1. International Economics
Li Yumei
Economics & Management School
of Southwest University

2. International Economics
Chapter 6
Economies of Scale, Imperfect Competition, and International Trade

3. Organization 6.1 Introduction
6.2 The Heckscher-Ohlin Model and New Trade Theories
6.3 Economies of Scale and International Trade
6.4 Imperfect Competition and International Trade
6.5 Trade Based on Dynamic Technological Differences
6.6 Costs of Transportation, Environmental Standards, and International Trade
Chapter Summary
Exercises

4. The Relaxation of H-O Model’s Assumptions
6.1 Introduction
The Relaxation of H-O Model’s Assumptions
Economies of Scale ( Constant Returns to Scale )
Imperfect Competition ( Perfect Competition )
Dynamic Technology ( Same Technology )
Transportation Costs ( No Transportation Costs )
Environmental Standards ( Free Trade )

5. 6.1 Introduction New Trade Theories
International Trade Based on Economies of Scale
International Trade Based on Imperfect Competition
International Trade Based on Technological Change
International Trade Based on Transportation Costs
International Trade Based on Environmental Standards (Trade Restrictions)

6. 6.2 The Heckscher-Ohlin Model and New Trade Theories
H-O Model
The Assumptions of New Trade Theories

7. H-O Model
Relaxing of H-O model’s assumptions not to affect the validity of the basic H-O model;
New theories need to be developed to explain the unexplained significant portion of international trade left by H-O model, such as economies of scale, imperfect competition, technological change, transportation costs, protection trade;

8. Assumptions of New Trade Theories
More than two nations, two commodities and two factors in world trade;
Different technologies ( technology viewed as a factor of production) ;
The absence of factor intensity reversal ;
Increasing returns to scale;
Complete specialization;
equal tastes;
Imperfect Competition;

9. Assumptions of New Trade Theories
International factor immobility;
Transportation costs to the flow of international trade ;
Prohibitive obstructions to the flow of international trade ;
With resources not fully utilized;
Trade balance;
The relaxing most of the assumption of H-O theory only
modifies but does not invalidate the theory. So new and
complementary trade theories are in need to explain the
significant portion of international trade.

10. 6.3 Economies of Scale and International Trade
Trade Based on Economies of Scale
Several Clarification on Trade Based on Economies of Scale
Linder theory
Conclusion

11. Economies of Scale Concept Reasons
Economies of Scale refers to the Increasing Returns to Scale.
It means the production situation where output grows
proportionately more than the increase in inputs or factors of
production.
Reasons
At a larger scale of operation, a greater division of labor and specialization becomes possible;
A larger scale of operation may permit the introduction of more specialized and productive machinery.

12. Trade Based on Economies of Scale
Content
With increasing returns to scale, mutually beneficial trade can
take place even when the two nations are identical in every
respect.
Illustration
Identity means the same production frontier and the same
indifference Map, therefore, using one single production frontier and one single indifference map to refer to both nations; It also means the identical no-trade equilibrium relative commodity prices in the two nations;
Increasing returns to scale result in production frontiers that are convex from the origin, or inward-bending;
See Figure 6.1 (page 169)

13. FIGURE 6-1 Trade Based on Economies of Scale.

14. Trade Based on Economies of Scale
Explanation of Figure 6.1 (page 169)
Without Trade
The domestic equilibrium point is at point A, that is PX/PY=PA’.
Nation 1 moves to the right of point A along its production frontier,
the relative price of X will fall and will continue to fall until Nation 1
becomes completely specialized in the production of X; Similarly,
Nation 2 moves to the left of point A along its production frontier,
the relative price of Y will fall and will continue to fall until Nation 2
becomes completely specialized in the production of Y.

15. Trade Based on Economies of Scale
With Trade
1. Nation 1 could specialize completely in the production of X and
produce at Point B; Nation 2 could specialize completely in the
production of Y and produce at Point B’;
2. By exchanging 60X for 60Y with each other, each nation will end
up consuming at Point E on indifference curve Ⅱ;
3. The gains of 20X and 20Y from trade arise from economies of
scale in the production of only one commodity in each nation.
Conclusion
In the absence of trade, the two nations would not specialize in the
production of only one commodity because each nation wants to
consume both commodities. With trade, each nation can gain from
economies of scale in the production of only on commodity.

