Monopolistic competition and trade

1. Monopolistic competition and trade Pierre-Louis Vézina p.vezina@bham.ac.uk

2. Introduction • Both external and internal economies of scale are important causes of international trade. • In this lecture we’ll see how internal economies of scale lead to monopolistic competition and trade

3. Introduction • Ricardo and Hecksher-Ohlin predict countries that are most different should trade more, and should trade different goods • Yet a lot of world trade is between similar countries, in similar goods • This is known as intra-industry trade

4. Intra-industry Trade • In 2010, the US exported $1 billion in motorcycles and imported $1.2 billion in motorcycles!

5. Intra-industry Trade • Intra-industry trade refers to two-way exchanges of similar goods. • About 25–50% of world trade is intra-industry. • Trade of manufactured goods among advanced industrial nations accounts for the majority of world trade

6. Intra-industry Trade

7. Intra-industry Trade

8. Intra-industry Trade

9. Intra-industry Trade

10. Intra-industry Trade

11. Intra-industry Trade • We need a theory to explain intra-industry trade! This is what Paul Krugman came up with in 1979… and won the Nobel Prize for 30 years later

12. Intra-industry Trade • We need a theory to explain intra-industry trade! Krugman, Paul R., 1979. "Increasing returns, monopolistic competition, and international trade," Journal of International Economics, vol. 9(4), pages 469-479, November. Paul Krugman, 2009. "The Increasing Returns Revolution in Trade and Geography," American Economic Review, American Economic Association, vol. 99(3), pages 561-71, June.

13. Monopolistic competition • Internal economies of scale imply that a firm’s average cost of production decreases the more output it produces. • Large firms have a cost advantage over small firms • This causes the industry to become uncompetitive and consist of a monopoly or of a few large firms as small firms become uncompetitive

14. Monopolistic competition • In monopolistic (or imperfect) competition, firms can influence the prices of their products and sell more by reducing their price • This situation occurs when there are only a few major producers of a particular good or when each firm produces a good that is differentiated from that of rival firms. • Each firm views itself as a price setter, choosing the price of its product. Firms have market power.

15. Monopolistic competition • In competitive markets, such as the wheat market, farmers don’t worry about selling more wheat as it won’t affect prices

16. Monopolistic competition • It’s different for Boeing, as its market is a duopoly and its production affect world supply and thus prices

17. Monopolistic competition • It’s different for Harley-Davidson and Kawasaki, who compete in a world of many motorcycle producers yet their bikes are differentiated. They have some market power.

18. Monopolistic competition • Before we dig into monopolistic competition, let’s do a refresher on monopoly theory • A monopoly is an industry with only one firm

19. Monopoly: A Brief Review • Suppose that the firm’s total costs are C = F + c × Q • Fis fixed costs, those independent of the level of output • c is the constant marginal cost. • Marginal cost is the cost of producing an additional unit of output. • Average cost is the cost of production (C) divided by the total quantity of production (Q). AC = C/Q = F/Q + c • A larger firm is more efficient because average cost decreases as output Q increases: internal economies of scale!

20. Monopoly: A Brief Review internal economies of scale!

21. Monopoly: A Brief Review • The demand curve the firm faces is a straight line Q = A – B(P), where Q is the number of units the firm sells, P the price per unit, and A and B are constants. P Q

22. Monopoly: A Brief Review • How much does the monopoly earn by selling one extra unit? What’s its marginal revenue?

23. Monopoly: A Brief Review • How much does the monopoly earn by selling one extra unit? What’s its marginal revenue? That’s the demand curve

24. Monopoly: A Brief Review • How much does the monopoly earn by selling one extra unit? What’s its marginal revenue? That the marginal revenue curve

25. Monopoly: A Brief Review • How much does the monopoly earn by selling one extra unit? What’s its marginal revenue? Note that MR falls faster than P That the marginal revenue curve Marginal revenue equals MR = P – Q/B (see Ch. 8 appendix)

26. Monopoly: A Brief Review

27. Monopoly: A Brief Review • The profit-maximizing output occurs where marginal revenue equals marginal cost. • At the intersection of the MC and MR curves, the revenue gained from selling an extra unit equals the cost of producing that unit. • The monopolist earns some monopoly profits, as indicated by the shaded box, when P > AC.

