1. 1 ECONOMICS 3150M Winter 2014 Professor Lazar Office: N205J, Schulich flazar@yorku.ca 736-5068

2. 2 Lectures 18: March 19 Ch. 6, 7, 8

3. 3 Internal Economies of Scale Small country-large country model Assumptions: –Two countries: A (small country); B (large country) –Two factors of production –Two products –Same tastes –Same production technologies –Same relative availabilities –Y1: internal economies of scale –Y2: constant returns to scale

4. 4 Internal Economies of Scale Internal economies of scale for Y1  imperfect competition –P1 > AC1 =  1 No assurance that {P1/P2} A > {P1/P2} B –Monopolist: may produce Y1 in both A and B, but not necessarily with same technologies  different degrees of economies of scale Competitive advantage  How was monopoly position obtained? –Oligopoly: possible that more than one firm will produce Y1 in the large country because economies of scale may be exploited at well below market demand level (MES < D) P/AC may be lower than in case of monopoly  depends on degree of rivalry Smaller number of oligopolists in small country, thus P/AC margin may be greater than in large country Competitive advantage  How did oligopolists arise?

5. 5 Oligopolistic Interdependence Prisoners’ dilemma – with no product differentiation: –With product differentiation and economies of scope and scale –Learning curves A/BB: No exportsB: Exports A: No exports $600, $600$400, $700 A: Exports $700, $400$500, $500

6. 6 Monopolistic Competition Model Large number of competitors (large undefined) producing different, yet similar products (product differentiation) Problems: –Competitive advantage and creation and introduction of different varieties of product – why does one firm produce a particular brand/variety? –Defining industry boundaries –Stability – tendency for consolidation if there is value in brand names – imperfect information and brand names as signal for quality –First mover advantages – distribution channels, brand name reputation, market pre-emption Linear model Circular model –Full price to consumers of variety j: Pj + disutility of variety j differing from desired variety {t[abs(Zj – Z*)]}

7. 7 Monopolistic Competition Model Entry/exit process in circular model –Pre-emption –Fighting brands –Distribution channels – economies of scale, transactions costs If Y1 characterized by monopolistic competition and Y2 is homogeneous product with constant returns to scale –Intra-industry trade –Inter-industry trade based on comparative advantage –Trade will lead to lower prices, lower unit costs and more varieties  gains from trade greater than in standard trade model with constant returns to scale

8. 8 Monopolistic Competition Model Standard m.c. model –Equilibrium: no. of firms, economies of scale, production point relative to MES –No. of firms and no. of varieties –Who created first variety? Competitive advantage Effects of entry  resulting from increase in D –P, output, production efficiency, profits, no. of firms and varieties In industries with economies of scale, variety of goods and scale of production constrained by size of country’s market

9. 9 Monopolistic Competition Model Extension of H-O model with internal economies of scale and monopolistic competition –Assumptions: Two countries Two products: Y1– heterogeneous product subject to economies of scale; Y2 – homogeneous product with constant returns to scale Two factors of production Y1 uses X1 relatively more intensively A has relative abundance of X1 Outcomes: –A: net exporter of Y1, net importer of Y2 –Both intra-industry (Y1) and inter-industry trade (Y1, Y2) B will produce and export some varieties of Y1, but be a net importer

10. 10 Monopolistic Competition Model Outcomes (cont’d): –No income distribution effects from intra-industry trade –Pattern of intra-industry trade cannot be predicted A will produce more varieties, but cannot predict which ones Adjustment costs as some producers of Y1 disappear in both countries –Least cost competitive: what determines who is least cost competitive? Relative importance of intra and inter-industry trade depends on how similar are the two countries – the more similar the more important intra-industry trade If B larger country, no differences in relative availabilities of factors of production and no differences if factor intensity of production –B: net exporter of Y1 – more firms and varieties pre-trade

11. 11 Monopolistic Competition Model Trade results from economies of scale and multiple varieties of product –Trade expands size of market  each country can specialize in narrow range of products/varieties Gains from trade: lower per unit costs and prices (increased production per firm); less excess capacity; more varieties thus wider range of choices –More firms serving combined markets, more output per firm  closer to most efficient scale of production, less excess capacity Internal economies of scale and comparative advantage –What country produces what varieties? –Intra-industry trade

12. 12 Brand Names Imperfect information Re. product quality/safety: lemons model – consumers believe all suppliers produce lowest quality and so bad drive out good suppliers Re. risks: adverse selection (insurance markets) – only bad risks buy insurance, good risks squeezed out (experience rating); credit crunch because of inability to quantify credit risks (credit risks improperly priced); magnitude of liabilities stemming from terrorist attack (following 9-11, insurance companies tried to terminate insurance for terrorist attacks) Re. quality, motivation of workers: statistical discrimination (do not hire from among certain groups of job applicants)

13. 13 Brand Names Brand names a signal for quality – quality difficult to measure without repeated use of product; brand name developed over time provides some assurance to consumers about quality of product Developing a brand name Consumers willing to pay price premium for established brand name products –Travel abroad, willing to purchase brands recognized from home (hotels, consumer goods, financial institutions, entertainment) –Example of products from China

14. 14 Brand Names –Value of brand name – Apple, Armani, BMW, Canali, Coach, Coca Cola, Disney, Ferrari, Goldman Sachs, GE, Google, Harvard, H&M, IBM, Ikea, McKinsey, Mercedes, Miele, Nike, Prada, Starbucks, Tata, Toyota, Trump, Virgin Group, Wynn, Samsung, etc. –Transferable to other markets? – geographic, product

15. 15 Intra-Industry Trade 25% of world trade –Most significant in “sophisticated” manufactured products (machinery, chemicals, pharmaceuticals, telecommunications equipment, autos, aerospace) and trade among industrialized countries Intra-industry trade often takes the form of production of specialized, skill or technology- intensive components in one country and assembly in another country –Apple develops a technology – manufactured by an EMS company, then sold by Apple

16. 16 Intra-Industry Trade Competitive advantage and introduction of new product/variety –Caters to domestic demand (tastes, income levels) –Uses familiar technology –PLC: growth in domestic demand  entry; expansion of demand in other markets –Small size initially of foreign markets  with economies of scale, supply foreign markets from domestic plants –Growth in foreign markets  expansion of production, creation of subsidiaries as consolidation reduces number of competitors –Companies with foreign subsidiaries will transfer production more quickly

17. 17 Mobility of Labor H-O model –2 factors of production: skilled and unskilled labor (LS, LU) –A has relative abundance of LS  {WS/WU} A < {WS/WU} B –Y1 uses LS more intensively LU: incentive to migrate from B to A and/or LS: incentive to migrate from A to B –Depends upon absolute wage rates (expressed in same currency) in addition to relative wage rates and mobility costs –Migration, if it occurs, will continue until {LS/LU} A = {LS/LU} B {WS/WU} A = {WS/WU} B {[WS*E]/P} A = {WS/P} B and {[WU*E]/P} A = {WU/P} B Migration eliminates basis for trade Income distribution effects Wage differentials persist in Canada, US, EU despite labor mobility

18. 18 Mobility of Labor Mobility costs: –Transportation costs –Relocation costs – family, language, religion, culture Migration instead of trade: gains from migration similar to gains from trade –US-Mexico –Politics –Economic consequences – wage rates of unskilled workers Canadian immigration policy favors skilled immigrants –Emigration of skilled labor reduces relative wage rates of unskilled workers  lower productivity for unskilled workers; underdevelopment