Lecture 3

1. Lecture 3 ECONOMIES OF SCALE, IMPERFECT COMPETITION AND INTERNATIONAL TRADE

2. Introduction. Internal and external economies of scale. Imperfect competition and trade The monopolistic competition model. The intraindustry trade : definition and importance. Measurement of intraindustry trade . External economies and international trade. Extensions and applications. Conclusion Index

3. Some uncomfortable facts about the classical models of trade: It only predicts trade between different countries. However, about 70-80% of trade (Grubel-Lloyd) is between similar countries. It is difficult to predict bilateral trade (gravity model) and justify the two-way-trade. Difficulty to explain the role of companies (intra-firm trade; multi-national trade). In this lecture we will discuss economies of scale models, imperfect competition and product differentiation. We will introduce these items slowly. These models are complementary (not substitutive) of the classic ones. 1. Introduction

4. In the classic models: They explain trade between countries based on comparative advantage. Countries gain from trade if they are different. Ricardian Model: Key: Differences in productivity (availability of technology) H exports good 1, which is produced with higher relative productivity; it imports good 2, since F produces it more efficiently. H-O Model: Key: Where does these differences in productivity come from? Differences in factor endowments. H exports good 1, whose production is intensive in the relatively abundant factor (K or L); it imports good 2, since F is specialized in producing the good that is more intensive in the factor that is relatively more abundant in F. There will be trade between 2 countries with equal productivity and the same factor endowment? 1. Introduction

5. Classic models assume: “Constant returns to scale”: Y=f(N); Si ?2N ? ?2Y Perfect competition: Small firms with similar cost structures; Non- differentiated products; “Price taker” and Economic profits =0. 2. Economies of scale

6. Now, we assume “Increasing returns to scale”: Y=f(N); If ?2N ? ?3Y Production is more efficient the more it is produced: The average costs decrease as productivity increases. Each country is specialized in a reduced number of products and imports the rest. Now, we are interested in the trade that arises when there are economies of scale and the possibility of product differentiation Thus, we will focus on the international trade arising between similar countries. 2. Economies of scale

7. An intuitive view: Although both countries have equal productivity and factor endowments, international trade can exist. Why? Because there are Economies of scale We assume that consumers demand “variety”. Each country is specialized in producing a variety of a good: by producing the entire quantity of that variety, costs are lower than if each country produced a portion of each variety. Conclusion: each country produces the whole amount of a single variety, and imports the rest in which it is not specialized: therefore international trade in different products (varieties) arises. The same number of varieties is produced but with lower cost (or more varieties with the same cost). Gains from trade arise in both countries. 2. Economies of scale and international trade

8. The key is in the fixed costs: to produce each variety there are fixed costs. By increasing the scale of production of a single variety, one can reduce the average cost per unit of output. However, to increase the scale production new factors of production are needed (which, in autarky, they would be used in other industries). A big country can scale up production without giving up varieties. But a small one has to choose between giving up some varieties or to produce them with lower costs (decreasing the scale). International trade makes it possible for a small country to take advantage of producing on scale without giving up variety. Each country specializes in producing a lot (all of it) of few varieties. It will exports the whole excess of production not consumed domestically. The rest of varieties will be imported. 2. Economies of scale and international trade

12. External ES: They appear when unit costs decrease with the size of the industry (not necessarily with the size of each company). Ex: clusters: The production cost in a pub in Huertas street is less than in any other area where there is no agglomeration of pubs. Lower costs of: supplies, publicity, customers, workers… Firms tend to be small, they offer the same product at a similar price. The market tends to work under “perfect competition”. Internal ES: They are produced when the unit cost decrease with the size of the company (not necessarily with the size of the industry). Ex: Production cost of transport services is lower for a big airport than for several small ones. The emergence of internal economies is related with the high fixed costs. Firms tend to be big, they offer a differentiated product on a different price. The market tends to behave with imperfect competition (oligopoly, monopolistic competition).

14. Internal ES: Problem: it forces us to move to a imperfect competition model: In imperfect competition, firms can affect the price. Industries with few producers Industries with product differentiation for consumers In order to sell more, the price must be decreased (strategic behaviors) Possible cases: Monopoly; oligopoly; Monopolistic competition

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16. 16 La empresa competitiva y la decisión de producir a corto plazo I

17. MONOPOLY The firm faces a growing demand: One may have to ? prices for an ? sold units The firm maximizes profits when: MR = MC

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19. MONOPOLY: marginal revenue and price Which is the relationship between MR and price? Two factors: It depends on the quantity that the firm is already selling. Ex: if the company is not selling much, then the effect of lowering the price on all units is small. It depends on the slope of the demand curve: Ex: if the curve is flat, the monopolist won’t have to reduce much the price in order to sell an additional unit. Therefore the difference between price and MR will be small. The marginal revenue (MR) is the income induced by a unit sold. For a monopolist, the MR is smaller than the price: because to sell an additional unit (?Q) it has to ?P, but not just the price of the last unit sold, but of all sales. For a monopolist, the MR is always below the demand.

