Chapter 6: Intra-Industry Trade PDF

WORLD ECONOMICS Chapter 6: Intra-industry Trade: Economies of Scale and Imperfect Competition Marc Arza 2023-2024 1of 50  Intra-industry Trade: Economies of Scale and Imperfect Competition Aims Thi...

WORLD ECONOMICS Chapter 6: Intra-industry Trade: Economies of Scale and Imperfect Competition Marc Arza 2023-2024 1of 50  Intra-industry Trade: Economies of Scale and Imperfect Competition Aims This chapter is about trade under monopolistic competition. We will analyse different types of equilibrium (with and without trade), both at the short-run and long-run. Finally, we will show some empirical applications of monopolistic competition and trade (i.e., index of Intra-Industry Trade and the Gravity Equation of Trade). References Feenstra, Robert C. and Alan M. Taylor, International Trade, Economics, MacMillan, 2017, Fourth Edition. 2of 50  Intra-industry Trade: Economies of Scale and Imperfect Competition 1. Introduction 2. Trade under Monopolistic Competition and Increasing Returns 3. Empirical Applications of Monopolistic Competition and Trade 3of 50  Intra-industry Trade: Economies of Scale and Imperfect Competition 1. Introduction 2. Trade under Monopolistic Competition and Increasing Returns 3. Empirical Applications of Monopolistic Competition and Trade 4of 50 Intra-industry Trade: Economies of Scale and Imperfect Competition  So far we have seen models of trade that explain why Germany exports cars to France and imports wine from France or why Vietnam exports clothes to the EU and imports computers from the U.S. → Inter-industry trade.  However, much of the world’s trade is intraindustry (e.g., Germany exports cars to Japan but it also imports cars from Japan; the U.S. exports and imports golf clubs).  How can we explain this? 5of 50 Intra-industry Trade: Economies of Scale and Imperfect Competition Source: OECD (2002) 6of 50 Intra-industry Trade: Economies of Scale and Imperfect Competition  Intra-industry trade is a growing phenomenon …  … related with the increasing number of supertrading economies (i.e., countries with a high trade share in GDP; there are currently eight OECD countries where both imports and exports account for more than half of GDP: Austria, Belgium, Czech Republic, Hungary, Ireland, Luxembourg, Netherlands, and Slovakia) … plus Thailand, Malaysia, Hong Kong and Singapore.  … related with the correlation between movements in export and import volumes. 7of 50  Intra-industry Trade: Economies of Scale and Imperfect Competition Source: OECD (2002) 8of 50 Intra-industry Trade: Economies of Scale and Imperfect Competition Source: OECD (2002) 9of 50 Intra-industry Trade: Economies of Scale and Imperfect Competition Source: Brulhart (2008) 10of 50 Intra-industry Trade: Economies of Scale and Imperfect Competition  New model with the following features:  Differentiated goods (different varieties of the same good) as opposed to homogeneous goods.  Imperfect competition (monopolistic competition) as opposed to perfect competition.  Economies of scale or increasing returns to scale. 11of 50 Intra-industry Trade: Economies of Scale and Imperfect Competition  Main idea: In this model trade arises not because of differences in technology (Ricardian model) or factor endowments (Heckscher-Ohlin model) across countries, but due to the existence of economies of scale that keep countries from producing the whole range of varieties of differentiated goods. 12of 50 Intra-industry Trade: Economies of Scale and Imperfect Competition  Main predictions of the model:  Countries trade different varieties of the same good: Intra- industry trade. Intraindustry trade produces extra gains from international trade, over and above those from comparative advantage, because intraindustry trade allows countries to benefit from larger markets. By engaging in intraindustry trade a country can simultaneously reduce the number of products it produces and increase the variety of goods available to domestic consumers. By producing fewer varieties, a country can produce each at larger scale, with higher productivity and lower costs and consumers benefit from the increased range of choice.  Larger countries tend to trade more: Gravity equation of trade. 13of 50  Intra-industry Trade: Economies of Scale and Imperfect Competition 1. Introduction 2. Trade under Monopolistic Competition and Increasing Returns 3. Empirical Applications of Monopolistic Competition and Trade 14of 50 Intra-industry Trade: Economies of Scale and Imperfect Competition  Assumption 1: each firm in the industry produces a variety of a differentiated good  since varieties are imperfect substitutes for each other, each firm faces a downward-sloping demand for its variety  and thus it can sort of behave as a monopolist  although still facing competition from the other firms. 