Economies of Scale, Imperfect

Competition and International

Trade
How the Limitations of Perfect
Competition Theories came to
forefront?
 Leontief Paradox and beyond
• Empirical test on validity of HOS results on US trade data with I-O
table for 1947
• Expected that exports would use abundant factor (K) intensively and
import-competing sectors would use scarce factor (L) intensively
• Results revealed US exports used relatively more L – Paradox?
• Selection year problem?
• Human capital / labour skill-related explanation
• Limitation of classical Constant Returns to Scale (CRS) assumption -
Demand or factor intensity change – role of dynamic aspect?
• Subsequently in 1950s, more developed-developed country trade in
industrial product observed – WHY?
Empirical Study Import Substitutes Exports
Leontief
Capital $ 3091339 $ 2550780
Labour (Person year) 170 182
Capital / Person Years $ 18184 $ 14015

Result: Greater Focus on Scale Economies

So? Why these perfect theories didn’t work?

• Technology varies across countries

• True that factor intensity can’t be reversed.

• In real world, perfect competition and Constant returns to scale

is just an assumption => The dream of a perfect world.

• Incomplete specialisation => Who says does not happen?

• Equal taste of the countries => Are we all same?

• No international factor mobility => We are stuck in our countries.

• Factors are fully utilised => We all are employed.

• Balanced Trade => Oh!! Really? Then we never had to borrow from
IMF..
 Economies of Scale and Implications for
International Trade
• Under increasing returns to scale:
– Output grows proportionately more than the increase in all inputs.
– Average costs (costs per unit) decline with the size of the market.
Output Total Total Average
labour labour Labour Input Cost per unit
6
Input Input Requirement
(IRS) (CRS) (IRS)
5
5 10 2.00

10 15 20 1.50 4

15 20 30 1.33 3
20 25 40 1.25
2
25 30 50 1.20 Average cost

30 35 60 1.16 1
Marginal cost
0
Difference with perfect 2 4 6 8 10 12 14 16 18 20 22 24
competition theories Output
 Increasing Returns and Comparative Advantage
• Increasing returns theory – despite limited comparative
advantage, trade can be beneficial if trade leads to lower cost
per unit due to economies of scale – efficiency factor – ‘Learning
by Exporting’
• No inter-industry specialization, but specialization in narrower
product categories – e.g. India exporting gear box to Thailand
and importing other auto parts (e.g. clutch).
• Gains from specialization and exchange
• Consumption benefits for varieties (e.g. garments)
• Home market effect – countries will specialize in goods with
large domestic demand since proximity will reduce
transportation costs
• Concern area – what happens to the small markets?
• Fear of De-industrialization – valid reason behind protectionism?
• Overall Welfare implications

Importance of market structure

Through which channels Trade is
influenced by Scale Economies?
 Categories of Scale Economies
– External
• The cost per unit depends on the size of the entire industry
within a particular geographical area but not necessarily on the
size of any individual firm.
• An industry will typically consist of many small firms and may be
perfectly competitive.
• As industry output grows, the average cost of a typical firm
declines.
• Example: Mumbai (audio-visual services), Bangalore (IT-enabled
services), Silicon Valley (semiconductors), clusters in general
– Internal
• The cost per unit depends on the size of an individual firm but
not necessarily on that of the industry.
• The market structure may be imperfectly competitive with large
firms having a cost advantage over small players.
• Example: Honda (automobile).

Both types of scale economies are important

determinants of international trade.
 External Economies: Key Routes
• Knowledge Spillovers
– Knowledge is one of the important input factor in highly
innovative industries.
– The specialized knowledge that is crucial to success in
innovative industries comes from:
• Research and development efforts
• Reverse engineering
• Informal exchange of information and ideas, modification
over newer ideas developed by others, staying near the
production frontier
• Labor Market Pooling
– A cluster of firms can create a pooled market for workers
with highly specialized skills.
– It is an advantage for:
• Producers
– They are less likely to suffer from labour shortages / inability
to access talent.
• Workers
– They are less likely to become unemployed.
 External Economies: Advantages
• Specialized Suppliers
– In many industries, the production of goods and services and
the development of new products requires the use of
specialized equipment or support services.
– An individual company does not provide a large enough market
for these services to keep the suppliers in business.
• A localized industrial cluster can solve this problem by bringing
together many firms that provide a large enough market to
support specialized suppliers.
– This phenomenon has been extensively documented in the
semiconductor industry located in Silicon Valley.
– Other example is the automobile network in ASEAN countries
– Carpet-making in Dalton, Georgia is another example
– Shoe cluster, Sinos valley, Brazil
– Cotton Knitwear cluster, Tirupur, India
– Electronics Network in South Korea

What enables a firm to enjoy Scale Economies?