16. Several Clarification on Trade Based on Economies of Scale
In the real world, no complete indifference map, this may result from historical accident;
There is no need to be identical in every respect for mutually beneficial trade to result from increasing returns to scale;
If economies of scale persist over a sufficiently long range of outputs, one or a few firms in the nation will capture the entire market for a given market (leading to monopoly or oligopoly);
International economies of scale (case study 6-1 page 170), such as parts, components as well as setting up of production facilities abroad.

17. Linder’s theory Content
Linder in 1961 postulates that a nation exports those
manufactured products for which a large domestic market
exists .These exports are products that appeal to the majority
of the population while a nation imports those products that
appeal to its low-and high-income minorities.
In the process of satisfying such a market, the nation acquires
the necessary experiences and efficiency to be able
subsequently to export these commodities to other nations
with similar tastes and income levels. This theory is called
preference similarity or overlapping demands theory.

18. Linder’s theory Application
1. Linder’s theory can be explained the trade in manufactures .
It is likely to be larger among countries with similar tastes
and income levels;
2. The theory is confirmed for his native Sweden, not
confirmed by other nations;
3. This theory is related to the economies of scale.

19. Conclusion
Even if two nations are identical in every respect,
there is still a basis for mutually beneficial trade
based on economies of scale. When each nation
specializes in the production of one commodity, the
combined total world output of both commodities
will be greater than without specialization when
economies of scale are present. With trade, each
nation then shares in these gains.

20. 6.4 Imperfect Competition and International Trade
Trade Based on Production Differentiation
Measuring Intra-Industry Trade
Formal Model of Intra-Industry Trade
Another Version of the Intra-Industry Model
Conclusion

21. Trade Based on Production Differentiation
Introduction
At present a large portion of the output of modern economies today
involves differentiated rather than homogeneous products. Such as
Chevrolet (雪佛兰) , Toyota (丰田) , Volkswagen (大众) , Volvo (沃尔
沃). This leads to a great deal of international trade happened
among the differentiated products of the same industry or broad
product group. This international trade is intra-industry trade, as
opposed to inter-industry trade in complete different products.
See Case study 6-2 page 172, the example of automobiles
Concept
Intra-industry trade refers to the trade in differentiated products
of the same industry.

22. Trade Based on Production Differentiation
Intra-industry trade and H-O
To take the advantage of important economies of scale in production; (it benefits consumers due to the wider range of choices)
1. Broad industrial classification;
2. Falling unit costs;
Intra-industry trade model developed by Helpman, Krugman, Lancaster
1. Based on production differentiation and economies of scale;
2. With differentiated products produced under economies of scale,
pre-trade relative commodity prices may no longer accurately
predict the pattern of trade;

23. Trade Based on Production Differentiation
3. With intra-industry trade based on economies of scale it is
possible for all factors to gain. While H-O model predicts that trade
will lower the return of the nation’s scarce factor;
4. Intra-industry trade is related to the sharp increase in international
trade in parts and components of a product.
Differences between Intra-industry trade and H-O model
1. The comparative advantage seems to determine the pattern of
inter-industry trade, while economies of scale in differentiated
products give rise to intra-industry trade;
2. Inter-industry trade reflects natural comparative advantage while
intra-industry trade reflects acquired comparative advantage;
3. Intra-industry trade is in fact consistent with trade based on
differences in factor endowments and comparative costs.

24. Measuring Intra-Industry Trade
Intra-industry trade index ( T)
T = 1﹣(X﹣M) / (X+M)
X represents the value of exports while M represents the imports in a particular industry or commodity group ;
The value of T ranges from 0 to 1;
When T=0, it means only exports or only imports;
When T=1, it means the exports and imports of a good are equal;
Case study 6-3 Growth of Intra-industry Trade (page 175)

25. Formal Model of Intra-Industry Trade
Figure 6.2
FIGURE 6-2 Production and Pricing Under Monopolistic Competition

26. Formal Model of Intra-Industry Trade
Explanation of Figure 6.2
1. D represents the demand curve faced by the firm for the
differentiated products that it sells;
Small inclination of D means that a small price change leads to a
large change in the firm’s sales (fairly elastic D due to many firms to
sell similar products).
2. Monopolistic competition
It means that there are many firms selling a differentiated product
and entry into or exit from the industry is easy .
3. MR below the demand curve (D)
This is because the firm wants to increase sales it must lower the
price (P) on all units of the commodity.

