7
9.6
10.0
13.0
Industry Imports as % of Industry sales
7.0
5.3
3.7
4.2
4.5
3.9
4.0
Source: Thorelli & Burnett, “The Nature of Product Life Cycle for Industrial Goods Business”

9. Linder Demand Theory
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.
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. Per-Capita Income Demand Patterns
Food
Clothing
Rent & Power
Medical Care
Education
Transport & Commun
Other Consumer
High-Income
U.S.
13% 6%
18%
14% 8%
27%
Japan 16 6 17 10 8 9 34
Upper Middle Inc.
Argentina 35 4 13 26
Korea 11 5 25
Lower Middle Inc.
Thailand 30 7 24
Cote d’Ivoire 40 23
Low-Income
Pakistan 54 15 3 1
Zaire 55 14
Source: World Bank, World Bank Development Report, 1990

11. Linder & Intra-Industry Trade
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.
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?
Product Differentiation plus IRS can lead to each country specializing in particular variants for the joint “mass market”.

12. Intra-Industry Trade Index of Intra-Industry Trade
IIIT = 1 – |X-M|/(X+M)
No IIT then IIIT = 0, All IIT then IIIT = 1.0
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. U.S. Imports/Exports of Auto Parts, Engines, & Bodies
Intra-Industry Trade
U.S. Imports/Exports of Auto Parts, Engines, & Bodies
(Millions of $)
Year
Total (All Areas)
U.K.
EEC
All W. Europe
Canada
Latin America
Japan
Imports
1965
193 18 50 72
113 1 7
1970
1,464 39
159
207
1,080 19
152
1975
3,235 73
325
433
2,033
528
1979
6,965
211
1,059
1,337
3,749
569
1,084
Exports
867 32 71
622
116 4
2,237 74
149
1,602
275 17
4,993 56
160
314
3,521
648 35
8,446
165
376
667
5,317
1,530 53
Source: R.B. Cohen, Trade Policy in the 1980’s, IIE

14. Types of Industry Structure – A Review
Perfect Competition, Monopoly, and Monopolistic Competition

15. “Price-taker” Markets
Perfect Competition
“Price-taker” Markets

16. Price Takers & Perfect Competition
General Condition for Maximizing Profits
Choose level of output so that Marginal Revenue = Marginal Cost
Price-Takers:
Firms that take market price as given when selling their product. Each is small relative to market, cannot affect price.
Purely Competitive (or Price-taker) Markets
Markets characterized by large number of small firms producing identical products in industry with complete freedom or entry/exit.
Price-Taker Behavior to Maximize Profits
Marginal Revenue of each unit of output sold = Market Price.
Price-taking firm sets output so Marginal Cost of last unit of output produced equals market price.
In LR equilibrium, firms earn zero economic profits as entry or exit occurs.

17. SR Equilibrium: Price-Taker Market
Price, p
MC = SR Supply above PMin
ATC
AVC p1 q1
SR Profits
pLR = MRLR
SR Losses p2 q2
pmin
Quantity, q

18. Perfect Competition & Supply Curves
SR Supply for Individual Firm = Marginal Cost curve above AVC.
SR Supply for Market = horizontal sum of all the marginal cost curves of firms in the industry.
LR Supply for Market: shows minimum price that firms will supply any level of market output, given sufficient time to adjust all factors of production & allow for any entry/exit from the industry.
Economies of Scale determine Shape of LR Supply
Constant Returns to Scale (i.e. Constant cost) industry will have horizontal LR Supply Curve.
Increasing Returns to Scale (i.e. Declining cost) industry will have downward-sloping LR Supply Curve.
Decreasing Returns to Scale (i.e. Increasing cost) industry will have upward-sloping LR Supply Curve.
LR Supply Curve is more elastic than SR Supply Curve
One or more factors fixed in SR, limits supply response to any change in demand. More flexibility in LR to adjust.