 Local and Non-Local Dimensions of Regional Development
Dimensions Local Manifestations
Firms • indigenous SMEs
• industrial clusters
• intra-regional markets
• venture capitalists
Labour • skilled and unskilled
workers
• permanent migrants
Technology • spillover effects
• tacit knowledge
• infrastructure and assets
Institutions • conventions and norms
• growth coalitions
• local authorities
• development agencies
Non-Local Forms
• global corporations
• entrepreneurial subsidiaries
• distant global markets
• decentralized business and
financial networks
• global production networks
• skilled experts and technologists
• transient migrants
• transnational business elites
• global standards and practices
• intra-firm R&D activities
• technological licensing
• strategic alliances
• labour and trade unions
• business associations
• national agencies and authorities
• inter-institutional alliances
• supranational and international
organizations
Source: Coe et al (2004)
 Case 1: Chinese exports from SEZs
• Promotion of own exports through 4
coastal SEZs since 1980s
• Development of hi-tech clusters in
long run
• Recent help to African countries to
develop their SEZs

Host Country Zone Main Products

Zambia Chambishi Copper and copper related industries
Lusaka Garments, food, appliances, tobacco and electronics. This zone is
classified as a subzone of the Chambishi zone.
Mauritius Jinfei Manufacturing (textiles, garments, machinery, high-tech), trade,
tourism and finance
Ethiopia Oriental Electrical machinery, construction materials, steel and metallurgy
Nigeria Ogun Construction materials, ceramics, ironware, furniture, wood
processing, medicine, and computers
Lekki Transportation equipment, textiles, home appliances,
telecommunications, and light industry Source: Kim (2013)
 Case: Scale Economies in China ..
Map Showing the Migration of Labor to
The Location of Globalized Industries in China, China’s Coastal Growth Centers
Largely Along the Coast

Source: He (2009)

Source: World Bank (2007)

 Case 2: Exports from India
1. IT Exports – Bangalore, Pune
2. Cosmetics industry in Mumbai – product innovations
through R & D, e.g., – aroma therapy – interestingly not
much inclination towards obtaining patent during initial
period – slow change.
3. Healthcare service exports from India – Gujarat, Kerala,
Delhi
4. Auto-parts products - Punjab

How are the Scale advantages realized?

Major jewellery manufacturing hubs in India

Source: FICCI (2013)

Geographical Map of the Automotive Clusters in India

Source: CII (2009)

The Development of Bangalore’s High-Tech Industrial Sectors
Period Main Development Major Effects
Pre 1945/ • Hindustan Aeronautics and of Indian (Tata) Local pool of skilled
1947 Institute of Science set up in Bangalore technical labour
Late 1940s • Large state enterprises set up by central Generates local
and 1950s government: Indian Telephone Industries, downstream
Hindustan Machine Tools, Bharat Electronics linkages
1960s and • Specialist technical institutions set up: Central Localised technology
1970s Machine Tool Institute (1961). cluster takes shape.
• Public sector firms joined by leading private
firms in a number of sectors.
• Large firms encourage the setting up of
‘dependent’ ancillary SME units.
1980s • Trade liberalisation and more competitive Beginnings of knowledge
product markets. intensive technical
• Ancillary SMEs becoming specialised and collaboration between
‘independent’ of large firms. large firms & SMEs
• Emphasis on flexibility, specialisation, precision
and quality in ties with SMEs.
• Use of NC and CNC machine tools grows.
1990s • TNCs enter Bangalore particularly in the India’s ‘Silicon Valley’.
computer software industry. The development
of information technology and telematics
sectors.
• Emergence of CAD/CAM technologies locally
And beyond ?? ??

Source: Nadvi (undated)

Role of Demand factors in
International Trade
 Other side: Linder’s Overlapping Product Thesis
• Focus on Supply side by classical theories
• Import-Substituting Strategy by developing countries and LDCs
during fifties and sixties
• Increasing North-North Trade
• Focus on demand-side of the relationship (consumers) – high-income
countries require high-tech products (luxuries), while low-income
countries import low-tech products (necessities)
• Role of Income Groups within a country
• Per capita income of a group of people in US is similar to that of a
group of people in India
• Per capita income of a group of people in Bangladesh is similar to
that of a group of people in India
• Here, Trade depends on traits of consumers
• Cultural Similarity (e.g. Indian export to UK; Air France and Africa)
• Distance (e.g. lower cost as well as awareness)

Implication: Tata Nano produced by India is

likely to find a major market in Sri Lanka,
while Mercedes-Benz is likely to get a
foothold in India.
 Is Linder Thesis valid in Indian context?
Major Export Destinations of the Country
Region 1996-97 2000-01 2004-05 2008-09 2012-13 2014-15
ASEAN 8.67 6.54 10.09 10.29 10.98 10.25
East Africa 1.51 1.26 1.37 2.40 2.95 3.27
East Asia (Oceania) 1.36 1.12 1.03 0.95 0.91 1.04
EU Countries 26.50 24.00 21.85 21.32 16.78 15.89
Latin America 1.18 1.87 2.15 2.96 4.50 3.71
NE Asia 16.31 14.10 15.83 13.80 13.11 12.17
North Africa 0.86 1.27 1.62 1.84 1.89 1.83
North America 20.87 22.82 17.96 12.57 13.26 15.31
Other European Countries 0.63 0.78 0.92 0.83 1.40 1.80
Other West Asia 1.97 2.57 3.67 3.32 3.78 3.60
South Asia 5.15 4.39 5.51 4.62 5.03 6.60
Southern African Customs 0.96 0.72 1.24 1.18 1.76 1.78
Union (SACU)
Unspecified 1.48 4.18 0.49 2.47 1.86 1.61
West Africa 0.96 1.74 1.98 1.84 2.17 2.25
West Asia- GCC 7.23 8.77 11.75 17.21 17.01 15.87