20. Demand: Q = A - B x PMR = P - Q / B The MR < Price  when ?Q ? ? MR  ??B ? MR ? P

22. Average and Marginal Cost

26. MONOPOLISTIC COMPETITION: the basic model Q= Firm’s sales S = Total sales in the industry n= number of firms p= price in the company P’ = average price charged by competitors

27. Assumption: all firms are symmetric in costs and demand, even thought their products are differentiated. To achieve the equilibrium we need to know the average price of the varieties (P’) and the number of firms (n). We will do it in 3 steps: Number of firms and average cost: since the firms are symmetric, in equilibrium, everyone produce with the same price (P=P’). Then Q=S/n. On the other hand, we know that the AC depends inversely on Q: AC = TC / Q = FC / Q + c = FC / S / n + c = (n FC) / S + c The more firms in the industry, (and/or) the smaller the share that each one produces = the higher the average cost (that is, the more difficult to take advantage of the increasing returns). MONOPOLISTIC COMPETITION: the basic model

28. 28 Number of firms and the price: the price that a firm charges also depends on the number of firms in the industry. When n increases, there is more competition, and prices will be reduced. On the other hand, each company accepts the price of the other firms (average price in the industry , P’) as given. Then the Demand can be written as: MONOPOLISTIC COMPETITION: the basic model

29. ? n ? ? competition ? ? price Q = S ( 1 / n - b ( p - p’)) = Q = S / n + S b P’ - S b p =

30. Substituting Q in MR we get: MR = p - Q / B = p - Q / Sb Since the company maximizes the profits when MR= MC MR = p - Q / Sb = c It can be rearranged as: p = c+ Q / Sb

32. The model captures certain key elements where there is imperfect competition, but not all of them. Ex: there are common behaviors in the oligopoly that are not captured by the model: MONOPOLISTIC COMPETITION : limitations of the model

33. In monopolistic competition without trade, the small countries are restricted by their size: they have to choose between + varieties or higher production costs. Trade increases market size, and the increase of the market produces the rise of Q and decreases of AC: AC = n x CF / S + c if n = constant and ?S ? ? AC If two markets are compared S1 < S2 , the S1 costs will be > S2 costs . Its CC curve changes. The PP Curve does not vary because p= c + 1/ bn MONOPOLISTIC COMPETITION AND TRADE

35. Equilibrium in the automobile market

36. Equilibrium in the Global Market S = S1 + S2 n = 10 (car varieties), with lower AC(= p)

37. In the monopolistic competition model: We assume that the cost of production is the same in all companies, even if they produce different varieties. We also assume that the cost of trade is =0. We know the size of the global production, but not who will be the producing country. We know how many company will be in the long run, but not how many or which ones will be in (H) or in (RM). We have to mix the model with the comparative advantage one.

39. In the H-O model, with constant returns , trade would be:

43. Characteristics and differences between intra/inter trade Inter-industry trade reflects the comparative advantage. Intraindustry trade has its origin in the economies of scale. Intraindustry trade has an unpredictable pattern: we don’t know which country produces which goods, while interindustry trade has a determined pattern by the differences between countries (K/L). The % intraindustry / interindustry trade between bilateral trade, it depends on the similarities between countries. Ex: (0CDE) H y F are = in technology and factors, then the intra % will be higher.

44. Index for measuring intraindustry trade (IIT) If Xj = 0 and Mj > 0 X j – M j = Mj ( X j + M j ) = Mj bj = 0 or If Mj = 0 X j > 0 X j – M j = Xj ( X j + M j ) = Xj bj = 0 “interindustry trade”

46. Gobalización, trade internacional y economía geográfica 46 Data about inter-industry vs intraindustry trade

47. Gobalización, trade internacional y economía geográfica 47 Data about interindustry / intraindustry trade

48. Besides the ES and product differentiation , there are other causes that can lead to Intraindustry trade 1.- Statistical aggregation problems 2.- Intra-firm trade 3 – Seasonality and stability of production and demand. 4.- Cross-border trade: Mexico –US 5.- Joint production –oil derivatives- the surplus has to be exported 6.- Distribution trade or re-exporting trade ( labeling, makilas...) 7.- Reciprocal Dumping

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50. 4. EXTERNAL ECONOMIES AND INTERNATIONAL TRADE 

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58. External economies and Specialization: swiss/thailand watches

59. 59 External economies and Specialization: swiss / thailand watches

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61. Dynamic external economies and specialization

62. Extensions: Economies of scale on “horizontal / vertical” integration. Trade modeling with n varieties, n countries… Dixit-Stiglitz Model(AER, 1977): base for most of the modern approaches of international trade with economies of scale. New Trade Theory Economic Geography Core-Periphery Model: concentration / specialization. Applications: International trade pattern / interregional in the UE and Spain: Inter o intraindustry trade. Ricardian / H-O-V / Dixit-Stiglitz / Ec Geography Evolution, link with productive structure, intrafirm trade…

63. The internal and external economies of scale can act like as an engine of international trade additional to the existence of Comp. Advant. or differences in factor endowment. The internal SE demand the develop of an imperfect competition model , it is the most used since the 70’ (Dixit-Stiglitz, 1977). With the SE comes the distinction between interindustry and intraindustry trade. The intraindustry trade has important consequences for the countries’ welfare. Its importance is growing between developed countries with similar factor endowments and technology levels. The advantages of external economies are less clear, and they give place to several arguments usually used in favor of protectionism in international trade. 6. Conclusions