Monopolistic competition model

1. Monopolistic competition model Structure: Gains from increasing market size Gains from Trade

2. RECAP: Monopolistic competition model Price Cost (AC = n*(Fcost/S) + c) CC P1 At n1: P1 > AC1 thus profits attract new firms \ n increases: Result: AC rises with smaller mkt share and P falls(competition) Pind = AC AC1 (P = c + 1/bn) PP n1 nequilibrium Number of firms

3. A turn-up for the Swedes : Saab cars are about to be made outside Sweden Economist; 1/29/2005, Vol. 374 Issue 8411, p62, 1/6p (see reading web-site) GM's purchase of Saab five years ago was supposed to give it a posh brand with better margins. But the Americans left the Swedes to go their own sweet way, and they created yet more losses. Part of the solution to GM Europe's problem is for Saab to share body parts and engines with Opel, at the risk of damaging the Swedish company's reputation for being quirky and upmarket. Economies of scale could be found by sending the two different marques down one production line. Both plants' proposals offered striking productivity improvements promising a reduction in manufacturing costs of 50%. Even the losing plant, he says, stands a fair chance of landing production of another of GM Europe's upcoming 45 new models. So it looks as though Germany (where closing a plant is a nightmare) has won the new model and is set to make the first truly non-Swedish Saab.

4. Monopolistic competition model & trade Main questions: What are main benefits ? What about distribution of firms and distribution of gains (within and between countries)? What characteristics determine whether this trade takes place?

5. Assumptions Same technology identical countries of size S each Same consumer preferences Increasing returns to scale Product differentiation No transport costs

6. First, lets look at increasing market size Assume market size doubles from S to 2S Implication: with fixed n, AC of each firm falls (as firm output increases) AC = n* (Fcost/S) + c becomes AC = n* (Fcost/2S) + c CC curve shifts to down and to right Does PP curve (P = c + 1/bn) change? NO

7. Increasing market size CC1 (AC = n*(Fcost/S) + c) Price cost (AC = n*(Fcost/2S) + c) Rise in S reduces AC and CC1 shifts to CC2. CC2 Poriginal PFinal PP (P = c + 1/bn) norig Number of firms nfinal

8. Increasing market size NOTE 1: Doubling of S is equivalent to shift out of CC to 2n at Poriginal CC1 (AC = n*(Fcost/S) + c) Price cost CC2 (AC = n*(Fcost/2S) + c) Rise in S reduces AC and CC1 shifts to CC2. Poriginal NOTE 2: nfinal < 2norig PFinal PP (P = c + 1/bn) norig 2norig Number of firms nfinal

9. Monopolistic competition model & trade Autarky: Each country consumes nautarky (for simplicity assume the same product varieties) Each country’s total market size = S Trade: Integration of the identical economies creates a new region of size 2S Hence: CC curve of integrated region lower than CC curves under autarky CC2: AC = n* (Fcost/2S) + c The outcome in terms of number of firms (product varieties) and price is thus equivalent to the doubling market size example

10. Monopolistic competition model & trade CC1 (AC = n*(Fcost/S) + c) Price cost CC2 (AC = n*(Fcost/2S) + c) Integration of the two economies is equivalent to shifting out CC1 by nautarky at Pautarky (to CC2) Pautarky PFree trade PP (P = c + 1/bn) naut 2naut Number of firms nfree trade

11. Monopolistic competition model & trade Outcome: Number of firms (variety) increased for integrated market (both countries together) Each firms produces a greater quantity of its product and experiences internal EoS 3) Price of goods decreased with lower AC Total variety produced at home falls while trade makes a greater overall variety available Similar countries export and import similar products >>> intra-industry trade

12. Monopolistic competition model & trade Question: Who produces what? Each variety is produced in 1 country (not both) but supplied to both countries. In which country will the firm produce? Problem: Location of firm cannot be determined in model! Happens through history & accident

13. Monopolistic comp & comparative advantage What conditions for intra-industry trade? Intra-industry trade reflects EoS EoS mainly found in higher value added manufactured goods Thus: Intra-industry trade occurs mostly between developed countries Further factor: Similarity in prices across products implies transport costs are important

14. Intra-industry trade indices Intra-industry trade Indices, 4-digit, 1996

15. Monopolistic competition model & trade Is there no role for comparative advantage? Recall: CA (so far) is driven by differences in (a) technology and (b) factor endowments. In this model countries are identical, but technology is characterised by EOS

16. Monopolistic comp & comparative advantage Comparative advan.: H-O. & factor endowments Assume 2 countries: US is capital abundant SA is labour abundant Trade pattern: US .Manufactures Agriculture (capital abund.) SA . . . (Labour abund.) Trade pattern characterised by INTER-INDUSTRY TRADE

17. Monopolistic comp & comparative advantage While: Agriculture contains HOMOGENOUS product No EoS and variety. Country with Comp. Advantage exports Agriculture (here SA) But: Manufactures contains DIFFERENTIATED products (monopolistic industry) EoS and variety possible Hence: INTRA-INDUSTRY TRADE possible

18. Monopolistic comp & comparative advantage Agriculture: Homogenous product (trade determined by comp.adv) Manufactures: Differentiated products (trade determined by EoS) Trade pattern: US (capital abund.) .Manufactures Agriculture Inter-industry trade . . . Intra-Industry trade SA (Labour abund.) . . . Trade pattern characterised by INTER- & INTRA-INDUSTRY TRADE

19. Monopolistic comp: Implications What about welfare? How do the welfare implications differ between the HO and Monopolistic competition model? Is liberalisation easier (i.e. lead to less anti-trade lobbying) between developed economies or between developed and developing countries?

20. Monopolistic comp: Implications Are there gains from trade between poor countries? Trade between developed – developing countries: => inter-industry trade (CA) Trade between developed – developed countries: => intra-industry trade in high value added manufactures (EoS) What about Trade between developing – developing countries = ? 1) When different endowment (mineral, land) then inter-industry trade (CA) 2)When similar: no trade? SADC and SACU?

21. Evidence

22. Measurement of Intra-industry trade Most common measurement of IIT: If inter-industry trade only, then IIT = 0 If intra-industry trade only, then IIT = 1

23. Intra-industry trade indices Intra-industry trade Indices, 4-digit, 1996

24. Intra-industry trade indices Intra-industry trade Indices SACU & SADC countries

25. Measurement of Intra-industry trade Problem with IIT measurement: The more aggregated the trade data, the greater the IIT index: Two-digit: economy divided into 28 sectors Four-digit: economy divided into 90 sectors Table: Intra-industry trade indices for SA

26. Policy implications Scope for expansion of intra-industry (and possibly any) trade in poorer regions such as SADC may be limited. Intra-industry trade has lower welfare impacts on factors opposition to liberalisation in wealthy countries muted May explain substantial liberalisation in manufacturing, but not agriculture