Source: Export-Import Database, Government of India

How Production Integration with Global
Value Chains occurs in a country?
 Integration: Intra-Industry Trade
• IIT pattern - industrialized nations have practiced intra-industry
specialization – focus on particular products within a given industry
• Simultaneous export and import within the same product group,
but with differing factor requirements
• Lead to narrower form of specialization, rather than producing full
product, greater focus on parts, components, specialized
machinery
• Role of external as well as internal scale economies
• Possibility of IIT both in homogeneous goods (low-tech products /
competitive firms) and differentiated products (sophisticated
products / oligopolies)
• How is trade distributed between IIT and HOS type trade across
countries?
• IIT trend in India
• Global examples of IIT – Integrated Production Networks

Intra-industry trade plays a particularly large role in the trade in

manufactured goods among advanced industrial nations, which
accounts for most of world trade.
 Inter-industry and intra-industry trade: Diagnostic
• Inter-industry trade reflects comparative advantage, whereas intra-
industry trade does not.
• The pattern of intra-industry trade itself is unpredictable, whereas
that of inter-industry trade is determined by underlying differences
between countries.
• The relative importance of intra-industry and inter-industry trade
depends on how similar countries are.
• Role of technological catching up (Vernon Product Cycle Hypothesis)
is crucial in intra-industry trade, while inter-industry trade does not
consider it.
• Intra-industry trade considers the possibility of countries
benefiting from larger markets – effect of recent RTAs.
• Gains from intra-industry trade will be large when economies of
scale are strong and products are highly differentiated – wider
array of choice for consumers.
• Inter-industry trade may require workers from import-competing
sector to leave the sector / region, whereas intra-industry trade
generally does not create a wider destabilizing effect.

• Is IIT relevant for India?

• Why IIT takes place?
 Similarity in India’s Overall Trade Pattern (%)
2012-13 2018-19 2012-13 2018-19
HS Code Commodity Group
(Export Share) (Export Share) (Import Share) (Import Share)
27 Mineral Fuels, Mineral Oils 20.65 14.53 36.94 32.67
and Products of their
Distillation
28 Inorganic Chemicals 0.44 0.60 1.08 1.48

29 Organic chemicals 4.03 5.52 3.20 4.35

30 Pharmaceuticals 3.35 4.47 0.36 0.40

39 Plastic and Articles thereof 1.71 2.43 1.96 2.96

71 Gems and Jewelry 14.59 12.25 17.08 12.56

72 Iron and Steel 2.69 2.94 2.78 2.44

73 Articles of Iron or Steel 2.48 2.20 0.84 0.99

84 Nuclear Reactors, Boilers, 3.85 6.35 7.18 8.52

Machinery and Mechanical
Appliances; parts thereof

85 Electrical Machinery and 3.62 3.86 6.08 10.13

Equipment and parts thereof

87 Automobile Products and 4.06 5.48 0.96 1.19

parts and accessories
thereof
Source: India’s Trade data
 How Valid is HOS Theorem / IIT in Real World?
US-India Trade (Rs. Lakh)
Commodity Group (HS US Export to Indian Export to
Code) India US
(2010-11) (2010-11)

Marine Products (3) 266.71 1,67,858.78 14,00,258.42

Edible Fruit and nuts (8) 146295.48 88076.35 52,888.41

Mineral Fuels (27) 515648.13 436481.98 1,693,378.72

Organic Chemicals (29) 335795.06 560063.28 1,289,128.12

Articles of Apparel (61) 1260.68 606512.29 1,352,251.79

Iron and Steel (72) 271576.78 220143.78

Iron and Steel Products 91893.92 847718.64

(73)
Nuclear Reactors, 1169817.43 535510.11
Machinery and
Equipments (84)

Electrical Machinery and 574935.11 607192.59

Equipments (85)

Automobile Products 78022.17 348664.01

(87)

Source: India’s Trade data

 How Valid is HOS Theorem / IIT in Real World?
US-India Trade in HS 71 (US $ Thousand) – 2012
HS Descriptions India’s India’s
Code Exports Imports
7101 Pearls, natural or cultured, etc 1,114 1,027
7102 Diamonds, not mounted or set 45,71,678 7,94,097
7103 Precious & semi-precious stone, not strug, 71,070 22,594
7104 Syn / reconstr prec /semi-prec stones, not strg / mounted/set 2,032 3,124
7105 Dust & powder of precious or semi-precious stones 3,894 1,176
7106 Silver, unwrght or in semi-manuf. Form 16,712 54,445
7107 Base metals clad with silver, nfw than semi-manufactured 440 55
7108 Gold unwrought or in semi-manuf forms 16 31,54,516
7109 Base metals or silver, clad with gold, nfw than semi-manufactured 17 19
7110 Platinum, unwrought or in semimanufactured forms 1,955 17,216
7111 Base metals, silver or gold, clad w plat, nfw than semi-manufactured 0 3
7112 Waste & scrap of precious metal 14,431 100
7113 Articles of jewellery & parts thereof 14,96,214 1,28,977
7114 Articles of goldsmith's/silversmith's wares & pts 809 524
7115 Articles of precious metal or metal clad with precious metal, nes 95 1,196
7116 Articles of natural or cultured pearls, prec/semi prec stones 1,741 22
7117 Imitation jewellery 51,448 565
7118 Coin 146 0