19. Monopolistic Competition
“Price-searcher” Markets with Low Barriers to Entry

20. Price Searcher Markets with Low Entry Barriers
Competitive Price-Searcher Markets (Monopolistic Competition)
Each firm faces a downward-sloping demand curve for their output.
Firms produce differentiated products. Output of other firms close substitutes, so individual firm’s demand curve is highly elastic.
Low entry barriers allow entry or exit of firms if existing firms earn non-zero economic profits. Each firm faces competition from existing firms in industry & potential new entrants.
Profit-maximizing Behavior for a Firm in Price Searcher Market
Set output level so that Marginal Cost equal to Marginal Revenue.
Marginal Revenue is related to shape of the firm’s Demand Curve.
Intuition for two factors at work to sell additional unit of output.
(+) In the long run, competition along with free entry and exit will drive prices down to level of average costs.
(-) LR equilibrium is not efficient, however, because firms produce less than the minimum ATC level of output.

21. SR Monopolistic Competition
1. Each firm has set of cost curves
Price, p
Demand
MR, Marginal Revenue
2. Each firm has demand curve for
its own product. Also has MR. MC
pMC
qMC
3. Each firm sets output so that
MR =MC to max. profits
SR Profits
4. In SR, firms may have
positive or negative profits.
ATC
Quantity, q

22. LR Monopolistic Competition
1. In SR, firm has positive profits.
DSR
MRSR
Price, p
2. New firms enter. Lowers each
firm’s demand & MR curves.
DLR
MRLR MC
pLR
qLR
3. In LR, zero economic profits at
profit max. MR = MC
ATC
Quantity, q

23. Markets with Low Entry Barriers
Competition is an important disciplinary force in a price-searcher market where barriers to entry are low.
Competition places pressure on producers to operate efficiently and cater to preferences of customers.
Competition provides firms with strong incentive to develop improved products and discover lower-cost production methods. (entrepreneurs & innovation)
Competition causes firms to discover the type of business structure and size that best keep per unit costs of production low.

24. “Price-searcher” Markets with High Barriers to Entry
Monopoly
“Price-searcher” Markets with High Barriers to Entry

25. Price Searcher Markets with High Entry Barriers
Monopoly is a market characterized by:
Single seller of a well-defined product with no good substitutes.
High barriers to entry of any other firms into market for the product.
Oligopoly is a market characterized by:
Small number of rival firms in industry.
Interdependence among sellers as each is large relative to market.
Substantial economies of scale in production of the good.
High barriers to entry firms into market.
Profit-maximizing Behavior for a Monopolist
Sets output level so that Marginal Cost = Marginal Revenue.
Marginal Revenue is related to shape of the Demand Curve. Intuition for two factors at work to sell additional unit of output.

26. Profit-Maximizing Monopolist
MC = Supply
Cost, C and
Price, p
MR Curve
Demand
qMonop
pMonop
qComp
pComp
Quantity, q

27. Oligopoly Oligopolists have a strong incentive to collude;
By colluding, i.e. acting as a cartel, oligopolists can coordinate supply decisions to maximize the joint profits of all the firms. Cartel seeks to create a monopoly in market.
Obstacles to collusion among oligopolistic firms;
Incentive for any firm to cheat on cartel agreement to increase its profits. Obstacles to success of collusion:
Increase in number of firms making up oligolpoly.
If price cuts by individual firms difficult to detect & prevent.
Low barriers to entry. Successful collusion induces new entrants.
Unstable demand conditions lower likelihood collusion successful.
Vigorous antitrust actions increase cost of collusion.

28. Problems with Natural Monopoly
Cost, C and
Price, p
Demand MR
qMonop
pMonop
pReg
qReg
ATC MC
Quantity, p

29. New Approaches to Trade I
Price-Discriminating Monopolists and Dumping

30. Monopoly and “Dumping”
Cost, C and
Price, P P0 Q0
1. Domestic Monopolist produces at MR=MC, (P0, Q0).
DInt = MRInt
PInt
2. Assume can export output as price-taker at Pint =MRInt
QExports
QHome
Total Q
3. Monopolist will equate MR across markets to allocate
total output so as to maximize profits.
PHome
4. Result is that PHome higher than PInt, i.e. firm is
“unfairly” dumping output in foreign market. MC
DHome
MRHome
Quantity, Q

