1. Monopolistic competition and trade
Pierre-Louis Vézina

2. Introduction
Both external and internal economies of scale are important causes of international trade.
In this lecture we’ll see how internal economies of scale lead to monopolistic competition and trade

3. Introduction
Ricardo and Hecksher-Ohlin predict countries that are most different should trade more, and should trade different goods
Yet a lot of world trade is between similar countries, in similar goods
This is known as intra-industry trade

4. Intra-industry Trade
In 2010, the US exported $1 billion in motorcycles and imported $1.2 billion in motorcycles!

5. Intra-industry Trade
Intra-industry trade refers to two-way exchanges of similar goods.
About 25–50% of world trade is intra-industry.
Trade of manufactured goods among advanced industrial nations accounts for the majority of world trade

6. Intra-industry Trade

7. Intra-industry Trade

8. Intra-industry Trade

9. Intra-industry Trade

10. Intra-industry Trade

11. Intra-industry Trade We need a theory to explain intra-industry trade!
This is what Paul Krugman came up with in 1979… and won the Nobel Prize for 30 years later

12. Intra-industry Trade We need a theory to explain intra-industry trade!
Krugman, Paul R., "Increasing returns, monopolistic competition, and international trade," Journal of International Economics, vol. 9(4), pages , November.
Paul Krugman, "The Increasing Returns Revolution in Trade and Geography," American Economic Review, American Economic Association, vol. 99(3), pages , June.

13. Monopolistic competition
Internal economies of scale imply that a firm’s average cost of production decreases the more output it produces.
Large firms have a cost advantage over small firms
This causes the industry to become uncompetitive and consist of a monopoly or of a few large firms as small firms become uncompetitive

14. Monopolistic competition
In monopolistic (or imperfect) competition, firms can influence the prices of their products and sell more by reducing their price
This situation occurs when there are only a few major producers of a particular good or when each firm produces a good that is differentiated from that of rival firms.
Each firm views itself as a price setter, choosing the price of its product. Firms have market power.

15. Monopolistic competition
In competitive markets, such as the wheat market, farmers don’t worry about selling more wheat as it won’t affect prices

16. Monopolistic competition
It’s different for Boeing, as its market is a duopoly and its production affect world supply and thus prices

17. Monopolistic competition
It’s different for Harley-Davidson and Kawasaki, who compete in a world of many motorcycle producers yet their bikes are differentiated. They have some market power.

18. Monopolistic competition
Before we dig into monopolistic competition, let’s do a refresher on monopoly theory
A monopoly is an industry with only one firm

19. Monopoly: A Brief Review
Suppose that the firm’s total costs are C = F + c × Q
F is fixed costs, those independent of the level of output
c is the constant marginal cost.
Marginal cost is the cost of producing an additional unit of output.
Average cost is the cost of production (C) divided by the total quantity of production (Q).
AC = C/Q = F/Q + c
A larger firm is more efficient because average cost decreases as output Q increases: internal economies of scale!

20. Monopoly: A Brief Review
internal economies of scale!

21. Monopoly: A Brief Review
The demand curve the firm faces is a straight line Q = A – B(P), where Q is the number of units the firm sells, P the price per unit, and A and B are constants. P Q

22. Monopoly: A Brief Review
How much does the monopoly earn by selling one extra unit? What’s its marginal revenue?

23. Monopoly: A Brief Review
How much does the monopoly earn by selling one extra unit? What’s its marginal revenue?
That’s the demand curve

24. Monopoly: A Brief Review
How much does the monopoly earn by selling one extra unit? What’s its marginal revenue?
That the marginal revenue curve

25. Monopoly: A Brief Review
How much does the monopoly earn by selling one extra unit? What’s its marginal revenue?
Note that MR falls faster than P
That the marginal revenue curve
Q=A-BP
P=A/B –(Q/B)
PQ=AQ/B –(Q/B)Q
MR=dPQ/dQ=A/B-2Q/B = P-Q/B
Marginal revenue equals MR = P – Q/B
(see Ch. 8 appendix)

26. Monopoly: A Brief Review

27. Monopoly: A Brief Review
The profit-maximizing output occurs where marginal revenue equals marginal cost.
At the intersection of the MC and MR curves, the revenue gained from selling an extra unit equals the cost of producing that unit.
The monopolist earns some monopoly profits, as indicated by the shaded box, when P > AC.

28. Monopolistic Competition
Monopolistic competition is a model of an imperfectly competitive industry where each firm
can differentiate its product (that gives it some monopoly power), and
takes the prices charged by its rivals as given (it ignores the impact of its own price on the prices of other firms)

29. Monopolistic Competition
Product differentiation describes quite well the manufacturing products traded around the world
Buyers of iPhones do not think of Samsung Galaxies as perfect substitutes
But the market demand for iPhones does depend on the number of imperfect substitutes and their price

30. Monopolistic Competition (cont.)
A firm in a monopolistic competition industry is expected to sell
more the larger the industry demand and the higher the prices charged by rivals
less the larger the number of competing firms in the industry and the higher the firm’s price
These concepts are represented by the function:

