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Monopolistic competition

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Title: Monopolistic competition


1
Monopolistic competition
  • Session 3
  • International trade and MNES
  • M1

2
INTRODUCTION
3
  • Monopolistic competition has been during two
    decades the work horse of international trade
    theory and empirics.
  • Provides a framework for IIT-H
  • Fits well the gravity equation
  • Elegant way of introducing increasing returns
  • Can easily be combined with comparative advantage
  • Fits well in CGE models
  • Convergence of IO and international trade
  • Limits
  • In the canonic version, the dynamics of the
    market structure is poor.
  • Firms are homogenous

4
3.1/ Some basics
  • Demand side
  • Supply side

5
DEMAND SIDE
  • How to represent the demand for variety?
  • Two possibilities
  • Representative consumer valorising varieties per
    se, varieties all symmetric
  • Heterogeneous consumers, looking for the ideal
    variety. The latter is a bundle of
    characteristics. Every variety is a different
    consumption technique, linearly combining these
    characteristics.
  • Corresponding respectively to
  • The SDS-Krugman type models
  • The Hotelling-Lancaster type models.
  • SDSK is more tractable in particular for
    empirical purposes.

6
  • Imposes to model preferences of the consumer with
    a two stage budgeting approach.
  • In a first stage, choice between categories of
    products.
  • In a second stage, choice among the varieties of
    a given product category, for categories with
    differentiated products.
  • Dimensionality can be increased beyond 2
    industries in applied models. Principles remain
    the same.
  • Often, nested CES, or CES nested in a Cobb
    Douglas. We will use below an even simpler
    version of the latter choice.

7
  • Lets replace the utility function
    UU(c1,c2,cm), where cj are the quantities
    consumed of goods j (1,2, m)?
  • ByUUU1(c11,c21,cn1), , Um(c1m,c2m,cnm)
  • We now have n varieties (i) in each of the m
    industries ( j)?
  • This decomposition of utility is subject two an
    assumption

8
  • Then we have the following nesting

w
S0
C
C2
Cm
C1
...
C2m
Cnm
C1m
...
C11
C21
Cn1
...
9
SUPPLY SIDE
  • Monopolistic competition
  • 2 characteristics
  • A- monopoly on each variety Fixed cost of
    production in each variety
  • B- many firms competitive aspect
  • Pricing strategy Marg. RevenueMarg. Cost (Cm)?
  • Equilibrium pricing P(Mark-up).Cm
  • Hypothesis of free entry in the long run
  • null profits and P AVC
  • Openness translates into additional economies of
    scale, reduced mark ups and real income gains

10
3.2 The synthesis between standard and new
theories of trade (Krugman, 1981)?
11
Motivation
  • 1- much of world trade is between countries with
    similar factor endowments.
  • 2- A large part of trade is intraindustry
    (two-way trade in similar products).
  • 3- Finally, much of the expansion of trade in the
    postwar period has taken place without sizable
    reallocation of resources or income distribution
    effects.

12
3.2,1 Closed economy Demand
  • 2 industries (1, 2) each producing a horizontally
    differentiated good
  • We must nest the two levels of utility
  • sub-utility attached to the consumption of the
    different varieties of a given good
  • utility attached to the consumption of the two
    goods.
  • ULog

13
  • Other assumptions
  • Within each industry, varieties are imperfect
    substitutes for consumers.
  • On the supply side, Labour will be specific to
    each industry.
  • Each country will have a potentially different
    (exogenous) repartition of the labour force
    within the two sectors.
  • Li1 is the labour force engages (and stuck) in
    industry 1.
  • Li2 respectively for industry 2.
  • Hence wage will be different in the two
    industries in a given country.
  • Production functions are the ones used
    previously, with now a subscript indicating the
    industry j.
  • Industries differ only by the quantity of their
    specific factor fixed and marginal costs are
    identical.
  • Lets normalise the labour stock to 2 and define
    a variable d indicating the distribution of
    labour among the two industries.

14
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16
  • Firms are of the same size in the two industries.
  • Since the two industries account for the same
    share in overall demand, and in absence of pure
    profit, relative return to the factor is simply
    determined by its relative specialisation in the
    industries.
  • Here, two variables are key the relative
    endowment in specific factor d and the
    substitutability alpha between varieties of the
    same good.
  • For d1 there is no specialisation of the
    specific factor and the relative wage is equal to
    1. For low values of d, the economy is
    specialised in industry 1 and L2 will receive a
    relative high return.
  • The weakest the alpha, the more differentiated
    are the products and the less important are the
    economies of scale.

17
  • Openness to trade
  • Zero transport cost
  • Same technology in the two countries
  • Symmetrical economies (mirror image
    assumption) the only difference between the two
    countries is the repartition of labour between
    the two industries.
  • When the economic distance is maximal d 0
  • When the economic distance is nil d 1
  • d is an inverse proxy of the economic distance.
  • In order to determine trade flows, one has to
    keep in mind that the consumer splits her income
    in two equal parts and then among the nj
    varieties.

