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C 1 INTRA-INDUSTRY TRADE AND THE SCALE EFFECTS OF ECONOMIC INTEGRATION Elisa Riihimäki Statistics Finland, Business Structures September 2005

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C 2 Objective of this presentation is to analyse the scale effects of economic integration in the framework of intra-industry trade Approach in two steps: 1) In a theoretical model of intra-industry trade, I determine two major scale effects through which integration might affect 2) And how to determine these scale effects in the econometric analysis

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C 3 The progress of integration increase competition in the international product market but also the wider market enables to expand sales and production a) The wider trade and capital flows increase the international price- competition between countries b) On the other hand, firms with access to the wider market were expected to take better advantage of economies of scale Thus, market power may arise from specialisation in production and differentiation of products to establish segmented markets (e.g. increased international trade in services)

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C 4 Theoretical model of intra-industry trade I consider an open economy where there are many firms at industry level producing differentiated good Supposing that product markets are imperfectly competitive, there is monopolistic competition in good markets Extension of the model of Dixit and Stiglitz (1977): Monopolistic Competition and Optimum Product Diversity. American Economic Review 67,

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C 5 Definition Intra-industry trade can be defined as the two-way exchange of goods in which neither country seems to have a comparative cost advantage This approximates a situation in which there are a large number of varieties and each firm has some power over the pricing of its product I suppose that international integration a) increase the price competition b) and enables better advantage of economies of scale

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C 6 Together with interaction between number of products/firms and degree of price competition, intra-industry trade and economic integration can be seen as the result of the interaction between product differentiation and economies of scale => Each industry contains a large, but limited because of economies of scale, number of potential differentiated products that consumers regard as imperfect substitutes Representative consumers tastes are assumed represented by the utility function where an index of consumption of the differentiated products at industry j positive constant

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C 7 By imposing the symmetry assumption a consumer maximising will set an index of consumption of the differentiated products at industry j whereproduct-demand elasticity an index of the price level in terms of international integration

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C 8 The product-demand elasticity can be thought as an increasing function of the number of products where number of products/firms An increase in the number of firms leads to an increase in the degree of competition

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C 9 We get then the demand of products type i wherethe price of variety i the elasticity of substitution between any two products types

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C 10 The industrys elasticity of substitution among differentiated goods can be thought as a decreasing function of the advantage of economies of scale A growth in the advantage of economies of scale in industry leads to a decrease in the degree of substitution among differentiated goods within industry where an exogenous comparative productivity for domestic industry relative to foreign

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C 11 Impact of a reduction in trade costs ( ) on product markets Let consider the impact of a reduction in marginal trade costs on product markets due to transactions costs and other trade barriers related to foreign trade For simplicity, it is assumed that the trade costs of import and export outputs are equal The effects on imperfectly competitive product markets of increased integration via declining trade costs are basically of two counteracting sorts

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C 12 1) Firstly, assuming that firms were expected to be able to expand production taking better advantage of economies of scale (a) it follows that product-substitutability ( ) decrease This has associated to reduced market imperfection and to increased incentive of product-differentiating

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C 13 Higher price competition makes product-demand ( ) more elastic 2) Secondly, market entry becomes easier or less costly implying that more goods become traded goods (n) The higher the degree of price competition is, i.e., the closer substitutes the good sale on the world market is, the more elastic with respect to own price output demand becomes

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C 14 => In the imperfect competition, we have then the condition of pricing rule for products types at industry j With in optimum, the price equals to the marginal revenue from exporting, where we must have that relative trade cost equals to mark-up factor

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C 15 Proposition for the characterisation of the optimal pricing rule: Lower trade costs with increased integration, higher number of firms and in consequence of its higher elasticity of product demand will reduce the mark-up price, whereas better advantage of economies of scale and in consequence of its lower elasticity of substitution between differentiated products will raise it => Product demand becomes more price elastic when product markets are more integrated, but is the effect of product market integration on the price sensitivity of the market share larger than its direct effect on the market share

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C 16 Econometric analysis 1) Constant scale returns To estimate constant-output ( = 1) price-relation ( ) it can be used restricted generalized least squares estimation (GLS) with constant scale returns 2) Scale effects of integration To estimate scale effects price-relation ( ) it can be used instrumental variables estimation (G2SLS) with scale returns

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C 17 There are two possible different control variables: a) the share of countrys exports to the other countries in production b) and the share of the countrys output in production of other countries which are deflated by countrys real competitiveness indicator (where country weights are based on countrys bilateral exports) a) The first attempts to measure foreign demand for countrys products b) and the second attempts to measure the overall demand of other countries furthermore, a real competitiveness indicator measures the international product market competition => The scale effects of integration ( ) measures the impact of international demand shock on the demand of factors

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C 18 a) A rise in exports increases the production of industry, which is supposed to increase the demand of factors The assumption is that higher export signals better scale economies (or less foreign competition) This makes all factor demands less elastic with own price via the scale effect of integration b) On the other hand, the more the rest of the other countries accounts for the output of industry, the more competitive that industry is for countrys firms and thus the more elastic all factor demands will be An increase in the real competitiveness indicator means that an industrys price competitive ability decrease is supposed to decrease the product demand and thus the demand of factors Thus, declining competitiveness indicator should make international product markets more competitive; this should make all factor demands more elastic

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C 19 If both scale ( ) and constant-output ( ) price- relations are consistently estimated, then the difference between these two is an estimate of the scale effects, and it would provide indirect evidence about the competitiveness of product market, and thus it can be determined the impact of integrations scale effects

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C 20 Statistical example For example, international trade in services (ITS) have increased last years Trade in services is often, in fact, trade with trade of goods, not pure services This is good example, how firms specialised within industry Increased competition could also reinforce pressures to specialise and differentiate goods increasing tradable services Average annual change of ITS in OECD-countries,

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