1. International Economics Tenth Edition
CHAPTER S I X 6
International Economics Tenth Edition
Economies of Scale,
Imperfect Competition, and
International Trade
Dominick Salvatore
John Wiley & Sons, Inc.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

2. Learning Goals:
Explain how international trade can result from economies of scale
Explain how product differentiation leads to intra-industry trade
Understand the technological gap and product cycle models of trade
Understand the relationship between transportation costs and environmental standards in international trade
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

3. 6.1 Introduction Two difficulties with the H-O theory:
(1) Some questions remain regarding the empirical validity of the theory.
(2) This implies that a great deal of today's international trade still left unexplained.
This chapter fills this gap with some new trade theories, which base international trade on economies of scale, imperfect competition, and differences in the development and spread of new technologies over time among nations. 

4. Leaves significant portion of international trade unexplained.
Introduction
Heckscher-Ohlin theory based comparative advantage on differences in factor endowments among nations.
Leaves significant portion of international trade unexplained.
Need complementary trade theories to fill in the gaps.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

5. The Heckscher-Ohlin Model and New Trade Theories
Relaxing most assumptions of H-O theory modifies but does not invalidate the theory.
However, relaxing assumptions of perfect competition and constant economies of scale require complementary theories to explain trade.
Additional trade models required to explain trade based on differences in technological changes over time.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

6. Economies of Scale and International Trade
Assumptions
(1) There are two nations (N1, N2) two commodities (X, Y)
(2) Both nations use the same technology in production.
(3) Both nations have the same amount of resources.
(4) Neither commodity is labor intensive or capital intensive.
(5) Both commodities are produced under increasing returns to scale in both nations.
- i.e., Output grows proportionately more than the increase in inputs of production. (eg., If all inputs are doubled, output is more than doubled: Economies of scale.)
(6) Tastes are equal in both nations.

7. Economies of Scale and International Trade
Increasing returns to scale
Production situation where output grows proportionately more than the increase in inputs (doubling inputs more than doubles output).
With increasing returns to scale, mutually beneficial trade can occur even if nations are identical in every way.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

8. FIGURE 6-1 Trade Based on Economies of Scale.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

9. Economies of Scale and International Trade
Related Sources of International Trade
(1) International economies of scale (Case Study 6-1)
- Products manufactured by international corporations have parts and components made in many different nations.
- During the past decade or so, there has been a sharp increase in international trade in parts and components, as well as in setting up of production facilities abroad, and these have been the source of new and significant international economies of scale.
- E.g., The New International Economies of Scale (Case Study 6-1)

10. Economies of Scale and International Trade
Increasing returns to scale
Significant international economies of scale from:
Outsourcing – purchase by firm of parts and components abroad in order to keep costs down.
Offshoring – firm producing in its own plants abroad some of the parts and components used in its products.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

11. Imperfect Competition and International Trade
International trade can involve the exchange of differentiated products of the same industry or broad product group.
Leads to intra-industry trade in differentiated products, as opposed to inter-industry trade in completely different products.
Allows economies of scale in production.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

12. Imperfect Competition and International Trade
Contrasts to H-O Model
Trade in H-O model based on factor endowment differentials, but intra-industry trade is based on product differentiation and economies of scale, and will likely be larger for nations of similar size and factor proportions.
With differentiated products produced under economies of scale, pretrade-relative commodity prices may not accurately predict patterns of trade as they do under H-O model.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

13. Imperfect Competition and International Trade
Contrasts to H-O Model
H-O model predicts trade will lower returns of nation’s scarce factor. With intra-industry trade based on economies of scale, it is possible for all factors to gain.
Intra-industry trade is related to sharp increases in international trade in parts and components of a product, or outsourcing.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

14. Imperfect Competition and International Trade
Comparative advantage seems to determine patterns of inter-industry trade.
More likely with dissimilar factor endowments.
Economies of scale in differentiated products gives rise to intra-industry trade.
More likely with similar factor endowments.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

15. Imperfect Competition and International Trade
Intra-industry Trade Index (T):
T = 1 -
|X - M|
X + M
X = exports
M = imports
Numerator is absolute value
T ranges from 0 to 1
T=0 when nation only imports or exports the good
T=1 when exports = imports.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