31. Price Discriminating Monopolist
1. Assume Price-discriminating Monopolist with constant MC across markets.
MR1 D1
MR2 D2 Q2 Q1
2. Will determine price/quantity in each market as MC =MR1 = MR2. P1 P2
3. Result will be different prices in each market depending on demand conditions.
Cost, C and
Price, P
Cost, C and
Price, P
Market 1
Market 2 MC MC
Quantity, Q
Quantity, Q

32. New Approaches to Trade II
External Economies of Scale and Trade

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

34. External Economies & Specialization
Cost, C and
Price, P
1. Strong External Economies tend to reinforce
existing patterns of IIT regardless of initial source.
ACDC PW Q0
2. Developed Country (DC) initial producer of Good
at Q0 and Pw = ACDC. C0
ACLDC
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 = C0 > Pw).
DWorld
Quantity, Q

35. Infant Industry Argument
Cost, C and
Price, P
1. LDC may try to protect its industry from ROW
exports to gain scale effects in prod’n.
DLDC
2. Prohibitive tariff or quota closes LDC market. LDC
producers face DLDC , produce to meet demand.
PLDC
3. Domestic producers reach ACLDC = PLDC < Pw. Can
now undersell DC producers on world market. C0 PW
ACDC
ACLDC
DWorld Q0
Quantity, Q

36. Dynamic Scale Economies
Cost, C and
Price, P
1. Strong Dynamic Learning effects reinforce
existing patterns of IIT.
LCDC PW Q0
2. Learning Curves, LC, reflect cost saving
from cumulative output learning effects. C0
LCLDC
3. Again, if DC is first in industry, cost savings
from learning will dominate lower LCLDC.
DWorld
Quantity, Q

37. New Approaches to Trade III
IRS, Imperfect Competition and Intra-Industry Trade

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

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

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

41. The Krugman Model - Details
IRS at firm level due to fixed costs.
Firm-level costs: C = F + cQ or AC = F/Q + c
Firms produce differentiated goods with market structure that of monopolistic competition.
Firm-level Demand: Q = S[1/n – b(P-Pbar)]
Where S = Industry sales, Pbar= Competitor’s Price, n = #firms.
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.
Industry-level Price (PP Curve):
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.
Equilibrium:
CC and PP Curves intersect at zero-profit # of firms in industry

42. The Krugman Model - Diagram
Cost, C and
Price, P CC
1. Fixed Costs imply upward-
sloping CC Curve. PP
2. Monopolistic competition implies
downward-sloping PP Curve.
AC2 P2 n2
4. With n2 in industry, each firm
makes -ve profits, exit occurs. n1 P1
AC1
3. With n1 in industry, each firm
makes +ve profits, entry occurs.
P* =AC n*
5. Only at n* firms in the industry
does each firm make zero profits,
no entry or exit occurs.
Number of Firms, n

43. Trade & the Krugman Model
Cost, C and
Price, P CC
1. Introduction of trade increases size of market. Result is lower CC Curve for any given level of n.
CCTrade n1
2. More firms in market after trade, i.e. greater variety of goods.
P0 =AC0
P1 =AC1
3. In addition, lower AC and so Price for goods after trade. PP n0
Number of Firms, n

44. Product Differentiation & Trade
With IRS technologies, trade & gains from trade can arise even if both economies identical. (Non-comparative advantage trade)
Several sources for gains from trade. Expansion of IRS sector leads to pro-competitive gains: profit effect and decreasing average cost effect.
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.
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.

45. Summary of Scale Effects on Trade Patterns

46. Empirical Summary of IRS Models
Gains from IRS occur in addition to gains from comparative advantage. Theories are thus complementary to Standard Trade model results.
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.
IRS models offer more possibilities for gains from trade.
Empirical evidence indicates IRS important determinant of trade flows for countries size of Canada or Western European nations. Primarily rationalization of manufacturing.
Increased mobility of factors of prod’n (mostly capital) suggests comparative advantage models may become increasingly less important.