Source: Trade Map data

 How Valid is HOS Theorem / IIT in Real World?
Bangladesh-India Trade (Rs. Lakh)
Commodity Group (HS Code) Bangladesh Export to Indian Export to
India (2010-11) Bangladesh (2010-11)

Marine Products (3) 26848.44 4052.11

Sugar and Confectionary (17) 100.38 218114.5
Organic Chemicals (29) 119.12 41974.47
Other Textile Fibres (53) 45115.29 506.62
Man-made Filaments (54) 843.18 29618.77
Other made up textile article 26421.95 861.4
(63)
Iron and Steel Products (73) 52.99 17633.2
Aluminum Articles (76) 48.53 13339.9
Nuclear Reactor, Machinery 368.62 51568.48
and Equipments (84)
Electrical Machinery and 1887.57 33151.46
Equipments (85)
Automobile Products (87) 18.14 109873.3

Source: India’s Trade data

 How Valid is HOS Theorem / IIT in Real World?
Bangladesh-India Trade in HS 41 / 42 (US $ Thousand) – 2012
HS Descriptions India’s India’s
Code Exports Imports

4101 Raw hides & skins of bovine / equine animals 19 1658

4102 Raw skins of sheep or lambs 1 0
4103 Raw hides & skins nes 0 0
4104 Leather of bovine/equine animal, other than leather of hd 4108/4109 13 1248
4105 Sheep / lamb skin leather, other than leather of hd no4108/4109 0 0
4106 Goat/kid skin leather, other than leather of hd no 41.08/41.09 0 23
4107 Leather of other animals, o/t leather of hd no 41.08/41.09 5706 2044
Leather further prepared after tanning or crusting ""incl. parchment-
4112 dressed leather"", of 370 0
Leather further prepared after tanning or crusting ""incl. parchment-
4113 dressed leather"", of 1122 5
Chamois leather, incl. combination chamois leather (excl. glacé-tanned
4114 leather subsequentl 0 0
Composition leather with a basis of leather or leather fibre, in slabs,
4115 sheets or strip, w 33 0
4201 Saddlery and harness for any animal, of any material 187 0
4202 Trunks, suit-cases, camera cases, handbags etc, of leather, plas, tex etc 273 3
4203 Articles of apparel & clothing access, of leather or composition leather 195 21
4205 Articles of leather or composition leather, nes 39 1
4206 Articles of gut, of goldbeater's skins, of bladders or of tendons 0 38
Source: Trade Map data
Example 1: The ‘International’ Burger

Sesame seeds
from Mexico

Pickles and
Sauce from
Germany

Onions from
US

Lettuce from
Ukraine

Cheese from
Poland

Source: Czinkota et al
Bun from Beef Patties
Russia from Hungary 29
Example 2: The fragmentation of production - Boeing 787 Dreamliner

30
Source: WTO (2011)
 Example 3: Complementary parts supply
system of an automobile assembler in ASEAN

31
Source: Hiratsuka (2010)
Why Anti-Globalization Protests
Emerge across countries?
 Short-Term Catch – Smile Curve Phenomenon
1. Cost: tasks are offshored to
developing countries precisely
Fabrication because production costs in these
Brand, countries are low relative to
Component Logistics coordination costs. This lowering of
manufacture costs at that stage necessarily
implies that the value added during
that stage goes down.
2. Relative market power: The tasks
that are easy to offshore are often
those that require low capabilities
and can be done in various countries
and, hence, have become subject to
more intense competition as many
developing countries have opened
up their trade, keeping value added
in those stages low.
3. Internationally mobile technology:
The transfer of advanced
technology to the offshore
locations is now more worthwhile
than in the 1970s in light of lower
coordination costs. Incorporation
of more advanced production
technology leads to cost savings
and drives down further the value
added of the offshored stages.
 Types of IIT: A Snapshot

Homogeneous Products Horizontally Vertically

Differentiated Differentiated
Products Products
Same Prices; Identical
products (Wheat,
Concrete, Petroleum) Similar Prices; Slightly Varying Prices; Widely
different product differing product
characteristics (Gasoline, characteristics
Associated Process Perfume, Chocolate) (Automobiles, Watches)

Reduction in Transportation
and Transaction Costs Associated Process

Provision of Homogeneous Services

(Insurance, Shipping, Finances Economies Product Overlapping
associated with International Trade) of Scale Cycle Demands
(Krugman) (Vernon) (Linder)

Provision of uninterrupted
flow of seasonal products GVC: Global Value Chain
(Tomatoes) IPN: International Production Network
IIT: World exports of parts and components, 1980-2011

Source: WTO (2013)

 IIT: Values of world trade in goods by stage of
processing and broad category (2005,2016,2017)
IIT: Intra-regional and major inter-regional imports of
intermediate goods, 2008 (in billions of US$)

Source: WTO (2011)

IIT: Export and Import of intermediates by
country category (2017)
 Reason’s behind Emergence of IIT
1. Transportation cost / Proximity – if a product costs $ 10 in Canada
and $ 7 in Argentina, there is a basis of trade.
• However, if per unit transportation cost is US $ 3, then a section
of the demand would not be met by the HOS trade – however, if
products are differentiated, then scope for IIT exists
2. Production for ‘Majority consumers’ – Linder Thesis
3. Seasonal production – Brazil will export agricultural products to
US in winter but import the same in summer
4. Differentiated products – non-identical existence of Toyota and
General Motors
5. Technological Catch up - Rich and Poor countries - Income
distribution – product cycle hypothesis and overlapping demand
effect - specialization in narrow as well as commonplace product
lines
6. MNC Operation – FDI, resource-seeking behaviour, transfer
pricing – trade in intermediate products

