1. Chapter 6 Scale Economies, Imperfect Competition, and Trade

2. Scale Economies With constant returns to scale, input use and total cost rise in the same proportion as output increases. – Because total cost and output go up by the same proportion, average cost (cost divided by the number of units produced) is constant (or steady). With scale economies, output quantity goes up by a larger proportion than does total cost, as output increases. – If output quantity expands faster than total cost increases, then the average cost of producing a unit of output decreases as output increases. © 2016 McGraw-Hill Education. All Rights Reserved. 2

3. Scale Economies © 2016 McGraw-Hill Education. All Rights Reserved. 3

4. Internal Economies of Scale In internal economies of scale the size of the individual firm matters, i.e. larger firms have a cost advantage over smaller firms. Scale economies that are internal to the firm can drive an industry away from perfect competition, because they drive individual firms to be larger than the (very) small firms that populate perfectly competitive industries. © 2016 McGraw-Hill Education. All Rights Reserved. 4

5. Internal Scale Economies If scale economies are modest or moderate, there is room in the industry for a large number of firms For products that are differentiated, a mild form of imperfect competition called monopolistic competition exists, where a large number of firms compete vigorously with each other in producing and selling varieties of the basic product. If a few large firms dominate the global industry, perhaps because of substantial scale economies, then we have an oligopoly. © 2016 McGraw-Hill Education. All Rights Reserved. 5

6. External Scale Economies External scale economies are based on the size of an entire industry within a specific geographic area. – The average cost of the typical firm producing the product in this area declines as the output of the industry (all the local firms producing this product) within the area is larger Types of external economies of scale: – Clustering of the production of some products in specific geographic areas due to a specialized supply of resources such as labor, equipment and support services – Greater knowledge spillover among the firms in the cluster © 2016 McGraw-Hill Education. All Rights Reserved. 6

7. Intra-Industry Trade Net trade for an industry is the difference between exports and imports of the industry’s product(s). Inter-industry trade: a country exports products in some industries and imports products in other industries. For each industry, net trade is either (almost) all exports or (almost) all imports. Intra-industry trade (IIT): two-way trade in which a country both exports and imports the same or very similar products (products in the same industry). © 2016 McGraw-Hill Education. All Rights Reserved. 7

8. Measuring Intra-Industry Trade IIT is the part of total trade in the product (exports plus imports) that is not net trade (IIT) = (X + M) – │X – M │ where X is the value of exports and M is the value of imports of the product Intra-industry trade for a product is equivalent to twice the value of the smaller of exports or imports. © 2016 McGraw-Hill Education. All Rights Reserved. 8

9. How Important is Intra-Industry Trade? © 2016 McGraw-Hill Education. All Rights Reserved. 9

10. Intra-Industry Trade for the United States, Selected Products, 2012 U.S. Exports (X) $millionU.S. Imports (M) ($millions)Total Trade (X+M) ($millions)Net Trade (X-M) ($millions)Intra-Industry Trade ($millions)IIT Shares (%) Perfumes(55310) 1,7231,9623,684(−)2393,44593.5 Cosmetics(55320) 3,7103,0586,768(+)6516,11790.4 Clothes washing machines (77511) 205308512(−)10341079.9 Microcircuits (77640) 33,48327,49060,973(+)5,99354,97990.2 Automobiles(78120) 53,901149,142203,042(−)95,241107,80253.1 Books and brochures (89219) 323134456(+)18926758.6 Photographic cameras(88111) 2,4141,7124,126(+)7013,42583.0 © 2016 McGraw-Hill Education. All Rights Reserved. 10

11. Average Percentage Shares of Intra- Industry Trade in the County’s Total Trade in Nonfood Manufactured Products Country198920052012 United States 55.358.363.6 Canada54.363.2 55.4 Japan27.841.2 38 Germany62.667.5 67.2 France71.373.9 71.5 United Kingdom69.071.7 71.6 © 2016 McGraw-Hill Education. All Rights Reserved. 11

12. What Explains Intra-Industry Trade? Some measured IIT reflects trade driven by comparative advantage Product differentiation: many different types and varieties of a product may exits Transportation cost and geographical location © 2016 McGraw-Hill Education. All Rights Reserved. 12

