International Economics

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International Economics

• Lecture 5 Imperfect Competition and Trade

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Outline

• Introduction
• Economies of Scale
• Monopoly
• Monopolistic Competition
• and Trade
• and Gains from an Integrated Market
• and Intra-Industry Trade
• Dumping
• External Economies

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Introduction

• Many industries are characterized by economies of
  scale (also referred to as increasing returns).
• Production is most efficient, the larger the
  scale at which it takes place.
• If firms operate with scale economies, they
  cannot be seen as atomistic, nor engage in
  marginal cost pricing.
• Under increasing returns to scale
• Output grows proportionately more than the
  increase in all inputs.
• Average costs (costs per unit) decline with the
  size of the market.

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Introduction (cont.)

• In many industries, firms do not act is if they
  are price takers.
• View themselves as a price setters.
• Know that they can sell more only by reducing
  their price.
• Possibly set prices considering response by close
  competitors.
• Three different market structures characterized
  by imperfect competition
• Monopoly
• A market in which a firm faces no competition
  (the simplest imperfectly competitive market).

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Introduction (cont.)

• Oligopoly
• There are several firms, each of which is large
  enough to affect prices, but none with an
  uncontested monopoly.
• Each firm decides its own actions, taking into
  account how that decision might influence its
  rivals actions.
• Monopolistic competition
• There are several firms, each of which is large
  enough to affect prices, but none with an
  uncontested monopoly.
• Each firm is assumed to be able to differentiate
  its product from its rivals.
• Each firm is assumed to take the prices charged
  by its rivals as given.
• Two basic models of international trade in which
  imperfect competition play a crucial role
• Monopolistic competition model
• (Reciprocal) dumping model

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Economies of Scale

• Economies of scale can be either
• External
• The cost per unit depends on the size of the
  industry but not necessarily on the size of any
  one firm.
• An industry can still consist of many small firms
  and be perfectly competitive.
• Internal
• The cost per unit depends on the size of an
  individual firm but not necessarily on that of
  the industry.
• The market structure will be imperfectly
  competitive with large firms having a cost
  advantage over small.
• Both types of scale economies are important
  causes of international trade.

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Internal Economies of Scale

• Average and Marginal Costs
• Average Cost (AC) is total cost divided by
  output.
• Marginal Cost (MC) is the amount it costs the
  firm to produce one extra unit.
• When average costs decline in output, marginal
  cost is always less than average cost.
• Suppose the costs of a firm, C, take the
  following linear form
• C F c ? Q
• The fixed cost in a linear cost function gives
  rise to economies of scale, because the larger
  the firms output, the less is fixed cost per
  unit.
• The firms average costs are given by
• AC C/Q F/Q c

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Average Versus Marginal Cost
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Monopoly A Brief Review

• Marginal revenue (the extra revenue the firm
  gains from selling an additional unit)
• Its curve, MR, always lies below the demand
  curve, D.
• In order to sell an additional unit of output the
  firm must lower the price of all units sold (not
  just the marginal one).
• Marginal revenue is always less than the price.
• Suppose the demand curve the firm faces is a
  straight line
• Q A B ? P ? P A/B Q/B
• Then the MR that the firm faces is given by
• MR P (?P/?Q) ? Q P Q/B

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Monopolistic Pricing and Production Decisions
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Monopolistic Competition

• A model of an imperfectly competitive industry
  which assumes that
• Each firm can differentiate its product from the
  product of competitors and is therefore the only
  producer of its own particular variety.
• Each firm ignores the impact that changes in its
  own price will have on competitors prices and
  takes the prices charged by its rivals as given.
• There is free entry and exit, implying that in
  equilibrium any new entrant would make losses.
• Are there any monopolistically competitive
  industries in the real world?
• Some industries may be reasonable approximations
  (e.g., detergents, toothpaste etc.).