Important Determinant: Market Structure

1. Transportation Cost / Proximity and IIT

• A buyer in Albany, New York may import corn from a firm in Montreal,
Quebec, while a firm in Seattle, Washington will export soya to a
buyer in Vancouver, British Columbia.
• Other example: Finland export to Russia
• New Zealand Apple compete with Argentina, Chile and South Africa
Trade flows across regions and change between 2015
and 2016
Distribution of World Trade: RegionWise
 5. Technology Diffusion Theory
(Raymond Vernon)
• Product Cycle Theory
• Importance of information and knowledge about products
• Complementary to ‘Technology Gap Theory’ proposed during 1970s
• Sequence:
1. Companies will manufacture products first in the countries in
which they were researched and developed, almost always
developed countries
2. The product matures in its home market
3. Product becomes standardized
4. Product as a cash cow begins to level or decline in home market
5. Product is internationalized

Implication: Transistor Radio was initially produced in US, to be

followed by Japan. Now any country can produce it, and the US
and Japan instead focus on production of more sophisticated
items like semiconductors.
Life Cycle of the International Product
Shortening Technology Gap?.

Quick Learning in
the Indian context?

46
6. Share of intra-firm exports in manufacturing exports of OECD countries

Source: Lanz and Miroudot (2011)

How presence of Scale Economies
Influence Trade Pattern?
 Economic Geography: Proposition
• Krugman (1991): involves interaction of increasing returns with
transport costs across countries (or regions). This is fundamentally
different with respect to models of comparative advantage.
• Propositions : (1) Transportation Costs play a key role in
international trade and inter-regional trade;
• (2) Spatial agglomeration of interrelated economic activity could
achieve cost-saving and benefit-increasing;
• (3) The cost-saving and benefit-increasing from the economic
spatial agglomeration could promote the further concentration of
economic development;
• (4) Early-development advantage could lead to the long-term
accumulation of economic activity.
 Economic Geography: Proposition

• Transport costs may diminish the trade volume, but will never lead
the good to be exported.

• The scale economies lead producers of individual goods to

concentrate their production in a single location.

• If a country has an unusually strong demand for a class of goods,

that country becomes a good choice as a site for production, and so
it is likely to export the goods in question.

• Implications for outsourcing.

Importance of Trade Facilitation measures ..

 Economic Geography ..
• It is the existence of economies of scale rather than their
degree that is crucial in determining trade patterns.
• Even if there are no economies of scale at the industry level,
small economies at the level of the individual product may have
such trend – evidence from OECD country’s trade data.
• Fragmentation (outsourcing) of production processes is on the
possibility of using services to break up a vertically integrated
production nexus into separate fragments, which may be
located nearby, in the same firm, or at some distance, perhaps
in a different country and under the control of different
firms.
• Lowering of the service link costs of connecting parts of a
production process may encourage the various parts to be
located in geographically separate locales.

1. an input tier wherein labor and natural resources locally found can be
combined to produce (semi-processed / intermediate) goods for the world
market
2. an output tier that combines intermediate goods / capital / technology
from the world market with local inputs to produce final consumer goods.
 Transport Cost and Location of Industry
1. Resource-based industries: near the regions where the raw
materials are obtained, as cost of transporting the raw
materials (e.g. mining products, metal ores) would be
higher.
• Better to ship the finished products – steel, chemicals,
aluminum.
2. Market-oriented industries: locate near the final market,
as produced version may be costlier to transport.
• Bottling plants of Coke in the country of final sales, better
to ship concentrate.
3. Footloose industries: goods that neither face substantial
weight gains or loses during the production process.
• Tend to locate wherever the manufacturing involves lower
cost – e.g. computer companies from US in Mexico.

Skilled workers and role of Government Support

International production network of a hard
disk drive made in Thailand

Source: Baldwin (2010)

 Important Considerations in Presence
of Scale Economies
1. How export potential of newcomers get affected by the presence
of scale economies in incumbents?
2. Scale economies and dumping
3. What is the sustainable number of players in a market?
4. Classical theories are static, i.e., specialization only on the basis of
local resources. However, the created / imported resources are
equally important – dynamic comparative advantage – role of
industrial policies.
• Creation of comparative advantage through mobilization of skilled
labour, technology and capital – acquired comparative advantage.
• Candidates for government intervention – ‘sunrise’ industries
characterized by high productivity, strong linkage with rest of the
economy and a possibility of long term growth / competitiveness
• Policy Instruments: tax, subsidy, tariff etc. – Implications?