31. Monopolistic Competition (cont.)
Q = S[1/n – b(P – P)]
Q is an individual firm’s sales
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 firm’s sales to its price
P is the price charged by the firm itself
P is the average price charged by its competitors

32. Monopolistic Competition (cont.)
We have Q = S[1/n – b(P – P)] = [(S/n)+S × b × P ]– S × b × P
Monopolistic firms face linear demand functions, Q = A – B(P)
(Note the similar form as the linear demand above, (B=S x b))
When firms maximize profits, they produce until marginal revenue equals marginal cost:
MR = P – Q/B = c
P = Q/ (S × b)+c
Assume each firm sells the same amount, Q=S/n
 P = c + 1/(b × n)
MR = P – Q/Sb =P-(b/n)

33. Equilibrium in a Monopolistically Competitive Market
P = c + 1/(b × n)
PP: As the number of firms n increases, the price that each firm charges decreases because of increased competition.

34. Monopolistic Competition (cont.)
What about the cost function?
Remember we just assumed that each firm sells the same amount; we thus assume that firms are symmetric. All firms also have the same cost function.
All firms should charge the same price and have equal share of the market Q = S/n
Average costs depend on the size of the market and the number of firms:
AC = C/Q = F/Q + c = n F/S + c

35. Equilibrium in a Monopolistically Competitive Market
AC = n F/S + c
CC: As the number of firms n increases, the average cost increases for each firm because each produces less.

36. Monopolistic Competition (cont.)
AC = n F/S + c
As the number of firms n in the industry increases, the average cost increases for each firm because each produces less.
As total sales S of the industry increase, the average cost decreases for each firm because each produces more.

37. Monopolistic Competition (cont.)
At some number of firms, the price that firms charge (which decreases in n) matches the average cost that firms pay (which increases in n).
At this long-run equilibrium number of firms, firms have no incentive to enter or exit the industry.

38. Equilibrium in a Monopolistic Competition Market
n2 is the zero-profit number of firms in the industry

39. Monopolistic Competition (cont.)
If the number of firms is greater than the equilibrium number, then firms have an incentive to exit the industry.
Firms have an incentive to exit the industry when price < average cost.
If the number of firms is less than the equilibrium number, then firms have an incentive to enter the industry.
Firms have an incentive to enter the industry when price > average cost.

40. Monopolistic Competition and Trade
Trade increases market size (S)
Industry sales increase leading to decreased average costs:
AC = n(F/S) + c
(Trade decreases average cost as each firm produces more)

41. Effects of a Larger Market
Trade (an increase in S) lowers the CC line

42. Monopolistic Competition and Trade (cont.)
Because average costs decrease, consumers can benefit from a lower price.
And because trade increases the variety of goods that consumers can buy, it increases their welfare
The result reads like an advertisement for free trade: lower prices, more varieties!

43. Trade and gains from variety

44. Trade and gains from variety
The number of available products in US imports tripled from 1972 to 2001
According to Broda and Weinstein, that’s a welfare gain equal to 2.6% of US GDP.
Christian Broda & David E. Weinstein, "Globalization and the Gains from Variety," The Quarterly Journal of Economics, MIT Press, vol. 121(2), pages , May (or this one).
A non-technical summary: Variety, the spice of life, has measurable value. But it's not easy to determine. THE NEW YORK TIMES, "ECONOMIC SCENE", JUNE 16, 2004

45. Trade and gains from variety
Economists “assume” people have love of variety
Discuss in small groups:
Do you think variety is the spice of life?
Let’s say you prefer the iPhone to the Galaxy, by how much would the price of the Galaxy need to fall for you to switch to it?
Do you think the two phones are close substitutes?
What type of goods are more likely to be substitutes? Cars? Restaurants? Clothing? Beers?

46. Trade and gains from variety
Broda and Weinstein start from the fact that people love variety:
Spending £20 can get you happier than before as your goods basket is now more varied!
With variety, you get more bang for your buck (more utility per pound)
To translate this love of variety gain into a price effect, they argue that:
The CPI measures the current cost of a fixed basket of goods and services
A cost-of-living index measures the cost of maintaining a certain “standard of living,” without restrictions on what is in the basket
A varied basket will maintain your standard of living at a lower price

47. Trade and gains from variety

48. Trade and gains from variety
Indifference curve
Budget constraint
Consumption of variety 1

49. Trade and gains from variety
Before trade only variety 1 is available. Consumption that maximizes utility is point A.

50. Trade and gains from variety
The consumption of 2 varieties after trade allows for the same utility at a lower price.
This graph is from Rob Feenstra who devoted his whole career to understanding the gains from trade from increased varieties.
He’s got more than one book about it!

51. Trade and gains from variety
For there to be gains from trade, you need an increase in varieties, and these need to be different, not close substitutes
Petrol from BP or Shell is pretty much the same thing for most drivers
iPhones and Galaxies are differentiated
Differentiated goods have a low elasticity of substitution  You don’t switch much to the alternatives when the price goes up

52. Trade and gains from variety
So how do we know if humans love variety?
Behavioural economists run some experiments
People eat 43% more M&Ms when there are ten colours in the bowl instead of seven.