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Assumptions of the Model

• Each firm in an industry producing differentiated
  products
• sells more the larger the total demand for the
  industrys output and the higher the prices
  charged by rivals.
• sells less the greater the number of firms in the
  industry and the higher its own price.
• A particular equation for the demand facing a
  firm that has these properties is
• Q S x 1/n b x (P P)
• where
• Q is the firms sales and S is the total sales of
  the industry
• n is the number of firms in the industry
• b is a constant term representing the
  responsiveness of a firms sales to its price
• P is the price charged by the firm itself and
  P-bar is the average price charged by its
  competitors

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The number of firms and average cost

• To simplify we assume that all firms have
  identical demand and cost functions.
• ? in equilibrium, all firms charge the same
  price P P
• In equilibrium
• Q S/n 0 S/n
• AC C/Q F/Q c F(n/S) c
• The larger the number of firms n in the industry,
  the higher the average cost AC for each firm
  because the less each firm produces (CC curve).
• The larger the total sales S of the industry, the
  lower the average cost for each firm because the
  more each firm produces.

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Solving the Model

• The method for determining the number of firms
  and the average price charged involves three
  steps
• Derive the relationship between the number of
  firms and the average cost of a typical firm
  (relationship derived above).
• Derive the relationship between the number of
  firms and the price each firm charges.
• Derive the equilibrium number of firms and the
  average price by setting price equal to average
  cost (i.e. assuming zero profits).
• Step 2
• The price the typical firm charges depends on the
  number of firms in the industry.
• The more firms, the more competition, and hence
  the lower the price each firm will charge.

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The number of firms and the price

• If each firm treats P-bar as given, we can
  rewrite demand in the following linear form
• Q (S/n S?b?P) S?b?P
• ? P (S/n S?b?P) Q/(S?b)
• Implies that MRP Q/(S?b).
• Since Q/S 1/n we can write this as MR P
  1/(b?n).
• Profit-maximizing firms set marginal revenue
  equal to their marginal cost, c
• cP 1/(b?n) ? P c 1/(b?n)
• negative relationship between the price P and the
  number of firms n in the market (PP curve).
  

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Equilibrium in a Monopolistically Competitive
Market
Only in point E will profit maximizing firms make
zero profits.
P2,
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Monopolistic competition and Trade

• Trade allows the creation of an integrated market
  that is larger than each countrys market.
• With a larger market size (S)
• Lower AC for a given number of firms ? CC curve
  shifts downwards.
• No effect on the relationship between price and
  number of firms.
• Market integration ? greater variety of products
  and lower prices.
• The number of firms in a new international
  industry is predicted to increase relative to
  each national market.
• But it is unclear if firms will locate in the
  domestic country or foreign countries.
• Possibly imports and exports within each industry
  (intra-industry trade).

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Effects of a Larger Market
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Inter-industry Trade

• According to the Heckscher-Ohlin model or
  Ricardian model, countries specialize in
  production.
• Trade occurs only between industries
  inter-industry trade
• In the Heckscher-Ohlin model suppose that
• The capital abundant domestic economy specializes
  in the production of capital intensive cloth.
• The labor abundant foreign economy specializes in
  the production of labor intensive food.

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Inter-industry Trade (cont.)
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Intra-industry Trade

• Suppose now that the global cloth industry is
  described by the monopolistic competition model.
• Because of product differentiation, suppose that
  each country produces different types of cloth.
• Because of economies of scale, large markets are
  desirable the foreign country exports some cloth
  and the domestic country exports some cloth.
• Trade occurs within the cloth industry
  intra-industry trade
• The domestic country still has a comparative
  advantage in cloth and should therefore export
  more cloth than it imports.

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Intra-industry Trade (cont.)
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Inter-industry and Intra-industry Trade

• Gains from inter-industry trade reflect
  comparative advantage.
• Gains from intra-industry trade reflect economies
  of scale (lower costs) and wider consumer
  choices.
• Comparative advantage in producing the
  differentiated good will likely lead to net
  exports of that good.
• The relative importance of intra-industry trade
  depend on how similar countries are.
• Countries with similar relative amounts of
  factors of production are predicted to have
  mostly intra-industry trade.
• Countries with different relative amounts of
  factors of production are predicted to have
  mostly inter-industry trade.
• Unlike inter-industry trade in the
  Heckscher-Ohlin model, intra-industry trade may
  not generate strong income distribution effects.

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Inter-industry and Intra-industry Trade (cont.)

• About 25 of world trade is intra-industry trade
  according to standard industrial classifications.
• But some industries have more intra-industry
  trade than other.
• industries requiring relatively large amounts of
  skilled labor, technology and physical capital.