27. Formal Model of Intra-Industry Trade
4. The average cost curve downward sloping (AC)
This is because the firm faces increasing returns to scale in
production.
5. MC﹤AC
This is for AC to decline, MC must be smaller than AC.
6. MR=MC
When the MC and MR curves intersect, it reaches the best level of
output for the firm. (Q=3, P= $4)
1) When MR﹥MC, it means that the firm need to expand output;
2) When MR ﹤MC, it means that the firm need to reduce output

28. Formal Model of Intra-Industry Trade
7. In the long run, the demand curve facing this firm (D) is
tangent to its AC curve
Since many firms enter into the industry and earn profits, P=AC=4$ at
Q=3. This means that the firms breaks even (normal return on
investment in the long run)
The relationship between inter-industry and intra—industry trade
When products are homogeneous, we have only inter-industry trade;
When products are differentiated, we have both inter- and intra-industry trade.
The more similar nations are in factor endowments and technology,
the smaller is the importance of inter-relative to intra-industry trade,
and vice versa.

29. Another Version of the Intra-Industry Model
Figure 6.3 (page 177)
FIGURE 6-3 Monopolistic Competition and Intra-Industry Trade

30. Another Version of the Intra-Industry Model
Explanation of Figure 6.3 (page 177)
1. The horizontal axis measures the number of firms (N) in a
monopolistically competitive industry while the vertical axis
measures the product price (P) and the average or per unit
cost of production (AC);
2. All firms sell at the same price even though their product is
somewhat differentiated; (identical demand and cost conditions)
3. Curve P shows the relationship between the number of firms in
the industry and the product price;
The negatively sloped curve P shows that the larger the number of
firms in the industry the lower is the product price due to the more
competition.

31. Another Version of the Intra-Industry Model
4. Curve C shows the relationship between the number of firms in
the industry and their average cost of production for a given
level of industry output;
The positively sloped curve C shows that the larger N is, the greater
their AC is. The reason is that when more firms produce a given
industry output, each firm’s share of the industry output will be smaller,
and so each firm will incur higher average costs of production.
5. The intersection of curve P and curve C defines equilibrium
point E (at which P=AC=$3, each firm breaks even)
1) With 200 firms, P=$4 (point F), while AC=$2 (point G), it means
more firms will enter the industry until long-run equilibrium point E is
reached;

32. Another Version of the Intra-Industry Model
2) With 400 firms, P=$2 (point E’) while AC=$4, it means that some
firms leave the industry until long-run equilibrium point E is reached.
6. By opening up or expanding international trade and thus
becoming part of a much larger integrated world market, firms
in each nation can specialize in the production of a smaller
range of products and face lower average costs of production.
Mutually beneficial trade can then take place even if nations are
identical in factor endowments and technology. Consumers in
each nation would benefit both from lower product prices and
from the larger range of commodities.
Curve C shifts down to curve C’ because an increase in market size or
total industry sales increases the sales of each firm, for any given
number of firms in the industry, and lowers the average production cost
of each firms. This leads to the new equilibrium point E’.

33. Conclusion A large portion of international trade today involves the
exchange of differentiated products. Such intra-industry trade
arises in order to take advantage of important economies of
scale in production, which differentiated products, the firm faces
a downward-sloping demand curve, produces in the downward-
sloping portion of its average cost curve, and breaks even. The
larger the number of firms in a monopolistically competitive
industry, the lower the product price and the higher the average
cost for a given level of output. With the enlargement of the
market that trade brings about, the commodity price will then be
lower and the number of firms greater. The more similar nations
are in factor endowments, the greater is the importance of intra-
relative to inter-industry trade.

34. 6.5 Trade Based on Dynamic Technological Differences
Technological Gap and Product Cycle Models
Illustration of the Product Cycle Model
Conclusion

35. Technological Gap and Product Cycle Models
Technological gap model
It sketched by Posner in 1961, a great deal of international
trade among industrialized countries is based on the
introduction of new products and new production process.
This gives the innovating firms and nation a temporary
monopoly in the world market. Such a temporary monopoly is
often based on patents and copyrights, which are granted to
stimulate the flow of invention.
Shortcoming: It does not explain the size of technological
gaps and does not explore the reason that technological gaps
arise or exactly how they are eliminated over time.

