BA 187 International Trade

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BA 187 International Trade

• Increasing Returns to Scale, Imperfect
  Competition Trade

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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)

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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
4. Pattern of trade is indeterminate, either
nation can specialize in either good.
PPF with IRS
Good X
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Strategic Trade with IRS
1. Assume PPF same for both nations exhibits
IRS.
Good Y
QY
PPF
Good X
QX
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Older Approaches to Trade Patterns

• Product Cycle and Linder Demand Theories

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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, prodn licensed to others.
• Stage IV Imitation I Phase Imitating country
  undersells originator in ROW.
• Stage V Imitation II Phase Imitating country
  undersells in originators market.

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The Product Cycle Model
Quantity
Stage I
Stage IV
Stage III
Stage V
Stage II
Time
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Dates of Product Introduction Characteristics
of Industry 1970-1979
Date of Product Introduction
Source Thorelli Burnett, The Nature of
Product Life Cycle for Industrial Goods Business
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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 nations income level yields pattern of demand
  for goods.
• The nations produce types of goods demanded
  within country, hence nations 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
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.

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Intra-Industry Trade

• Index of Intra-Industry Trade
• IIIT 1 X-M/(XM)
• 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

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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.

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SR Monopolistic Competition
1. Fixed Costs generate IRS for each firm.
Cost, C and Price, P
AC
MC
Quantity, Q
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LR Monopolistic Competition
Cost, C and Price, P
AC
MC
Quantity, Q
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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 S1/n b(P-Pbar)
• Where S Industry sales, Pbar Competitors
  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
Cost, C and Price, P
Number of Firms, n
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Trade the Krugman Model
Cost, C and Price, P
CC
P0 AC0
PP
n0
Number of Firms, n
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Intra-Industry Trade
U.S. Imports/Exports of Auto Parts, Engines,
Bodies (Millions of )
Source R.B. Cohen, Trade Policy in the 1980s,
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

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Monopoly and Dumping
Cost, C and Price, P
MC
DHome
MRHome
Quantity, Q
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Price Discriminating Monopolist
1. Assume Price-discriminating Monopolist with
constant MC across markets.
Cost, C and Price, P
Cost, C and Price, P
Market 1
Market 2
MC
MC
Quantity, Q
Quantity, Q
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New Approaches to Trade III

• External Economies of Scale and Trade

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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.

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External Economies Specialization
1. Strong External Economies tend to reinforce
existing patterns of IIT regardless of initial
source.
Cost, C and Price, P
DWorld
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 prodn.
Cost, C and Price, P
C0
PW
ACDC
ACLDC
DWorld
Q0
Quantity, Q
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Dynamic Scale Economies
1. Strong Dynamic Learning effects reinforce
existing patterns of IIT.
Cost, C and Price, P
DWorld
Quantity, Q
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Summary of Scale Effects on Trade Patterns
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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 prodn (mostly
  capital) suggests comparative advantage models
  increasingly less important.