• Support and results

• China: steel, automobiles, textile
• India: Agriculture, Heavy industries
• Why the contrast is performance?
 Can a country always ‘Specialize’
despite enjoying Scale Advantages?
 1. Scale Economies and Specialization
• Countries that start out as large producers in certain industries tend to
remain large producers even if some other country could potentially produce
the goods more cheaply.
• Entry may be denied by historical accident, and a less efficient producer may
continue to service the global market because of product differentiation.
Price, Cost • Switzerland produce watch at price P1 as its
(per watch) price falls with time.
• Thailand can produce the commodity more
cheaply (P2) but it is difficult for it to reach
the efficient scale due to presence of the
• Thailand is the Swiss players, as initial cost is C0.
newcomer • Can Thai government subsidize?
• Switzerland is
C 0
the incumbent. 1
P1 ACSWISS
2
P2 ACTHAI

Q1 Quantity of watches
produced and demanded

So how important are trade policies?

Can Trade Reduce Welfare?
Trade and Welfare with External
Economies: National Choice
Price, Cost
(per watch)

C 0

1
P1
P2 2
ACSWISS
ACTHAI
DWorld
DThai

Quantity of watches
produced and demanded

• Switzerland equilibrium is at 1, at price P1.

• Thailand, if no trade, equilibrium is at 2, at price P2.
• Thailand can produce importable more cheaply, when forced to
produce for itself.
• Argument for protection?
Why Dumping occurs in
International Market?
 2. Dumping: Theory and Evidence
• Price discrimination
• The practice of charging different customers different prices
• Dumping
• The most common form of price discrimination in international trade,
co-existence of an imperfectly competitive home market, and a
highly competitive world market (Krugman models).
• A pricing practice in which a firm charges a lower price for an
exported good than it does for the same good sold domestically.
• Technical dumping might occur during the price adjustment attempts
of a firm to fight exchange rate volatility (Leidy and Hoekman, 1990)
• Examples: US-Vietnam Catfish Dumping (Brambilla et al, 2009).
India — Tariffs on ICT Goods (Chinese Taipei)
 Dumping
• Dumping can occur only if two conditions are met:
• Imperfectly competitive industry
• Segmented markets (Helpman, 1982)
• Example:
Exporter Domestic Price Export Price Export Price
in China to India to US
China $ 10 $ 9.5 $9

• Given these conditions, a monopolistic firm may find that it

is profitable to engage in dumping.
• Dumping per se is not WTO-incompatible, but it’s margin
should not cross 2 percent ad valorem
 Why Dumping takes place?
• Predatory intent – displacing foreign competition in its home market
by entry with a lower price – short run losses compensated by long run
monopoly profit
• Global competition and the urge to sell at a marginally lower price in
foreign market to fulfill tender requirement – continue to charge
monopolistic price in the home market due to limited competition
• Subsidy from home government to cover initial losses, driven mainly by
– ‘national pride’, ‘sunrise argument’, ‘employment creation’ etc .
• How is dumping margin determined?
Sl. Country Domestic Price Export Price Absolute Level
No. in home country to India of Dumping
A China $ 115 $ 95 $ 20
B Russia $ 300 $ 75 $ 225
C Thailand $ 20 $8 $ 12

A. Dumping Margin = 20 / 95 X 100 = 21.05%.

B. Dumping Margin = 225 / 75 X 100 = 300.00%.
C. Dumping Margin = 12 / 8 X 100 = 150.00%.
 And how Dumping takes place?
Consider a single monopolistic domestic firm
Cost, C and
Price, P The foreign demand curve is a
straight line due to competition
3
PDOM
MC The Firm produce
the Monopoly
2 1 output, exploit the
PFOR position in domestic
DFOR = MRFOR industry (MC =
MRDOM = PFOR) and
export the rest
DDOM
MRDOM
O QDOM QMONOPOLY Quantities produced
and demanded, Q
Domestic sales Exports
• Production = OQM
Total output • Domestic Consumption = OQD
• Exports = QDQM
 0
100
200
300
400
500
600
700
800
China

Russian Federation

Ukraine

Brazil

India

Indonesia

South Korea

Malaysia
Initiations

Mexico

Singapore

South Africa

Taipei, Chinese
Measures

Thailand

Turkey
Which Exporters are most affected by Dumping?

European Union

Japan
Constructed from WTO AD database

United States
 Which Sectors are most affected by Dumping?
1200

1000
Initiations Measures

800

600

400

200

0
Chemical and Plastic and Paper and Textile and Cement, Glass Base Metals Machinery and
Allied Rubber Wood Garments etc. Equipment
industries

Constructed from WTO AD database

 Reciprocal Dumping
• Developed with the theoretical backbone proposed by Brander (1981),
Brander and Krugman (1983)
• Dumping occurs in international trade for systematic reasons associated
with oligopolistic behaviour.
• Oligopolistic rivalry between firms naturally gives rise to 'reciprocal
dumping': each firm dumps into other firms' home markets
• Assumption: 'segmented markets' perception - each firm perceives each
country as a separate market and makes distinct quantity decisions for
each.
• At equilibrium, each firm has a smaller market share of its export market
than of its domestic market. Therefore, perceived marginal revenue is
higher in the export market.
• Thus, perceived marginal revenue can equal marginal cost in both markets
at positive output levels.
• This is true for firms in both countries, which thus gives rise to two-way
trade.
• Moreover, each firm has a smaller mark-up over cost in its export market
than at home: the f.o.b. price for exports is below the domestic price, and
therefore there is reciprocal dumping.
 3. Intra-Firm Trade and Benefits of
Trade Liberalization
1. The gain from the fragmentation of production is the direct consequence
of lower trade costs and services trade liberalisation
– Each “block” of production can be produced in the country where the marginal
cost is the lowest
– There is an “optimal” number of blocks, as increasing fixed costs to manage a
production split up across several countries at some point offset the gains from
further fragmentation.
2. Intra-industry reallocation of market shares among heterogeneous firms,
i.e. firms of different productivity levels, following trade liberalisation.
– Trade liberalisation forces the least productive firms to exit the market while
the most productive firms increase their market share. The result is a
productivity increase at the aggregate industry level.
– Firms that are relatively less productive and not involved in offshoring can
coexist with MNEs in the same industry because of the plurality of cost-
efficient strategies focusing on competing advantages in terms of location, size
and organisational choices.
3. Increase in product variety or technological spillovers.

