Economies of scale, imperfect competition and international trade

1
Economies of scale, imperfect competition and
international trade

• Ch 6 Krugman and Obstfeld
• Eco3024F

2
Structure

• Introduce new model of trade Monopolistic
  competition model
• Introduce concepts
• Internal Economies of Scale (EOS)
• External Economies of Scale (EOS)
• Develop Monopolistic Competition Model

3
Trade theory

• So far, what causes trade
• Different technology (Ricardo)
• Different factor endowments (HO)
• Different tastes
• Hence when countries are different in production
  or consumption
• What happens when countries are very similar? Do
  we have to expect no trade?

4
The composition of regional trade

• W Europe N America account for nearly 60 of
  world trade
• W Europe exports 67 of it exports to itself
• Commodity composition of trade is very similar

5
Intra-Industry trade

• Intra-industry trade
• Trade within same industries, where countries
  export import the same kind of products (or
  slightly differentiated products)
• Inter-industry trade
• Trade between different industries

6
More examples Trade flows
7
Trade theory

• High income countries have similar endowments and
  technologies, (as well as tastes?)
• Intra-industry trade seems to occur between
  developed economies
• Traditional trade theory cannot explain why trade
  such as this occurs
• To explain this we draw on 2 models incorporating
  economies of scale
• External EOS
• Internal EOS (Krugman model)

8
Defining Economies of Scale

• Lets look at the two forms of economies of scale
• 1) Internal EoS
• 2) External EoS

9
Defining Economies of Scale Internal

• (1) Internal economies of scale occur when the
  cost per unit of output depends on the size of a
  firm.
• lower input cost (bulk purchase discounts)
• costly and lumpy inputs (RD advertising)
• Fixed costs
• Internal economies of scale result when large
  firms have a cost advantage over small firms,
  which leads to an imperfectly competitive market.
  
• Market characterised by small number of large
  firms (Boeing and Airbus, motor vehicles)

10
Defining Economies of Scale Internal

• Declining average costs can arise if there are
  large fixed costs in establishing an industry
• Let Total Cost (TC) be defined as
• TC Fcost cQ
• where Fcost is the Fixed cost and c is the
  Marginal cost per output (Q)
• Average costs are
• AC TC/Q Fcost/ Q c
• A larger firm is more efficient because average
  cost decreases as output Q increases internal
  economies of scale.

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Defining Economies of Scale Internal

• Example New Airbus

Cost per Unit
Ac
Mc
Planes
12
Defining Economies of Scale External

• (2) External EoS
• Average cost depends on size of the industry
• External economies of scale may result if a
  larger industry allows for more efficient
  provision of services or equipment to firms in
  the industry
• specialized suppliers (localized industrial
  clusters)
• labour market pooling (highly spec. skills)
• knowledge spillovers
• infrastructure ( transport network)
• Market structure perfectly competitive with
  numerous firms (City of London, Silicon Valley)

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Why Economies of Scale cause trade

• Under constant returns to scale there was no
  possibility of lowering costs by scaling up
  production
• Assume 2 countries UK Germany
• Each has 6 labour allocated to car production
• 2 models of cars (BMW Land Rover) produced
  using same technology

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Why Economies of Scale cause trade

• Autarky
• Assume PBMW PLR under autarky
• each country produces both models and will
  allocate half labour to production of each car
• UK 3 labour per model
• BMW 60 units Land Rover 60 units Total
  120 cars
• Germany 3 labour per model
• BMW 60 units Land Rover 60 units Total
  120 cars
• World production
• BMW 120 cars Land Rover 120 cars

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Why Economies of Scale cause trade

• Trade
• each country specializes in one model
• UK 6 labour to Land Rover
• BMW 0 units Land Rover 480 units Total
  480 cars
• Germany 6 labour to BMW
• BMW 480 units Land Rover 0 units Total
  480 cars
• World production
• BMW 480 cars Land Rover 480 cars

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PPF with Economies of Scale
Increasing returns to scale gives rise to a
concave PPF curve
BMW
480
240
60
PLR/PBMW 1
Land Rover
480
240
60
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Gains from Trade with EOS
Assuming preferences dont change and are
equivalent in both countries Relative price will
be same after trade
BMW
480
240
60
PLR/PBMW 1
Land Rover
480
240
60
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Monopolistic competition model
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Monopolistic competition model

• Monopolistic competition is a model of an
  imperfectly competitive industry which assumes
• Large number of firms, but each firm can
  differentiate its product from the product of
  competitors.
• Each firm faces its own demand curve and can set
  its own price
• Cannot affect average price, dont think
  strategically about competitor even though each
  firm faces competition it behaves as if it were a
  monopolist

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Monopolistic competition
Under Monopoly firm earns profit

4. However, under Monopolistic competition, if
profits exist, firms enter. Demand falls until P
AC. Equilibrium at zero profit
P
AC
MC
D
MR
Q
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Insight from forthcoming attraction Equilibrium
in Krugmans Monopolistic competition model

• Assume
• Model of monopolistic competition firms with cost
  functions TC F cQ (i.e. there are internal
  economies of scale)
• All firms have the same cost function and produce
  variations of same product (symmetric) then, in
  equilibrium Pfirm Pindustry
• Discuss adjustment to equilibrium in country with
  given market size (S) if profits exist (PgtAC)
• Two relationships define equilibrium
• Number Firms-Average Cost Firms enter, output of
  existing firms decline and average costs rise
• Number Firms - Price Firms enter, price
  competition rises and prices fall
• Equilibrium establishes at P AC. Adjustment is
  through firms entry/exit and P adjustment

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Developing Krugmans monopolistic competition
model

• In following sections we will
• Develop the Number Firms-Average Cost
  relationship
• Develop the Number Firms - Price relationship

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Number Firms-AC relationship

• A firm in a monopolistically competitive industry
  is expected
• to sell more the larger the total sales (S) of
  the industry and the higher the prices charged by
  its rivals.
• to sell less the larger the number of firms (n)
  in the industry and the higher its own price.
• These concepts are represented by the
  mathematical relationship

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Number Firms-AC relationship (cont.)

• Q S1/n b(P Pind)
• Q is an individual firms sales
• S is the total sales of the industry
• n is the number of firms in the industry
• b is a constant term representing the
  responsiveness of a firms sales to its price
• P is the price charged by the firm itself
• Pind is the average price charged by its
  competitors
• Hence a firm will sell more
• the higher the demand in the industry (S)
• the lower its price relative to competitors
  (P-Pind)

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Number Firms-AC relationship (cont.)

• To make the model easier to understand, we assume
  that all firms have identical demand functions
  and cost functions.
• Thus in equilibrium, all firms charge the same
  price P Pind
• In equilibrium,
• Q S/n 0 REMEMBER FOR LATER
• AC C/Q F/Q c F(n/S) c

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Number Firms-AC relationship (cont.)

• AC F(n/S) c
• The larger the number of firms n in the industry,
  the higher the average cost for each firm because
  the less each firm produces.
• The larger the total sales S of the industry, the
  lower the average cost for each firm because the
  more that each firm produces.

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Number Firms-AC relationship (cont.)

• The relationship can be expressed as follows

Average Cost
(AC F(n/S) c)
CC
AC
Number of firms