Transcript Principles of Macroeconomics

BA 187 – International Trade
Increasing Returns to Scale,
Imperfect Competition & Trade
1
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)
2
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
2. In autarky, nations produce & consume at point A.
3. If each nation specializes in one of the goods and then
trades to reach pt. E, both achieve higher utility.
QY
4. Pattern of trade is indeterminate, either nation
can specialize in either good.
E
UTrade
A
UAut
PPF
with IRS
QX
Good X
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Strategic Trade with IRS
Good Y
QY
E1
PPF
1. Assume PPF same for both nations & exhibits IRS.
2. Assume that international terms of trade given.
3. Pattern of trade is technologically indeterminate,
either nation can specialize in either good.
4. Nation is not indifferent between which good it
produces. Will want to specialize in Good Y, as
this results in highest utility.
5. Still mutual gains from trade but now strategic.
U1Trade
E2
U2Trade
QX
Good X
4
Older Approaches to Trade Patterns
Product Cycle and Linder Demand
Theories
5
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.
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The Product Cycle Model
Quantity
Stage I
Stage II
Stage III
Stage IV
Stage V
Consump.
Exports
Imports
Prod’n
Innovating
Country
Prod’n
Exports
Consump.
Imitating
Country
Imports
Time
7
Dates of Product Introduction &
Characteristics of Industry 1970-1979
Date of Product Introduction
Prior to
1930
19301949
19501954
19551959
19601964
19651969
After
1969
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
10.5
Industry Exports as
% of Industry sales
8.7
7.9
9.6
10.0
10.0
8.5
13.0
Industry Imports as
% of Industry sales
7.0
5.3
3.7
4.2
4.5
3.9
4.0
Characteristic
Real Market
Growth %
Source: Thorelli & Burnett, “The Nature of Product Life Cycle for Industrial Goods Business”
8
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.
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Per-Capita Income Demand Patterns
Food
Clothing
Rent &
Power
Medical
Care
Education
Transport &
Commun
Other
Consumer
U.S.
13%
6%
18%
14%
8%
14%
27%
Japan
16
6
17
10
8
9
34
Argentina
35
6
9
4
6
13
26
Korea
35
6
11
5
9
9
25
Thailand
30
16
7
5
5
13
24
Cote d’Ivoire
40
10
5
9
4
10
23
Pakistan
54
9
15
3
3
1
15
Zaire
55
10
11
3
1
6
14
High-Income
Upper
Middle Inc.
Lower
Middle Inc.
Low-Income
Source: World Bank, World Bank Development Report, 1990
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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”.
11
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.
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New Approaches to Trade I
IRS, Imperfect Competition and
Intra-Industry Trade
13
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.
14
SR Monopolistic Competition
1. Fixed Costs generate IRS for each firm.
Cost, C and
Price, P
2. In SR number of firms fixed, each with
produces differentiated product.
3. Each sets MR=MC to determine output level.
4. In SR all firms earn positive economic profits.
Implies will have entry into industry.
P
ProfitSR
AC
AC
MC
MRSR
QMCSR
DSR
Quantity, Q
15
LR Monopolistic Competition
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.
3. In LR equilibrium, each firm earns zero economic
profits. More firms & more types of goods.
P=AC
AC
MC
MRSR
DSR
DLR
MRLR
QMCLR
Quantity, Q
16
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
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The Krugman Model - Diagram
1. Fixed Costs imply upwardsloping CC Curve.
Cost, C and
Price, P
2. Monopolistic competition implies
downward-sloping PP Curve.
CC
3. With n1 in industry, each firm
makes +ve profits, entry occurs.
AC2
P1
4. With n2 in industry, each firm
makes -ve profits, exit occurs.
5. Only at n* firms in the industry
does each firm make zero profits,
no entry or exit occurs.
P* =AC
AC1
P2
PP
n1
n*
n2
Number of Firms, n
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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
2. More firms in market after
trade, i.e. greater variety of goods.
P0 =AC0
3. In addition, lower AC and so
Price for goods after trade.
P1 =AC1
PP
n0
n1
Number of Firms, n
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Intra-Industry Trade
U.S. Imports/Exports of Auto Parts, Engines, & Bodies
(Millions of $)
Total
(All Areas)
EEC
All W.
Europe
Canada
Latin
America
U.K.
Japan
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
207
528
1979
6,965
211
1,059
1,337
3,749
569
1,084
1965
867
18
32
71
622
116
4
1970
2,237
32
74
149
1,602
275
17
1975
4,993
56
160
314
3,521
648
35
1979
8,446
165
376
667
5,317
1,530
53
Year
Imports
Exports
Source: R.B. Cohen, Trade Policy in the 1980’s, IIE
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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.
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New Approaches to Trade II
Price-Discriminating Monopolists
and Dumping
22
Monopoly and “Dumping”
1. Domestic Monopolist produces at MR=MC, (P0, Q0).
Cost, C and
Price, P
2. Assume can export output as price-taker at Pint =MRInt
3. Monopolist will equate MR across markets to allocate
total output so as to maximize profits.
4. Result is that PHome higher than PInt, i.e. firm is
“unfairly” dumping output in foreign market.
PHome
P0
MC
PInt
DInt = MRInt
DHome
MRHome
Q0
QHome
Quantity, Q
QExports
Total Q
23
Price Discriminating Monopolist
1. Assume Price-discriminating Monopolist with constant MC across markets.
2. Will determine price/quantity in each market as MC =MR1 = MR2.
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
P1
P2
MC
MC
D2
D1
MR2
MR1
Q1
Quantity, Q
Q2
Quantity, Q
24
New Approaches to Trade III
External Economies of Scale and
Trade
25
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.
26
External Economies & Specialization
1. Strong External Economies tend to reinforce
existing patterns of IIT regardless of initial source.
2. Developed Country (DC) initial producer of Good
at Q0 and Pw = ACDC.
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).
Cost, C and
Price, P
C0
PW
ACDC
ACLDC
DWorld
Q0
Quantity, Q
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Infant Industry Argument
1. LDC may try to protect its industry from ROW
exports to gain scale effects in prod’n.
2. Prohibitive tariff or quota closes LDC market. LDC
producers face DLDC , produce to meet demand.
3. Domestic producers reach ACLDC = PLDC < Pw. Can
now undersell DC producers on world market.
Cost, C and
Price, P
C0
PW
PLDC
ACDC
ACLDC
DWorld
DLDC
Q0
Quantity, Q
28
Dynamic Scale Economies
1. Strong Dynamic Learning effects reinforce
existing patterns of IIT.
2. Learning Curves, LC, reflect cost saving
from cumulative output learning effects.
3. Again, if DC is first in industry, cost savings
from learning will dominate lower LCLDC.
Cost, C and
Price, P
C0
PW
LCDC
LCLDC
DWorld
Q0
Quantity, Q
29
Summary of Scale Effects
on Trade Patterns
30
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 increasingly less
important.
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