More Trade Theories

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More Trade Theories

• Linder Theory (demand side of trade)
• H-O centres on expected trade patterns when
  countries have different capacities for
  production, but similar tastes
• H-O does explain trade patterns to some extent,
  but
• in its purest form, H-O would lead to the
  conclusion that developed countries are more
  likely to trade with developing countries (who
  have very different endowments) rather than with
  each other.

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Linder Theory continued

• Assumptions
• consumer tastes depend on per capita income level
• (per capita means per head, or per person)
• production at home depends on tastes
• trade is a by-product of the home markets
  production and consumption pattern
• So, in a country with some inequality, the goods
  demanded will reflect the tastes of people at
  varying levels of income, and
• the goods produced will depend on the size of the
  market demand

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Linder Theory - Example

• Let goods produced (and consumed) by country I be
  ordered according to quality
• A, B, C, D, E - A lowest, E highest
• Let country II have income distribution that fits
  demand for goods C, D, E, F and G
• Then, trade would occur in goods C, D, E, where
  both countries have a demand for the good
• we would therefore expect most trade to be
  intra-industry trade (countries should both
  import and export the same goods)

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Linder Theory - Example

• Let country III have income such that it produces
  goods E, F, G, H, and I
• Country III will trade goods E, F, G with country
  II
• Country III will trade only good E with country I
• THEREFORE, countries will trade together more, if
  they have similar per capita incomes,
• MOST trade will be intra-industry trade, and
• with this theory, we cannot predict the pattern
  of trade (which country will export more/less of
  which good

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Linder Theory - tests and implications

• tests of Linder theory have shown it to be a good
  predictor of trade
• Problem
• it cant predict patterns, nor volumes

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Kemp Model

• Kemp model - implications of increasing returns
  to scale
• Two goods and two countries, (goods X and Y)
• both goods have increasing returns to scale in
  production
• economies of scale are such that the ppf is
  convex to the origin (economies of scale do not
  always imply a convex ppf)
• economies of scale are EXTERNAL to the firm, and
  pertain to the industry

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Kemp - continued

• there are three possible equilibria
• 1. only good X is produced
• 2. only good Y is produced
• 3. both goods are produced, and ppf is tangent
  to indifference curve (NOT A STABLE equilibrium)
• If economy happens to be at equilibrium 3, and
  country starts to trade, it will move to either 1
  or 2, depending on the terms of trade.
• pattern of trade may depend on historical
  accident, since for some TOT production of either
  good is preferable to production of both goods

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Kemp - continued

• In the diagram -
• At TOT1 only X is produced
• At TOT2 only Y is produced,
• At TOT3 either only X, or only Y or some mixture
  is produced (who knows)
• note the middle equilibrium is unstable, and can
  only occur by coincidence
• With economies of scale if two countries have
  same ppf and same tastes and therefore same PX/PY
  they can still gain from trade

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Krugman Model

• model of intra-industry trade under monopolistic
  competition with product differentiation

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Krugman Model

• monopolistic competition - each firm acts like a
  monopolist, (unique product), but the presence of
  many close substitutes causes economic rents to
  disappear
• product differentiation - the creation of a
  separate identity for a product that is not in
  fact unique, usually through advertising, and the
  encouragement of brand loyalty

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Monopolistic Competition

• Firm behaves as a monopoly, facing a downward
  sloping demand curve
• Firm chooses BOTH quantity to produce AND price
  to charge
• MR downward sloping, not MRP
• Firms quantity of output determined by MRMC,
  charges highest price it can at that output
• In the short-run firm makes profit (shaded area)
• In the long run AC shifts up (or demand shifts
  left) and profits disappear

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Krugmans model

• firms experience economies of scale in production
• simple presentation includes only labour as
  factor of production. For firm i,
• Li a bQi example L3 20 2 Q3
• With this equation, the cost of production is
• C WLi W(a bQi)
• Therefore the marginal cost of production is
• MC Wb