15of 50 Intra-industry Trade: Economies of Scale and Imperfect Competition  Assumption 1: each firm in the industry produces a variety of a differentiated good  … this is quite different from perfect competition: both buyers and sellers are price takers, there is a large number of firms, there are no barriers to entry, the firms' products are identical, there is complete information (i.e., there are no information asymmetries) firms are profit maximizers 16of 50 Intra-industry Trade: Economies of Scale and Imperfect Competition Figure 6.1 In Monopoly, profits are maximized where MR=MC Price and price is determined from the Demand curve: QM and PM Monopoly equilibrium A PM Marginal cost, MC Marginal MR = MC Industry revenue, MR demand, D QM Quantity 17of 50 Intra-industry Trade: Economies of Scale and Imperfect Competition  Assumption 2: there are many (N≥2) firms in the industry  With N firms, D/N is the demand each firm faces if all charge the same price.  If only one firm lowers its price though, and given that the good is differentiated, it will face a flatter demand, d.  See graph with N=2 (duopoly) on next slide. 18of 50 Intra-industry Trade: Economies of Scale and Imperfect Competition Figure 6.2 When If the there are two good was firms in the and homogeneous Price industry If onethefirmand goods both charge its pricePto are differentiated lowered 1, the, ittotal P2then market at demand P2 itcapture would is will onlythe Qwhole 1 at A capture withofeach part market the firm andselling market andQ would 2 atQQ sell sell B4atatC.C’ 3 P1 B A Industry demand C' C P2 curve, D Demand curve facing each firm, d Firm demand when both firms charge the same price, D/2 Q2 Q4 Q1 Q3 Quantity 19of 50 Intra-industry Trade: Economies of Scale and Imperfect Competition  Assumption 3: firms produce using a technology with increasing returns to scale  Average costs of production fall as quantity produced increases. y  This is because firms face fixed production costs (e.g., initial investments in machinery and facilities or a research start-up cost, etc.).  i.e., firms’ cost structure: TC(Q) = F + c(Q)·Q 20of 50 Intra-industry Trade: Economies of Scale and Imperfect Competition  Assumption 4: firms can enter and exit the industry freely  In the long run firms will make zero profits, just as in perfect competition. What does zero profits mean? This is not about receiving zero returns for each firm: this is about average returns. Entry into a competitive industry will continue until all opportunity for positive economic profit is reduced to zero. The firms in a perfectly competitive industry are price takers, which means that they take the price the market gives them. The price and output of the industry is determined by the equilibrium point of the industry supply and demand curve (number of firms will strongly determine equilibrium). Without barriers to entry in a perfectly competitive market, the profit will attract new firms into the industry. If more and more firms enter the industry, the industry supply curve will shift more to the right, resulting in lower prices and less profit for the individual firm. This will cause some firms to leave, which would decrease the supply and shift it to the left, resulting in higher prices. This cycle will continue until all profits are reduced to zero and no firm makes any positive economic profits. 21of 50 Intra-industry Trade: Economies of Scale and Imperfect Competition  Assumption 5: love for variety (consumers like mixed bundles of product varieties)  Each country will want to consume all product varieties (local and foreign): The more a consumer has of a particular good, the less (s)he is willing to give up of something else to get even more of that good. The idea behind this assumption is that consumers like variety. If you like birthday cake and haven’t had cake lately, you might be willing to give up a lot for some cake. You might pay a high price for a cake, take the afternoon to bake a cake, or trade away your last carton of milk for some cake. On the other hand, if you’ve just polished off two-thirds of a cake, you are unlikely to be willing to pay much money for more, and you may very well want to trade the rest of the cake to get back some of that carton of milk. Like free disposal, it is possible to think of special cases in which the assumption of consumers liking variety will be violated (e.g., most people would prefer having either two water skis or two snow skis to having one of each). Nonetheless, we will almost always adopt this assumption because it holds true in a large number of situations and greatly simplifies our analysis. 