36. Technological Gap and Product Cycle Models
Technological gap model was fully developed by Vernon in
1966. It means that when a new product is introduced, it
usually requires highly skilled labor to produce. As the
product matures and acquires mass acceptance, it become
standardized; it can then be produced by mass production
techniques and less skilled labor. Therefore, comparative
advantage in the product shifts from the advanced nation that
originally introduced it to less advanced nations, where labor
is relatively cheaper. This may be accompanied by foreign
direct investment from the innovating nation to nations with
cheaper labor.

37. Technological Gap and Product Cycle Models
Vernon also pointed out that high-income and labor-saving
products are most likely to be introduced in rich nations , the
reasons as follows:
1. The opportunities for doing so are greatest there;
2. The development of these new products requires proximity to
markets ;
3. There is a need to provide service.
Pattern of Trade: According to technological model, the most
highly industrialized economies are expected to export non-
standardized products embodying new and more advanced
technologies and import products embodying old or less advanced
technologies.

38. Illustration of the Product Cycle Model
Figure 6.4 (five stages)
Stage 1: new-product phase
Production and consumption are only in the innovating country.
Stage 2: product-growth phase
Production is perfected in the innovating country and increases
rapidly to accommodate rising demand at home and abroad.
Stage 3: product-maturity phase
The product becomes standardized, and the innovating firm may
find it profitable to license other domestic producing the product for
domestic consumption.

39. Illustration of the Product Cycle Model
Stage 4: the production increase in the imitating country
Production of the product in the innovating country declines while in
the imitating country the production of the product becomes
standardized and begins to undersell the innovating country in third
markets.
Stage 5: the rapid increase of production in the imitating country
The imitating country starts underselling the innovating country in
the latter’s markets as well, and production of the product in the
innovating country declines rapidly or collapses.
The last two stages are referred to as the product-decline stage.
Technological diffusion, standardization and lower costs abroad
thus bring the end of the life cycle for the product.

40. FIGURE 6-4 The Product Cycle Model

41. Conclusion According to the technological gap model, a firm exports a
new product until imitators in other countries take away its
market. In the meantime, the innovating firm will have
introduced a new product or process. According to the related
product cycle model, a product goes through five stages: the
introduction of the product, expansion of production for
export, standardization and beginning of production abroad
through imitation, foreign imitators underselling the nation in
third markets, and foreigners underselling the innovating firms
in their home market as well.

42. 6.6 Costs of Transportation, Environmental Standards, and International Trade
Costs of Transportation and Non-traded Commodities
Costs of Transportation and the Location of Industry
Environmental Standards, Industry Location, and International Trade

43. Costs of Transportation and Non-traded Commodities
Costs of transportation or logistics costs refer to all the costs of
transferring goods from one location (nation) to another, including
freight charges, warehousing costs, costs of loading and unloading,
insurance premiums, and interest charges while goods are in transit.
Non-traded Commodities
Considering the costs of transportation in trade, the goods can be defined
as traded commodities and services , and non-trade commodities and
services. Non-traded commodities and services means that the transport
costs exceed price differences across nations (such as cement).
Only the pre-trade price difference in the two nations exceeds the
transport costs from one nation to the other, a homogeneous good will be
traded internationally.

44. Costs of Transportation and Non-traded Commodities
Illustration of the Trade Based on Costs of Transportation (Figure 6.5 page 185)
Assumptions
1. The constant rate of exchange ;
2. The constant level of income;
3. Different produced, consumed and traded of the commodities under the consideration of transport costs
Explanation of Figure 6.5
1. Using the common vertical axis to measure the dollar price of
commodity X in Nation 1 and Nation 2;
2. Using the common horizontal axis to measure the increasing
quantities of commodity X, from the origin to the right referring
Nation 2 and from the origin to the left referring Nation 1.