28. Monopolistic Competition • Monopolistic competition is a model of an imperfectly competitive industry where each firm • can differentiate its product (that gives it some monopoly power), and • takes the prices charged by its rivals as given (it ignores the impact of its own price on the prices of other firms)

29. Monopolistic Competition • Product differentiation describes quite well the manufacturing products traded around the world • Buyers of iPhones do not think of Samsung Galaxies as perfect substitutes • But the market demand for iPhones does depend on the number of imperfect substitutes and their price

30. Monopolistic Competition (cont.) • A firm in a monopolistic competition industry is expected to sell • morethe larger the industry demand and the higher the prices charged by rivals • lessthe larger the number of competing firms in the industry and the higher the firm’s price • These concepts are represented by the function:

31. Monopolistic Competition (cont.) Q = S[1/n – b(P – P)] • Q is an individual firm’s sales • Sis 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 firm’s sales to its price • P is the price charged by the firm itself • P is the average price charged by its competitors

32. Monopolistic Competition (cont.) • We have Q = S[1/n – b(P – P)] = [(S/n)+S × b × P ]–S × b × P • Monopolistic firms face linear demand functions, Q = A – B(P) • (Note the similar form as the linear demand above, (B=S x b)) • When firms maximize profits, they produce until marginal revenue equals marginal cost: MR = P – Q/B = c P = Q/ (S × b)+c • Assume each firm sells the same amount, Q=S/n •  P = c + 1/(b × n)

33. Equilibrium in a Monopolistically Competitive Market P = c + 1/(b × n) PP: As the number of firms n increases, the price that each firm charges decreases because of increased competition.

34. Monopolistic Competition (cont.) • What about the cost function? • Remember we just assumed that each firm sells the same amount; we thus assume that firms are symmetric. All firms also have the same cost function. • All firms should charge the same price and have equal share of the market Q = S/n • Average costs depend on the size of the market and the number of firms: AC = C/Q = F/Q + c = n F/S + c

35. Equilibrium in a Monopolistically Competitive Market AC = n F/S + c CC: As the number of firms n increases, the average cost increases for each firm because each produces less.

36. Monopolistic Competition (cont.) AC = n F/S + c • As the number of firms n in the industry increases, the average cost increases for each firm because each produces less. • As total sales S of the industry increase, the average cost decreases for each firm because each produces more.

37. Monopolistic Competition (cont.) • At some number of firms, the price that firms charge (which decreases in n) matches the average cost that firms pay (which increases in n). • At this long-run equilibrium number of firms, firms have no incentive to enter or exit the industry.

38. Equilibrium in a Monopolistic Competition Market n2 is the zero-profit number of firms in the industry

39. Monopolistic Competition (cont.) • If the number of firms is greater than the equilibrium number, then firms have an incentive to exit the industry. • Firms have an incentive to exit the industry when price < average cost. • If the number of firms is less than the equilibrium number, then firms have an incentive to enter the industry. • Firms have an incentive to enter the industry when price > average cost.

40. Monopolistic Competition and Trade • Trade increases market size (S) • Industry sales increase leading to decreased average costs: AC = n(F/S) + c • (Trade decreases average cost as each firm produces more)

41. Effects of a Larger Market • Trade (an increase in S) lowers the CC line

42. Monopolistic Competition and Trade (cont.) • As a result of trade, the number of firms in a new international industry increases • (But it is unclear if firms will locate in the domestic country or foreign countries.)

43. Monopolistic Competition and Trade (cont.) • Because average costs decrease, consumers can benefit from a lower price. • And because trade increases the variety of goods that consumers can buy, it increases their welfare The result reads like an advertisement for free trade: lower prices, more varieties!

44. Monopolistic Competition and Trade (cont.) • The number of available products in US imports tripled from 1972 to 2001

45. Monopolistic Competition and Trade (cont.)

46. Monopolistic Competition and Trade (cont.) • The number of available products in US imports tripled from 1972 to 2001 • According to Broda and Weinstein, that’s a welfare gain equal to 2.6% of US GDP. Christian Broda & David E. Weinstein, 2006. "Globalization and the Gains from Variety," The Quarterly Journal of Economics, MIT Press, vol. 121(2), pages 541-585, May.

47. Monopolistic Competition and Trade • International trade creates a larger market • Let’s consider a numerical example to look at its effects on prices, scale, and product variety • Let’s look at the car industry

48. The car industry b=1/30,000 P=c+1/(b × n) P=5,000+30,000/n F= $750,000,000 c=$5000 • C=750,000,000 + (5,000 × Q) • AC= 750,000,000/Q + 5,000 • AC= n(750,000,000/S) + 5,000

49. Equilibrium in the Automobile Market

50. Equilibrium in the Automobile Market