22of 50 Intra-industry Trade: Economies of Scale and Imperfect Competition  Assumption 5: love for variety (consumers like mixed bundles of product varieties)  Each country will want to consume all product varieties (local and foreign): The number of firms in a monopolistically competitive industry and the prices they charge are affected by the size of the market: o In larger markets there usually will be both more firms and more sales per firm; consumers in a large market will be offered both lower prices and a greater variety of products than consumers in small markets. o Clearly, consumers would prefer to be part of a large market rather than a small one: being part of a large market implies accessibility to a greater variety of products at a lower prices. 23of 50 Intra-industry Trade: Economies of Scale and Imperfect Competition  Equilibrium Without Trade - Short-Run Equilibrium  We are not yet considering effects of trade.  Each firm behaves just like a monopolist and earns profits (see Figure 6.4).  Profits are quite large. 24of 50 Intra-industry Trade: Economies of Scale and Imperfect Competition Figure 6.4: Short-run equilibrium without trade Price Short run equilibrium here is the same as for a monopolist. MR = MC with price from demand. Since P > AC, firm is making a profit. P0 AC MC Demand curve mr0 facing each firm, d0 Q0 Quantity 25of 50 Intra-industry Trade: Economies of Scale and Imperfect Competition  Equilibrium Without Trade - Long-Run Equilibrium  If there are positive profits being made, firms will enter into the industry until they all earn zero profits.  See Figure 6.5: Equilibrium at point A.  Equilibrium price PA  Equilibrium number of firms NA  Notice the role played by demand D/NA. 26of 50 Intra-industry Trade: Economies of Scale and Imperfect Competition Figure 6.5: Long-run equilibrium without trade Price Equilibrium is at A, producing Q1, where mr1 crosses MC. This gives price, PA, from the demand, d1 Drawn by the profits in the industry, firms enter. The demand for this firm drops to d1 with corresponding mr1. d1 is more elastic, due to competition, and therefore flatter than d0 PA A Long-run equilibrium without trade AC MC d1 mr1 d0 Q1 Quantity 27of 50 Intra-industry Trade: Economies of Scale and Imperfect Competition Figure 6.5: Long-run equilibrium without trade Price At Q1, the no-trade price PA = AC so the firms are all earning zero monopoly profits and there is no entry or exit P0 Short-run equilibrium without trade PA A Long-run equilibrium without trade AC MC d1 mr1 d0 Firm demand when all firms D/NA charge the same price Q1 Q0 Quantity 28of 50 Intra-industry Trade: Economies of Scale and Imperfect Competition  Short-Run Equilibrium with Trade  Assume Home and Foreign are exactly the same.  Same number of consumers  Same technology and cost curves  Same number of firms in the no-trade equilibrium  When trade opens, the number of customers available to each firm doubles, but there are also twice as many firms and varieties.  See Figure 6.6:  Each firm lowers the price expecting to earn profits at point B  but they end up at point B’ making losses! 29of 50 Intra-industry Trade: Economies of Scale and Imperfect Competition Figure 6.6: Short-run equilibrium with trade Price Opening As trade all firms makes lower their the firm’s price to Pdemand even more 2, the relevant demand is D/N at elastic,A B’ selling shown by d2only. The Q’firm 2. Atchooses this point to firms are at Q2, produce incurring where MR=MC,losses and some selling at Pfirms 2. Atwill thisbe forced price the to exit firm the makes industry monopoly profits as P2>AC Long-run equilibrium without trade Short-run equilibrium with trade PA A P2 B B’ d2 AC MC mr2 D/NA Q1 Q’2 Q2 Quantity 30of 50 Intra-industry Trade: Economies of Scale and Imperfect Competition  Long-Run Equilibrium with Trade  Since firms are making losses, some of them will go bankrupt and exit the industry.  Long-run equilibrium –point C in Figure 6.7:  The demand for each firm is tangent to AC so that each firm earns zero profits.  Equilibrium number of firms: NT < NA  Equilibrium price: pW 31of 50 Intra-industry Trade: Economies of Scale and Imperfect Competition Figure 6.7: Long-Run Equilibrium with Trade Price Since Since some The demand firms PW = AC, have firms faced exited byare making each the is firm zero d3 industry, with mr3we monopoly are=MC. profits, mr leftnowith T firms firms shows exit which that or enter the each 3 gives each industry, firm and firm produces CQ aisshare of the the long runWdemand equilibrium 3 at a price P shown by D/N T with trade Long-run equilibrium without trade D/NT Long-run equilibrium PA A with trade PW C AC d3 MC mr3 Q1 Q3 Quantity 32of 50 Intra-industry Trade: Economies of Scale and Imperfect Competition  How does long-run equilibrium with trade compare to that without trade?  Even with the exit of some firms, we still expect that the number of firms (and varieties!) is greater than the number available in each country before trade: 2NT > NA  Each of the remaining firms produces a higher quantity than in the no-trade situation (Q3 > Q1) and charges a lower price (pW