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Indexes of Intraindustry Trade for U.S.
Industries, 1993
Note an index of 1 means that all trade is
intra-industry trade. An index of 0 means that
all trade is inter-industry trade.
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Price Discrimination and Dumping

• Price discrimination
• The practice of charging different customers
  different prices
• Dumping
• The most common form of price discrimination in
  international trade
• A pricing practice in which a firm charges a
  lower price for an exported good than it does for
  the same good sold domestically
• It is a controversial issue in trade policy and
  is widely regarded as an unfair practice in
  international trade.
• Dumping can occur only if two conditions are met
• Imperfectly competitive industry
• Segmented markets
• Given these conditions, a monopolistic firm may
  find that it is profitable to engage in dumping.

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Dumping
PFOR
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Reciprocal Dumping

• A situation in which dumping leads to two-way
  trade in the same product.
• Its net welfare effect is ambiguous
• It wastes resources in transportation. -
• It creates some competition (pro-competitive
  effect of trade).

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The Theory of External Economies

• There are three main reasons why there may be
  external economies of scale
• Specialized suppliers
• Labor market pooling
• Knowledge spillovers

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Specialized Suppliers as a Source of External
Economies

• Suppose production or the development of new
  products requires the use of specialized
  equipment or support services.
• An individual company does not provide a large
  enough market for these services to keep the
  suppliers in business.
• A localized industrial cluster can solve this
  problem by bringing together many firms that
  provide a large enough market to support
  specialized suppliers.
• This phenomenon has been extensively documented
  in the semiconductor industry located in Silicon
  Valley.

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Labor Market Pooling as a Source of External
Economies

• A cluster of firms can create a pooled market for
  workers with highly specialized skills.
• It is an advantage for
• Producers
• They are less likely to suffer from labor
  shortages.
• Workers
• They are less likely to become unemployed.

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Knowledge Spillovers as a Source of External
Economies

• Knowledge is an important input in highly
  innovative industries.
• Specialized knowledge crucial for success in
  innovative industries comes from
• Research and development (RD) efforts
• Reverse engineering
• Informal exchange of information and ideas
• Reverse engineering and informal exchange of
  information make complete appropriation of RD
  efforts impossible and create spillovers.
• These spillovers may have limited geographical
  scope, creating incentives for clustering.

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External Economies and International Trade

• External economies can give rise to a
  forward-falling supply curve
• The larger the industrys output, the lower the
  price at which firms are willing to sell their
  output.
• A country that has large production in some
  industry will tend to have low costs of producing
  that good.
• Countries that start out as large producers in
  certain industries tend to remain large producers
  even if some other country could potentially
  produce the goods more cheaply.
• Historical accidents may affect the trade
  pattern.

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External Economies and International Trade (cont.)
C0
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External Economies and International Trade (cont.)

• Trade based on external economies has more
  ambiguous effects on national welfare than either
  trade based on comparative advantage or trade
  based on economies of scale at the level of the
  firm.
• A country can actually be worse off with trade
  than without.

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External Economies and Losses from Trade
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Dynamic Increasing Returns

• Learning curve
• It relates unit cost to cumulative output.
• It is downward sloping because of the effect of
  the experience gained though production on costs.
• Dynamic increasing returns
• A case when costs fall with cumulative production
  over time, rather than with the current rate of
  production.
• Dynamic scale economies constitutes theoretical
  argument for protectionism.
• Temporary protection of industries generates
  experience gain (infant industry argument).

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The Learning Curve
C0
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Summary

• Economies of scale imply falling average costs
  with output at the firm or industry level.
• External economies of scale refer to the amount
  of output by an industry.
• Internal economies of scale refer to the amount
  of output by a firm.
• Monopolistic competition
• Each firm has some monopoly power due to product
  differentiation
• but must compete with other firms whose prices
  are believed to be unaffected by each firms
  actions.
• Monopolistic competition allows for gains from
  trade through lower costs and prices, as well as
  through wider consumer choice.

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Summary (cont.)

• Monopolistic competition predicts intra-industry
  trade, and does not predict strong changes in
  income distribution within a country.
• Location of firms under monopolistic competition
  is unpredictable, but countries with similar
  relative factors are predicted to engage in
  intra-industry trade.
• Dumping is predicted to occur when
• the industry is imperfectly competitive...
• and markets are geographically segmented.
• External economies give an important role to
  history and accident in determining the pattern
  of international trade.
• When external economies are important, countries
  can conceivably lose from trade.