53. Trade and gains from variety
And so do capuchin monkeys…

54. Trade and gains from variety
This research is by Dan Ariely and a team in Rome
It argues monkeys choose variety for variety’s sake and suggests that variety-seeking “contributed to the rise of bartering and then abstract money in human society.”

55. Trade and gains from variety
Gains from variety is also about input variety
Firms benefit from international trade through their increased access to previously unavailable inputs (specific parts and components)
These make them more productive and thus adds to the gains from trade

56. Trade and gains from variety
What to keep in mind?
Consumers and firms have love of variety
More imported varieties with low elasticities of substitution lead to gains from trade

57. International trade creates a larger market
The car industry
International trade creates a larger market
Let’s consider a numerical example to look at its effects on prices, scale, and product variety

58. The car industry b=1/30,000 P=c+1/(b × n) P=5,000+30,000/n
F = $750,000,000
c=$5000
C=750,000,000 + (5,000 × Q)
AC= 750,000,000/Q + 5,000
AC= n(750,000,000/S) + 5,000

59. Equilibrium in the Automobile Market

60. Equilibrium in the Automobile Market

61. Equilibrium in the Automobile Market
Integrating markets through international trade has the same effects as growth of a market within a single country.

62. Hypothetical Gains from Market Integration
Consumers in a car-producing country are not limited to buying the car models that are produced domestically:
many of those consumers choose to buy models that are produced elsewhere and imported.

63. Hypothetical Gains from Market Integration
Consumers in a car-producing country are not limited to buying the car models that are produced domestically:
many of those consumers choose to buy models that are produced elsewhere and imported.
It is unclear if firms will locate at Home or Foreign.

64. Gains from Market Integration
One of the most striking real-world economic integration between similar countries occurred between the US and Canada
Started with the signing of the North American Auto Pact in 1964
Before then, most car models were produced in the US for US consumers and in Canada for Canadian consumers
High tariffs on auto trade made it uneconomical to export most car models across the border

65. Gains from Market Integration
Because the Canadian auto market was roughly 1/10th the size of the US’, this implied substantial scale disadvantages: labour productivity there was about 30% lower
The 1964 Pact established free trade for autos
It allowed manufacturers to consolidate the production of car models in one country and export that model to foreign consumers

66. Gains from Market Integration
General Motors cut in half the number of models assembled in Canada.
However, Canadian automotive exports to the US increased from $16 million in 1962 to $2.4 billion in 1968.
That same year, US automotive exports to Canada were valued at $2.9 billion  intra-industry trade in action.
By the early 1970s, the Canadian auto industry’s 30% labour productivity shortfall relative to its US counterpart had disappeared

67. Gains from Market Integration
Later, this transformation of the automotive industry was extended to include Mexico.
In 1989, Volkswagen consolidated its North American operations in Mexico
In 1994, Volkswagen started producing the new Beetle for the entire North American market in that same Mexican plant.

68. Gains from Market Integration
Lileeva and Trefler (2010) look at 5,000 Canadian manufacturing plants that did not export prior to 1988 and divide these plants into those that started exporting after the passage of the free trade agreement and those that did not. In the raw data, the labor productivity of those that started to export rose 29 percent more than for nonexporters; starting to export was highly correlated with within-plant productivity growth.
The auto pact was extended to (almost) all manufacturing trade
The free trade agreement caused the productivity of new exporters to rise by 15.3%

69. Gains from Market Integration
Read more:
Marc J. Melitz & Daniel Trefler, "Gains from Trade When Firms Matter," Journal of Economic Perspectives, American Economic Association, vol. 26(2), pages , Spring.

70. Gains from Market Integration
Another prominent example of economic integration began in 1957… the EU!
Many politicians predicted that German manufacturers would eradicate their European competitors.
The facts did not treat such predictions kindly: intra-industry trade as a share of EU trade more than doubled from 1960 to 1990

71. Recap
Internal economies of scale imply that more production at the firm level causes average costs to fall.
With monopolistic competition, each firm can raise prices somewhat above those on competing products due to product differentiation but must compete with other firms
Monopolistic competition allows for gains from trade through lower costs and prices, as well as through wider consumer choice.
Location of firms under monopolistic competition is unpredictable, but countries with similar relative factors are predicted to engage in intra-industry trade.

72. Outro
Trade was once dominated by the movement of goods that could only be produced, harvested, or mined regionally. The international trade landscape is now dominated by two striking facts:

73. Outro
The first is the rise of intra-industry trade— that is, two-way trade in similar products.
UK exports Minis and UK consumers can now buy a car from Toyota (Japan), Kia (Korea), VW (Germany), General Motors (US), etc...
UK exports Topshop and UK consumers get H&M, Gap, and Zara
Each country gains access to more varieties, even though the number of varieties worldwide may fall

74. Outro
The second striking fact is that world trade is dominated by big productive firms.
For example, Intel is so large that it is the largest industrial employer in both Oregon and New Mexico and accounts for 20% of Costa Rica’s exports.
Taiwan’s Foxconn infamously employs 450,000 workers in a single one of its many export-oriented electronics factories in China. These are big companies…