The “New Trade Theory” + some other post-HO-models

1. The “New Trade Theory” + some other post-HO-models Appleyard & Field (& Cobb): Chapter 10 Krugman & Obstfeld: Chapter 6

2. Today’s Lecture • Economies of scale and the Krugman model • Some other post-HO-models • Imitation Lag • The Product Cycle Theory • Gravity Models • New Economic Geography • Heterogeneous Firms

3. The “Krugman Model”: Assumptions • Internal economies of scale • Monopolistic competition (non-homogeneous goods) • One factor of production (labour) • Identical preferences • Large number of goods produced with the same technology • Full employment Paul R. Krugman (1979): Increasing returns, monopolistic competition, and international trade. Journal of International Economics, Vol. 9(4): 469-479

4. Key assumption 1: Economies of Scale • External: cost per unit depends on the size of the industry, not the firm (Silicon Valley, Hollywood...) • Internal: cost per unit depends on the size of the firm, not industry (Nokia, Phillips, GE...) • Krugman models technology as L = a + b*Q  Q = 1/b*L – a/b • the amount of labour required (L) to produce amount of input (Q) depends on b and constant a (fixed cost) → Doubling the inputs more than doubles the output (increasing internal economies of scale)

5. Production Possibilities Frontier with Economies of Scale Good Y Good X

6. Key assumption 2: Monopolistic Competition • Each firm produces a different brand of the good (goods that are not exactly the same, but that are substitutes for one another) • Each firm takes prices of rivals as given (=no strategic pricing) → Each firm behaves as if it were a monopolist • However, we assume easy entry and exit → zero-profits in the long run • as long as (average cost < price) more firms enter the market

7. Long-Run Market Equilibrium of Monopolistically Competitive Market The more firms there are: • the less each firm produces → higher average cost (due to increasing returns to scale) → upward sloping cost curve • the harder the competition → decreasing price → downward sloping price curve Price AC p* P n* Number of firms

8. Introducing Trade to the Monopolistic Competition Model • Trade increases market size → firms exploit more of the returns to scale → average cost decreases → price decreases → number of firms increases • i.e. a larger variety of products is available for smaller price • everybody are better off even if the countries are identical Price ACA ACFT pA pFT P nA nFT Number of firms

9. Intra- and Inter-industry Trade • Inter-industry trade: countries export goods of one product category and imports goods of other product category as in the Ricardianand the Heckscher-Ohlin models • Basis for trade: Comparative Advantage due to differences in productivity (Ricardian model) or in factor endowments (HO-model) • Intra-industry trade: countries export and import products of the same products category as in the Krugman model • Basis for trade: Internal economies of scale

10. Impact of Trade • Ricardian Model • complete specialization (linear PPF) • increase of country’s consumption possibilities • Heckscher-Ohlin Model • shift of production towards commodity that uses intensively country’s abundant factor of production • real income of the abundant factor increases and the real income of scarce factor decrease • increase of country’s consumption possibilities • Krugman Model • more firms and more varieties of goods • lower cost of production → lower price

11. The “integrated” framework • integrating HO-style and ”Krugman” style models • endowment-based comparative advantage + • horizontal product differentiation and increasing returns to scale • allows for technology differences, factor price inequality, and trade costs • Something of a current standard paradigm Helpman, Elhanan, and Paul Krugman (1985): Market Structure and Foreign Trade: Increasing Returns, Imperfect Competition and the International Economy. Cambridge, MA: MIT Press.

12. Other Explanations of Intra-Industry Trade • Transport costs in large countries (e.g. a buyer in Maine buys the Canadian rather than the Californian product) • Dynamic economies of scale: product differentiation + learning-by-doing • Problems with statistics • Aggregation: the categories are too wide (e.g. “beverages and tobacco”) • Different quality of goods inside a product category

13. Imitation Lag • Assume that it takes time for new technology to spread • Imitation lag: the time between product’s introduction in country 1 and appearance of a version of that product produced in country 2 • Demand lag: time between products appearance in country 1 and its acceptance in country 2 • Net lag: imitation – demand lag → Trade focuses on new products

14. The Product Cycle Theory • The product cycle consists of three stages (new, maturing, standardized) • A new product is introduced in a rich country • High-income demands, labour-saving production technique • The firms operate only in the domestic markets and learn production techniques and consumer responses • Maturing product • Economies of scale start to realize • Demand in other rich countries starts to emerge • Part of the production may be shifted to these countries and they might even start exporting to the original country

15. The Product Cycle Theory • Standardized product • Product is well know to consumers and producer • Production may shift to the developing counties Production, consumption (in the developed country) Consumption1 exports imports Production1 time Vernon (1966): International Investment And International Trade in the Product Cycle. Quarterly Journal of Economics 80(2). maturing product stage standardized product stage new product stage

16. Gravity Models • Focus to explain the volume of trade between countries • Popular framework in empirical work: Typically the volume of exports and imports is modelled as a function of countries national incomes, distance and other observable characteristics such as population size and institutional dummies (e.g. free trade area)

17. New Economic Geography • Firms decide the location of production in the presence of • economies of scale→ rationale for concentrating production, imperfect competition • transportation cost → rationale for decentralizing production • Dynamic comparative advantage may be based on coincidence that has set off a cumulative process • Trade may take place as a result of “arbitrary specialization based on increased returns” • Policies may influence the beginning of such an cumulative process P. Krugman (1991): Geography and Trade. MIT Press.

18. Models with Heterogeneous Firms Melitz (2003, Econometrica) model • Extension of the “Krugman model” • firms can enter an industry by paying a fixed entry cost, they then learn their productivity (profitability) and leave if this is too low • There are fixed and variable costs also for exporting → only the most productive firms export • reductions in barriers to trade → increase profits of exporters and reduce the export productivity cutoff → labor demand within the industry rises → increase in wages → profits of nonexporter decrease → less productive firms bankrupt A new source of gains from trade: Increase in productivity See Bernard, Jensen, Redding and Schott (2007): Firms in International Trade, Journal of Economic Perspectives, 21(3), 105–130