18
Thanks to the symmetry, we conclude that
19
  • We can easily check that trade is balanced.
  • We also check that bilateral trade sums to Y see
    remark on gravity above.
  • The latter result does not depend on d, which is
    on the contrary specific to this model here
    economic distance does not imapct the volume of
    trade.
  • We observe that IIT (as measured by the GL ratio)
    is inversely related to economic distance.
  • Actually, GLd.
  • When the two economies are not specialised (d1,
    the labour force is equally distributed in the
    two activities in the two economies), trade is
    100 intra-industry.
  • When the labour force is quite exclusively
    employed in industry 1 in the domestic economy (d
    0) and in industry 2 in Foreign, then trade is
    purely inter-industry and GL 0.

20
4.2.2 Stolper Samuelson effects
  • We now tackle distributive effects.
  • Since we are considering a framework where trade
    is of intra-industry nature, without additional
    economies of scale, gains accruing to the economy
    are associated with variety only.
  • Two types of workers.
  • Need to tackle the change in their real income.
  • 2 different numeraires and 2 industries where one
    can be employed. This leads to 4cases. Lets
    define wkj, the real return, in numeraire j, of
    factor L employed in industry k.

21
  • Each consumer will demand a quantity cij of each
    variety i of each good j
  • Leading to a utility of
  • We will now calculate the utility of workers
    employed in one industry, taking into account
    their real income.
  • This is done first in autarky and then under free
    trade.
  • One specific factor will gain in variety and lose
    in real return
  • The other one will gain on both fronts.
  • We will concentrate on the former, who needs to
    compensate a Stolper Samuelson loss by a Krugman
    type gain.

22
  • The autarkic utility levels of workers employed
    in the two industries are
  • For Home, the abundant factor is L1. Hence, we
    know that the specific factor L2 will be the
    victim of the Stolper-Samuelson effect. We
    concentrate on L2.

Stolper-Samuelson
Krugman
23
  • The utility change for L2 is
  • Note that the real wage of L2 in terms of
    numeraire 2 is not affected. Thus, we can
    simplify the former expression as

24
  • The change in w2 is inversely proportional to the
    initial distribution of income (w2/w1).
  • And we know that w1/w2d/(2-d).
  • Thus the Stolper-Samuelson effect is
  • If d1 the loss is log10. Hence when the
    economic distance between the two trade partners
    is nil, there is only intra-industry trade and
    the Stolper-Samuelson effect vanishes. Every
    factor will gain (in variety).

25
4.2.3 Stolper Samuelson effects and Krugman-type
compensation
  • Lets now concentrate on the latter gain.
  • Under free trade the two sets of variety (Home,
    Foreign) are available to the consumer.
  • Hence, after simplification
  • Summing Stolper-Samuelson and Krugman effects,
    and rearranging the terms, we get

26
  • We now consider all cases where d lt1 in order to
    have a Stolper Samuelson effect.
  • For the first term is always
    gt0.
  • Regarding the third term, as long as d lt 1 we
    have
  • In order to have the second term gt 0 we need to
    have
  • Lastly, for the first term is
    always compensating the third one.
  • Hence, is a sufficient condition
    to have the scarce factor not losing.

27
  • The former result is easily interpreted the
    differentiation will be large if alpha is low.
  • And the variety gain will be large enough to
    compensate for the Stolper Samuelson loss.
  • Now, what about situations where
    ?
  • There exists accordingly a threshold d0 such as
    the scarce factor always gains to trade. And
    this threshold is increasing in alpha.

28
  • Interpretation in order to have the two factors
    gaining to trade, a lesser differentiation of the
    products will have to be compensated by a more
    limited economic distance.

d
d0
29
ECONOMIC DISTANCE
CONFLICT
MUTUAL INTEREST
0
0.5
1
DIFFERENTIATION
30
4.2.4 Standard theory and SDS-Krugman reconcilied
  • We now conclude by reconciling Krugman type
    models and the standard theory of trade (of a HOS
    type), using the integrated equilibrium.
  • As proposed by Helpman and Krugman (1985).
  • Consider two industries, each producing a
    horizontally differentiated product, with two
    different production functions.
  • Varieties of good 1 are produced with a more
    capital intensive technique.
  • As long as the zero profit condition is assumed,
    the integrated equilibrium framework can be
    mobilised easily, and we can rely on the net
    factor content of trade.
  • Economic distance will be defined here as the
    relative capital intensity of the two countries.
  • Identical countries will trade on a purely IIT
    basis, why different countries will combine inter
    and intra-industry trade.

31
L
0
K
D
C
K
L
0
32
  • Home will export and import varieties of both
    goods, but will be a net exporter of varieties of
    good 1 and a net importer of varieties of good 2.
  • The net factor service content of trade is the
    one predicted by HOV.
  • IIT has no impact in Stolper-Samuelson terms.
  • The largest the economic distance
  • The lowest the GL index.

X1
M1
X2
M2
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