1. Imperfect Competition, Increasing Returns, and Product Variety
Chapter
Imperfect Competition, Increasing Returns, and Product Variety

2. Difference Ricardian Model: Technological difference
Heckscher-Ohlin Model: Endowment different, identical tech.
Specific Factor Model: Endowment different, factor immobile.
But all assume market structure is perfect competitive
Imperfect competition matters
International competition between large firms.
The role of government: it will pass on a strategic advantage to domestic firms

3. Index to measure intra-industry trade
Previous models based on comparative advantage imply that a traded good is either importer or exported, but not both.
Index=1-(|X-M|)/(X+M)
The index ranges from zero, in which no intra-industry trade occurs, to one when exports and imports are balanced and intra-industry trade is at its maximum.

4. Table 7.1 Average Levels of Intra-Industry Trade, All Commodities, Selected Countries, (percentages)

5. Stylized Facts of Intra-industry Trade
Low for simple, undifferentiated products in which the U.S. has either a strong comparative advantage (corn) or disadvantage (crude petroleum).
High for nearly all complex, differentiated goods (photographic equipment) whatever the apparent state of the comparative advantage of the U.S.
High for some simple goods (fertilizers, inorganic chemicals) for which the U.S. seems to neither have a strong comparative or disadvantage.

6. Love of Variety Individuals may exhibit a love for variety.
Demand side
Each country’s variety is distinct from that in the other country.
Individuals consume a given amount of clothing and have available two variety of food.
The indifference curve for these two varieties hits the axes, showing that individuals can survive consuming only quantity C or D– An Ideal Variety
If restricted to consuming only one variety, and if the relative price of the first variety is higher than that of the second one, then individuals consume only the second variety.

7. Figure 7.2 Love of Variety

8. Love of Variety
However, for given prices of the two varieties, a mixture of varieties shown by A or by B could be obtained more cheaply and yield the same level of utility.
Intra-industry trade could improve real incomes even in the absence of any inter-industry trade.
There need to be no losers with trade – everyone benefits by having a wider selection of each type of commodity.

9. Increasing Returns to Scale
Internal IRS
the scale of a firm increases. Accordingly, the fixed cost of each product decreases.
Fixed cost could include management cost, designing cost, R&D.
External IRS
It happens within an industry. The number of firms increases, which cause the scale of an industry expand.

11. Production and Trade under IRS

12. Production and Trade under External IRS
Industry: demand and supply curves are regular.
At P1, no trade since price is too high in int’l market
LRAC is downward sloping due to the external IRS.
MC1 and AC1 in the right figure denotes firm’s case in Autarky.
Since external IRS, more firms enter the industry.
Market supply increases to S’.
Also, IRS makes each firm’s AC and MC decrease
Due to the decrease AC and MC of each firm, the industry’s AC and MC will decrease as well.
S’ shift right to S2.
The cost advantages cause trade.

13. Production and Trade under External IRS
The increased foreign demand shift aggregate demand right from D1 to D2.
New equilibrium at a lower price
Firms earn zero profit in the long run.
Consumers’ welfare increase due to a lower price.
Therefore, it exists gains from trade.

14. Production and Trade under Internal IRS
Internal IRS  Monopolistic Competition
The demand curve is downward sloping
Firms produce differentiated products
Firms also face competition
Free Entry
MR=MC

15. Monopolistic Competition

16. Monopolistic Competition with Trade

17. Monopolistic Competition with Trade
Before trade: demand is D1 and price is P1.
AC is higher than MC due to the fixed cost
Optimal quantity to produce is Q1.
After trade: foreign demand increases
D1 D2, MR1 MR2
Excess Profit exists in the short run as the shaded area.

18. Monopolistic Competition with Trade

19. In the long run, excess profit disappears.
New firms entry, which would absorb part of consumers
Demand curve D1 shift down first.
However, due to international trade, more quantity demanded under trade once price falls.
D1 shift to D3
Demand curve D3 is more elastic than that before trade, D1.

20. Monopolistic Competition with Trade
P3=LAC3, zero profit.
Effects of trade in the short run
Output up,
AC down
SR positive profit.
Price could down (as shown), consumers better off
Price could up, consumers worse off.
Effects of trade in the long run
Output up (but not necessarily higher than that in the SR)
AC=P down
Consumers better off
Firms zero profit
The whole society gains from trade.

21. Krugman (1979) Internal IRS
Chapter
Krugman (1979) Internal IRS

22. Assumptions Supply Side Firms face monopolistic competition
Production input requirement:
Labor is the only input, no capital
Assume each firm is symmetric
Li=a +byi
C=Lw=w(a+by)=aw + bwy
AC=aw/y+bw
MC=bw

23. Cost Curve AC MC y

24. Increasing Returns in Production
Assume that each variety entails two different types of costs: a fixed-cost and constant marginal production costs.
Therefore, to produce each variety, the average costs of production decline.
Monopolistic competition
Free Entry, zero profit
MR=MC
Assumptions: each firm produces a separate variety in which the cost structure is the same for all firms.
Demand is identical for all varieties.