13. Monopolistic Competition and Trade Monopolistic competition describes an industry with the following characteristics: A large number of firms each producing a variant of a product that consumers view as unique. The product differentiation may be based on branding, physical characteristics, quality, effectiveness, or anything else that matters to consumers. Each firm has some degree of monopoly power based on its established production of its unique variety. There is ease of entry and exit of firms in the long run © 2016 McGraw-Hill Education. All Rights Reserved. 13

14. The Market with No Trade The three key characteristics of monopolistically competitive market for small compact cars with no trade in the U.S. are: Differentiation: The price that a firm can charge decreases as the number of models available in the market increases. The price curve (P) is downward sloping Internal scale economies: Crowding of models reduces the ability for the firm to achieve scale economies. The unit cost curve (UC): an upward sloping curve Ease of entry and exit from market: In the long run, a typical firm earns zero economic profits on its model © 2016 McGraw-Hill Education. All Rights Reserved. 14

15. The U.S. Market for Compact Cars, No Trade © 2016 McGraw-Hill Education. All Rights Reserved. 15

16. Opening to Free Trade If the world is now open to trade, 1. Domestic automobile company, for example Ford, can export their models to foreign consumers. 2. Foreign automakers in the rest of the world can export their models to the United States © 2016 McGraw-Hill Education. All Rights Reserved. 16

17. Markets for Compact Cars, No Trade and Free Trade © 2016 McGraw-Hill Education. All Rights Reserved. 17

18. Basis for Trade In this setting the basis for trade is product differentiation. The basis for exporting is the domestic production of unique models for foreign consumers The basis for importing is the demand by domestic consumers for unique models produced by foreign firms. Intra-industry trade in differentiated products can be large, even between countries that are similar in their general production structure © 2016 McGraw-Hill Education. All Rights Reserved. 18

19. Net Trade and Intra-Industry Trade © 2016 McGraw-Hill Education. All Rights Reserved. 19

20. Gains from Trade A major additional source of national gains from trade is the increase in the number of varieties of products available to consumers through imports Another source of gains from trade arises from increased competition between domestic and foreign firms and lower prices of domestic varieties. © 2016 McGraw-Hill Education. All Rights Reserved. 20

21. Gains from Trade Unlike the H-O model, the opening up of trade has little impact on the domestic distribution of factor incomes if the additional trade is intra-industry. Gains from greater variety can offset any losses in factor income resulting from inter- industry shifts in production that do occur. © 2016 McGraw-Hill Education. All Rights Reserved. 21

22. Global Oligopoly In an oligopoly market a small number of firms dominate total production of a product. Examples: – Boeing and Airbus account for nearly all the world’s production of large commercial aircrafts – Sony, Nintendo, and Microsoft design and sell most of the world’s video game consoles. – Companhia Vale de Rio Doce (CVRD), Rio Tinto, and BHP Billiton mine more than half of the world’s iron ore © 2016 McGraw-Hill Education. All Rights Reserved. 22

23. Oligopoly, Scale Economies, and Trade If substantial scale economies exist over a large range of output, then production of a product tends to be concentrated in a few large facilities in a few countries to take advantage of the cost-reducing benefits of the scale economies. Countries that have these production locations export the product. Other countries import the product. © 2016 McGraw-Hill Education. All Rights Reserved. 23

24. Oligopoly Pricing Each firm in an oligopoly is competing with a few other large firms, so any action it takes will provoke reactions from rivals – Prisoner’s dilemma – Cartels If the oligopoly firms can restrain their price rivalry, then the exporting countries benefit from the higher export prices and better terms of trade. © 2016 McGraw-Hill Education. All Rights Reserved. 24

25. External Scale Economies External Scale Economies (also called agglomeration economies) exist when the expansion of the entire industry’s production within a geographic area lowers the long-run average cost for each firm in the industry in the area. Production tends to be concentrated in a small number of locations, and countries with these locations export the product. © 2016 McGraw-Hill Education. All Rights Reserved. 25

26. External Economies Magnify and Expansion in a Competitive Industry © 2016 McGraw-Hill Education. All Rights Reserved. 26

27. Problem 11: Data for Japanese exports and imports, 2012 Product Japanese Exports($millions) Japanese Imports($millions) Perfumes(55310) 3234 Cosmetics(55320) 1,2911,183 Clothes washing machines (77511) 3967 Microcircuits (77640) 27,99717,456 Automobiles(78120) 97,27610,882 Photographic cameras (88111) 1126 Books and brochures (89219) 96251 © 2016 McGraw-Hill Education. All Rights Reserved. 27