1. To check the contribution of network partners in Home

Country’s exports – TIVA database in Trade Analytics
2. Determining the Optimum number of producers in each market
What should be the optimum number of
firms in presence of Scale Economies?
 Monopolistic competition
• Two key assumptions are made to get around the problem of
interdependence:
– Each firm is assumed to be able to differentiate its
product from its rivals (each product is imperfect
substitute of its rivals).
– Each firm is assumed to take the prices charged by its
rivals as given.
• Market Equilibrium
• All firms in the industry are symmetric
– The demand function and cost function are identical for all
firms.
• The method for determining the number of firms and the
average price charged involves three steps:
– First, a relationship between the number of firms and the
average cost of a typical firm is derived.
– Second, a relationship between the number of firms and
the price each firm charges is derived.
– Finally, the equilibrium number of firms and the average
price that firms charge is derived.
 Imperfect Competition
• First, assume that the demand curve the firm faces is a
straight line:
Q=A–BxP (6-1)
• Then the MR that the firm faces is given by:
MR = P – Q/B (6-2)
• If Q is higher, MR is lower as decrease in price to sell a
greater quantity costs the firm more.
• When average costs decline in output, marginal cost is always
less than average cost. Suppose the costs of a firm, C, take
the linear form:
C=F+cxQ (6-3)
• The fixed cost in a linear cost function gives rise to
economies of scale, because the larger the firm’s output, the
less is fixed cost per unit.
• The firm’s average cost is given by:
AC = C/Q = F/Q + c (6-4)
 Demand Curve under Imperfect Competition
• Imagine an industry consisting of a number of firms producing
differentiated products.
• A firm can sell more, if the industry demand is high, less
competition is there (i.e., less firms) and it is price competitive.
– A particular equation for the demand faced by a firm that has the
properties mentioned earlier is:

Q = S x [1/n – b x (P – P )] (6-5)
• where:
– Q is the firm’s sales
– S is 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

• If all firms charge the same price, all have equal market share.
• If the firm enjoys a price competitiveness, then it has a higher
market share, or vice versa.
 1. Imperfect Competition: CC Curve
• How do the average costs depend on the number of firms in
the industry?
• Under symmetry, P = P, equation (6-5) tells us that
Q = S/n but equation (6-4) shows us that the average cost
depends inversely on a firm’s output.
• AC = C/Q = F/Q + c (6-4)
• We conclude that average cost depends on the size of the
market and the number of firms in the industry.
• When each firm have same price (i.e., P = P), Q = S/n is
replaced in the AC equation:

AC = F/Q + c = n x F/S + c (6-6)

The more firms there are in the industry the higher is

the average cost – CC Curve. The reason is, the more the
number of firms, the less each of them individually
produce, so average cost is higher. Upward sloping.
 2. Imperfect Competition: PP Curve
• How do the price depend on the number of firms in the
industry?
• Equation (6-5) can be written as:
• Q = (S/n + S x b x P ) – S x b x P
• or, Q = A - S x b x P
• or, P = A / (S x b) – Q / (S x b)
• By manipulation from (6-2): MR = P - Q / (S x b)
• At equilibrium: MR = MC
• or, P - Q / (S x b) = c
• or, P = Q / (S x b) + c
• Suppose each firm have same price (i.e., P = P), then, Q =
S/n.
• Hence, P = c + 1 / (b x n) (6-10)
The equation gives rise to PP curve, implying that the
more firms are there in the industry, the lower the price
they charge. This is the result of increasing competition.
Downward sloping.
Equilibrium in a Monopolistically Competitive Market
PP curve – The more firms there are, the more intensely they compete, and
hence the lower is the price.

Cost C, and CC curve - The

Price, P greater the
CC number of
AC3 firms in the
P1 industry (i.e.,
E the lower the
P2, AC2 quantity
produced and
AC1 sold by each
P3 firm), the
PP higher would be
its average
cost and price.

n1 n2 n3 Number
of firms, n
Interaction of the curves leads to equilibrium
 How the Market behaves
If the price (P1) exceeds the average cost ((AC1), i.e., the PP curve is above
the CC curve, then the industry is making profit, then more firms enter the
market.
Cost C, and If the price
Price, P (P3) is lower
CC than the
AC3 average cost
P1 (AC3), i.e., the
E PP curve is
P2, AC2 below the CC
curve, then the
AC1 industry is
P3 making losses,
PP then several
firms will exit
from the
market.

n1 n2 n3 Number
of firms, n

Industry equilibrium will be reached at P2 with n2 number of firms.