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Krugmans model

• firms experience economies of scale in production
• simple presentation includes only labour as
  factor of production. For firm i,
• Li a bQi example L3 20 2 Q3
• With this equation, the cost of production is
• C WLi W(a bQi)
• Therefore the marginal cost of production is
• MC Wb

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Krugmans model

• firms experience economies of scale in production
• simple presentation includes only labour as
  factor of production. For firm i,
• Li a bQi example L3 20 2 Q3
• With this equation, the cost of production is
• C WLi W(a bQi)

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Krugmans model

• the cost of production is
• C WLi W(a bQi)
• There is a fixed cost, Wa, and a variable cost
  WbQi
• Therefore the marginal cost of production is
• MC Wb
• Marginal cost is constant
• Average cost is Wa/Qi Wb
• Average cost is decreasing as output increases.

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Elasticity of demand and MR

• Under monopolistic competition price depends on
  the elasticity of demand, and the marginal
  revenue
• P MR eD / (eD 1)
• If firm maximizes profit, MR MC and so,
• P MC eD / (eD 1)
• Derive P MR eD / (eD 1)

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Basic Krugman Diagram

• Look at relationship between per capita
  consumption of a product and P/W (real cost to
  purchaser)
• First PP curve
• as consumption of a companys good increases
  (demand increases), P/W for the good also
  increases because eD becomes less elastic as Q
  increases.

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The ZZ curve

• ZZ curve - zero economic profit
• profit PQ-(abQ)W0
• PQ(abQ)W
• P/W(abQ)/Q
• P/Wa/Qb
• or, let the total population LT, and they
  consume cLT
• P/Wba/(cLT)

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The ZZ curve

• As per capita consumption rises, output rises and
  brings scale economies.
• reductions in unit cost lead to lower prices and
  zero economic profit
• above ZZ curve profits are greater than zero
• below ZZ curve profits are less than zero
• and increase in LT shifts ZZ down, because, P/W
  increases for per a given per capita consumption,
  i.e. the more people there are, the lower the
  real price for the good due to economies of scale

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Trade in the Krugman Model

• International trade allows economies of scale to
  be realized, more so than with limited or no
  trade
• The ZZ curve moves down, P/W falls (meaning real
  wage W/P rises) because goods become cheaper.
• Also, c drops for each good - per capita
  consumption decreases as more choice is available
• However, total production of each good increases
  as more people buy it

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Paul Krugman

• Will definitely win a Nobel prize sooner or later
  
• is a major contributor (founder) of the school of
  new trade theories
• examines trade under increasing returns to scale
  and the subsequent market systems arising from
  those returns monopolistic competition and
  oligopoly

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Intra-Industry Trade Reasons

• product differentiation (see 173 types of cars)
• transportation costs and geographic location
• dynamic economies of scale -- two similar goods
  produced in two countries, each decreases
  production costs by learning by doing, the good
  gets a bigger share of market and is traded
  between countries
• aggregation of classification
• Differing income distribution - Linder idea, add
  possibility that countrys producers cater to
  main market, other parts of distribution buy
  imports

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Oligopoly and reciprocal dumping A

• If a firm has a monopoly in home country and a
  second firm has a monopoly in its country,
• each firm sells at monopoly prices at home
• each firm sees potential profit selling in other
  country (price gt MC)
• each firm sells in other market, taking into
  account the behaviour of the previous monopolist.
• there is intra-industry trade.

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Gravity Model

• Predict volume of trade between 2 countries based
  on
• national income for each country
• distance
• other variables, such as measure of economic
  integration (free trade agreements, etc),
  population, etc.
• works for countries with similar income and
  intra-industry trade

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Measuring Intra-Industry Trade

• (appendix B)
• Let Xi be a countrys exports of good i
• Let Mi be a countrys imports of good i
• The measure of intra-industry trade for a country
  is

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Example

• Industry X M
• A 1000 200
• B 50 2000
• C 500 400
• Calculate intra-industry trade index for this
  economy