45. FIGURE 6-5 Partial Equilibrium Analysis of Transport Costs

46. Costs of Transportation and Non-traded Commodities
3. In the absence of trade, Nation 1 produces and consumes 50X
at the equilibrium price of PX=$5 while Nation 2 produces and
consumes 50X at the equilibrium price of PX=$11;
4. With the opening trade, Nation 1 will export commodity X to
Nation 2. Nation 1 exports 60 X to Nation 2 without transport costs;
5. Under $2 transport costs the two nations share the transport costs;
Nation 1 will produce 70X and consume 30X and export 40X at
PX=7; Nation 2 will produce 30 X and consume 70X and import
40X at PX=9;

47. Costs of Transportation and Non-traded Commodities
Conclusion
1. Considering the transport costs, it reduces the level of
specialization in production and also the volume of traded goods
as well as gains from trade;
2. With transport costs the absolute (and relative )price of commodity
X differs in the two nations, its factor price will not be equalized
completely even if all the other assumptions of the H-O model hold;
3. The more steeply inclined DX and SX are in Nation 1 relative to
Nation 2, the greater is the share of transport costs paid by Nation 1.

48. Costs of Transportation and the Location of Industry
Resource-oriented(资源导向) industries
They are those that tend to locate near the source of the raw
materials used by the industry( such as mining). This is because
the transport costs of raw material are substantially higher than
for shipping the final goods to the market.
Market-oriented (市场导向)industries
They are those that locate near the markets for the products of
the industry (such as soft-drink companies). This is because the
produced goods are difficult or heavy to transport.

49. Costs of Transportation and the Location of Industry
Footloose (自由) industries
They are those producing goods that face neither substantial
weight gains nor losses during the production process (such as
computer companies).
These industries have high value-to-weight ratios and to be
highly mobile, or footloose. They intend to locate where the
availability of other inputs leads to the lowest overall
manufacturing costs.
Many governments offer preferential tax treatment to domestic
and foreign investors to attract these footloose industries.
See Case Study 6-6 (page 187)

50. Environmental Standards, Industry Location, and International Trade
They refer to the levels of air pollution, water pollution, thermal
(e.g., heat) pollution, and pollution resulting from garbage
disposal that a nation allows.
Environmental pollution results whenever the environment is
used (abused) as a convenient and cheap dumping ground for all
types of waste products arising from the production,
consumption, or disposal of goods and services.
Industry Location
Environmental policies influence the industry location in order to
reduce the spillover of environment costs.

51. Environmental Standards, Industry Location, and International Trade
Environmental pollution can lead to serious trade problems
because the price of traded goods and services often does not
fully reflect social environmental costs.
A nation with lower environmental standards can in effect use
the environment as a resource endowment or as a factor or
production in attracting polluting firms from abroad and
achieving a comparative advantage in polluting goods and
services.
World Bank Study (1992) indicated that polluting or dirty
industries and their exports have expanded faster than clean
industries and their exports in poor developing countries than
in rich countries. Environment standards and Trade are
controversial topic. (see Case study 6-7 page 188)

52. Chapter Summary Further development of H-O model New Trade Theory
Economies of Scale (constant returns to scale)
Imperfect competition (perfect competition)
Technological gap (same technology)
Transportation costs (no transportation costs)
New Trade Theory
Economies of Scale trade theory explains that even if two nations are identical in every respect, there is still a basis for mutually beneficial trade based on economies of scale.
Intra-industry trade explains the trade happed among the same industry due to the differentiated goods and economies of scale.

53. Chapter Summary
Product cycle explains the international trade based on the technological gap, and the process of the production of goods from innovating nation to imitating country.
Transport costs and Environment standards’ impact on the traded goods explains that transport costs and environment standards will influence the specialization in production and volume of trade.
New Trade Theories explain the unexplained trade phenomenon left by H-O model
New trade theories explain the present large deal of the trade in
the same industry based on economies of scale and
differentiated goods.

54. Exercises
Discussion Questions:
Page 191 to 192 from 1 to 14 questions

55. Exercises Additional Reading
For the effect of economies of scale on market structure and
international economies, see:
E. Helpman, “Increasing Returns, Imperfect Markets, and Trade Theory,” in R.W.Jones and P.B.Kenen, eds., Handbook of International Economics, Vol.1, International Trade (Amsterdam: North-Holland, 1984),pp
H. Helpman and P.R. Krugman, Market Structure and Foreign Trade ( Cambridge, Mass: MIT Press, 1985)
For intra-industry trade, see:
B. Balassa, “Trade Creation and Trade Diversion in the European Common Market,” Economic Journal , March 1967, pp. 1-21

56. Internet Materials http://www.census.gov/foreign-trade/sitc1/