16. FIGURE 6-2 Production and Pricing Under Monopolistic Competition.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

17. FIGURE 6-3 Monopolistic Competition and Intra-Industry Trade.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

18. Imperfect Competition and International Trade
Key characteristics of Intra-industry trade:
(1) While inter-industry trade (eg., trade in the H-O model) is based on comparative advantage among nations, intra-industry trade is based on product differentiation and economies of scale.
(2) With intra-industry trade, pretrade-relative commodity prices may no longer accurately predict the pattern of trade.
(3) While the H-O model predicts that trade will lower the return of the nation's scarce factor, with intra-industry trade it is possible for all factors to gain.

19. Imperfect Competition and International Trade
Key characteristics of Intra-industry trade:
(4) Intra-industry trade is related to the sharp increase in international trade in parts and components of a product.
(5) Intra-industry trade arises more between nations with similar tastes and income levels.
(6) While most of the trade between developed and developing countries is inter-industry trade, an increasing proportion of the trade among industrial countries is intra-industry trade.

20. Trade Based on Dynamic Technological Differences
Product Cycle Model (Vernon, 1966)
Advanced industrialized countries develop and introduce new products, with temporary monopoly power as the sole exporter of the product.
As the technology producing the product becomes more widespread, production will spread to other nations.
This moves international trade to a standard comparative advantage framework
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

21. Trade Based on Dynamic Technological Differences
Product Cycle Model (Vernon, 1966)
As production becomes standardized, the original introducer of the product loses its technologically based comparative advantage in the production of the product and becomes an importer of the product.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

22. FIGURE 6-4 The Product Cycle Model.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

23. Costs of Transportation, Environmental Standards and International Trade
Transportation costs
Transport, or logistics, costs are the freight charges, warehousing costs, costs of loading and unloading, insurance premiums, and interest charges incurred while goods are in transit between nations.
Homogeneous goods will be trade internationally only if the pretrade price difference exceeds transport costs.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

24. Costs of Transportation, Environmental Standards and International Trade
Transportation costs
Nontraded goods and services are goods for which transport costs exceed price differences across nations.
Examples:
Cement is not traded internationally because of its high weight-to-value ratio.
Average people do not travel from New York to London for a haircut.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

25. Two ways to analyze transport costs
Costs of Transportation, Environmental Standards and International Trade
Two ways to analyze transport costs
General equilibrium analysis
Uses production frontiers or offer curves, and expresses transport costs in terms of relative commodity prices.
Partial equilibrium analysis
Analyze absolute cost by holding constant exchange rates, income, and all else in the two nations except amount of good produced, consumed and traded.
More straightforward method than general equilibrium analysis.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

26. FIGURE 6-5 Partial Equilibrium Analysis of Transport Costs.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

27. Costs of Transportation, Environmental Standards and International Trade
Transport costs influence location of production and industry:
Resource-oriented industries locate near the source of raw materials used by the industry.
Market-oriented industries produce goods that become heavier or more difficult to transport during production, so they locate near the markets for their products.
Footloose industries face neither substantial weight gains nor losses during production, and can locate where availability of other inputs leads to lower manufacturing costs.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

28. Environmental standards
Costs of Transportation, Environmental Standards and International Trade
Environmental standards
Refers to levels of air, water and thermal pollution resulting from garbage disposal that a nation allows.
A nation with lower environmental standards can use the environment as a resource endowment, achieving comparative advantage in polluting goods and services.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

29. Case Study 6-3 U.S. Intra-Industry Trade in Automotive Products
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

30. Case Study 6-5 Growth of Intra-Industry Trade
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

31. Case Study 6-6 Intra-Industry Trade Indexes for G-20 Countries
Homework: Calculate Intra-industry Trade indices for your home country and Korea in 2014 (Use Comtrade HS 3-digit level), Due Nov 10, 2015.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

32. Appendix to Chapter 6 (Skip)
External Economies and Specialization
The Learning Curve and Specialization
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

33. FIGURE 6-6 External Economies and Specialization.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

34. FIGURE 6-7 The Learning Curve and Specialization.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

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Case studies and tables.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.