 Effects of India-ASEAN FTA
• Consider the automobile market.
• Suppose in India 50000 vehicles are produced, while in
ASEAN 90000 vehicles are produced. Now the total market
size increases after formation of the FTA.
• Trade and availability of greater range of products in both
markets.
• S, the total industry sales is now higher in the integrated
market.
• The PP curve is: P = c + 1 / (b x n)
• So, regional market integration do not affect the PP curve
• The CC curve is: AC = n x F/S + c
• S, the market size after integration, is higher.
• So, average cost falls as a result of market integration,
implying CC shifts towards right.
• How beneficial is the market integration for consumers?
 Scale Economies and Trade: Effects of a Larger Market
The number of firms in a monopolistically competitive industry and the
prices they charge are affected by the size of the market.

• International CC1
trade allows Cost C, and
creation of an Price, P
integrated
CC2
market that is
larger than
each country’s 1
market. P1
• Hence firms
produce more 2
and their P2
average cost
declines. PP

n1 n2 Number
of firms, n

Result: Greater variety of products and lower prices for consumers

 Numerical Example of Integration
• Suppose, we consider the automobile market
• The demand curve is: P = A - BQ
• It is assumed that in the demand curve facing a given producer, b =
1/30000
• Also, the demand facing any given producer is given by:
• Q = S X [1/n – (1/30000) X (P – P)]
• Cost curve is given by C = F + c. Q
• F = 750,000,000 and MC = 5,000.
• The PP curve shows: P = c + 1 / (b x n)
• The CC curve shows: AC = F/Q + c = n x F/S + c
• The market conditions can be calculated accordingly:

Category Home Market, Foreign Market, Integrated Market,

before Trade before Trade After Trade
Total Sales of Autos 900,000 1,600,000 2,500,000
Number of Firms 6 8 10
Sales per firm 150,000 200,000 250,000
Average Cost 10,000 8,750 8,000
Price 10,000 8,750 8,000
 Numerical Example ..
Numbers / Formula Home Market (India) Foreign Market (ASEAN)

F 750,000,000 750,000,000

MC 5,000 5,000

PP curve: P = c + 1 / (b x n) P = 5000 + 1/[(1/30000) X P = 5000 + 1/[(1/30000) X

6] 8]
= 5000 + 5000 = 5000 + 3750
= 10000 = 8750
Q = S/n Q = 900,000 / 6 Q = 1,600,000 / 8
= 150,000 = 200,000
CC curve: AC = F/Q + c = n AC = (750,000,000 / AC = (750,000,000 /
x F/S + c 150,000) + 5000 200,000) + 5000
= 5000 + 5000 = 3750 + 5000
= 10000 = 8750
Integrated Market (Indo-ASEAN FTA) – Supports only 10 firms

Q = S/n Q = 2,500,000 / 10 = 250,000

PP curve: P = c + 1 / (b x n) P = 5000 + 1/[(1/30000) X 10] = 5000 + 3000 = 8000

CC curve: AC = F/Q + c = n AC = (750,000,000 / 250,000) + 5000 = 3000 + 5000

x F/S + c = 8000
A. Equilibrium in Home Market
B. Equilibrium in Foreign Market
C. Integrated Market
How Integration Affect Merger and Acquisitions?

Are Mergers always good?

Source: Gomez (2013)

 Case: Competition Policy in EU
• The EC's regulation on merger control seeks to avoid a situation in
which competition is significantly impeded, in particular by the creation
or strengthening of a dominant position, as a result of mergers and
acquisitions.
• Under the Merger Regulation, the Commission assesses proposed
concentrations on the basis of whether a dominant position is created
or strengthened, or more generally whether they significantly impede
competition.
• In general, the Commission only examines mergers where the parties
have a combined worldwide turnover of €5 billion and each party has a
Community-wide turnover of €250 million.
• However, it will also examine mergers where the combined worldwide
turnover is €2.5 billion and where the following three conditions are
fulfilled: (i) the parties' combined turnover exceeds €100 million in at
least three EC Member States; (ii) each party has a turnover of €25
million in the same three EC Member States; and (iii) the individual
Community-wide turnover of each party exceeds €100 million.
• Transactions that fulfil either of these two tests are exempt from
review by the Commission if each party to the transaction realises more
than two thirds of its turnover in a single EC Member State.

Mergers must be approved by the Commission before they are put

into effect.
 Case: Competition Policy in India
• An acquisition / merger where the transferor and transferee jointly
have, or a merger or amalgamation where the resulting entity has, (i)
assets valued at more than INR 15 billion or turnover of more than
INR 45 billion, in India; or (ii) assets valued at more than USD 750
million in India and abroad, of which assets worth at least Rs 7.5
million are in India, or, turnover more than USD 2250 million of
which turnover in India should be at least Rs 22.5 billion.
• An acquisition / merger where the group to which the acquired
entity would belong, jointly has, or a merger or amalgamation where
the group to which the resulting entity belongs, has (i) assets valued
at more that INR 60 billion or turnover of more than Rs 180 billion,
in India; or (ii) assets valued at more than USD 3 billion in the
aggregate in India and abroad, of which assets worth at least Rs 7.5
billion should be in India, or turnover of more than USD 9 billion,
including at least Rs 22.5 billion in India.
 4. Dynamic Comparative Advantage

Sometimes an infant industry is protected until it reaches

that comparative advantage.