25. Firms maximize their profits
MR=MC
It implies p(1-1/e)=bw
TR=P(Q)*Q
MR=P’(Q)*Q+P=P[(dP/dQ)*Q/P+1]
Elasticity of demand: e=-(dQ/dp)*(P/Q)
p/w=b*e/(e-1)=b*[1+1/(e-1)]
Assumption: the elasticity of demand is decreasing in consumption.
Consumption upe downp/w up

26. Example: a linear demand curve
p a
b d
o e f
elasticity =(ef/de)*(de/oe)=ef/oe=df/ad

27. Equilibrium at Autarky

28. Firms maximize their profits
P=AC
P=aw/y+bw
Market clear condition for product market:
For each variety:
where c is consumption per capita
P/w=a/y+b
P/w=a/(Lc)+b
Number of Variety

29. Trade Consumer Better-off?
Consumer consumes more or less within each variety?
Consumer consumes more or less varieties?
More varieties in each country?
Firms produce more or less?
More varieties in the world?
When labor increases, the inverse of real wages decrease. i.e., the real wages increase.

30. Diagram Analysis
p/w
MR=MC
P=AC c

31. From Autarky to Trade
In the H-O model, there is no reason for two identical countries to trade.
However, now suppose two countries produce different varieties, then they could trade.
But the key point is: what is the economic consequence?
Labor increases due to international trade
P=AC shift to the left due to the increase of labor

32. Implications Trade causes the consumption of each variety decrease.
This raises the elasticity of demand, reducing the equilibrium price and therefore raising real wages.
This is a source of gains for consumers.
But output of each variety increases
This is because the drop of output price makes the output necessarily increase as moving on the average cost curve.
Any firm that produces both in autarky and under free trade will be selling more with trade.

33. Cost Curve AC MC y

34. Number of Varieties Market clear condition of the labor market:
L=N*Li=N*(a+byi)=N*(a+bLci)
N=L/(a+bLci)=1/[(a/L)+bci)]
Both the increase of labor endowment and the decrease of the consumption lead to the increase of the number of varieties.
Consumer enjoy more varieties but consume less on each variety!

35. The Scale Effect v.s. Selection Effect
Scale effect: output of each variety increases
Selection Effect:
Recall L=N*(a+by)
Labor is fixed for each country, but output increases
Number of variety in each country reduces!
Opening trade between countries indeed implies that some firms must exit in each, while the remaining firms expand their output and take advantage of scale economics.

36. Figure 7.4 Size and Number of Firms

37. Size and Number of Firms
Assume same technology, same tastes.
Foreign is a large market (the U.S.) and devotes more resources to the clothing sectors.
Its firm in autarky will not resemble exactly the firms at home.
The RC curve shows how in each country sharing a common technology, large firm size goes hand in hand with the production of a greater number of varieties.
In autarky, the smaller home market is served by firms (at H) that are fewer in number and smaller in size than in the larger foreign market (F).

38. Size and Number of Firms
With trade, if the same resources are devoted to clothing as in autarky, producers concentrate (at H’ and F’), all firms are the same (larger) size, and a larger number of varieties is available for consumers (at W).
A move toward the southeast represents, for each country a cutback in the number of varieties produced but an increase in the scale of operation for each variety.

39. Inter-industry Trade
According to the Heckscher-Ohlin model or Ricardian model, countries specialize in production.
Trade occurs only between industries: inter-industry trade
In a Heckscher-Ohlin model suppose that:
The capital abundant domestic economy specializes in the production of capital intensive cloth, which is imported by the foreign economy.
The labor abundant foreign economy specializes in the production of labor intensive food, which is imported by the domestic economy.

40. Inter-industry Trade (cont.)

41. Intra-industry Trade
Suppose now that the global cloth industry is described by the monopolistic competition model.
Because of product differentiation, suppose that each country produces different types of cloth.
Because of economies of scale, large markets are desirable: the foreign country exports some cloth and the domestic country exports some cloth.
Trade occurs within the cloth industry: intra-industry trade

42. Intra-industry Trade (cont.)
If domestic country is capital abundant, it still has a comparative advantage in cloth.
It should therefore export more cloth than it imports.
Suppose that the trade in the food industry continues to be determined by comparative advantage.

43. Intra-industry Trade (cont.)

44. Inter-industry and Intra-industry Trade
Gains from inter-industry trade reflect comparative advantage.
Gains from intra-industry trade reflect economies of scale (lower costs) and wider consumer choices.
The monopolistic competition model does not predict in which country firms locate, but a comparative advantage in producing the differentiated good will likely cause a country to export more of that good than it imports.

45. Inter-industry and Intra-industry Trade (cont.)
The relative importance of intra-industry trade depend on how similar countries are.
Countries with similar relative amounts of factors of production are predicted to have intra-industry trade.
Countries with different relative amounts of factors of production are predicted to have inter-industry trade.
Unlike inter-industry trade in the Heckscher-Ohlin model, income distribution effects are not predicted to occur with intra-industry trade.

46. Inter-industry and Intra-industry Trade (cont.)
About 25% of world trade is intra-industry trade according to standard industrial classifications.
But some industries have more intra-industry trade than others: those industries requiring relatively large amounts of skilled labor, technology and physical capital exhibit intra-industry trade for the US.
Countries with similar relative amounts of skilled labor, technology and physical capital engage in a large amount of intra-industry trade with the US.

47. Inter-industry and Intra-industry Trade (cont.)
Note: an index of 1 means that all trade is intra-industry trade.
An index of 0 means that all trade is inter-industry trade.