Increasing returns to scale

Financial Management MBA Programme

University of Coburg

December 2020, Alba Patozi

New Trade Theory: Introduction
• In the 1980s international trade theory was revolutionised by the
(still) new trade theory.
• An important motivation for this was the empirical performance of
classical trade theory.
Lesson outline
• Trade Facts
• Building Blocks and Model
• Application
Traditional trade theories:
• Trade driven by differences in relative autarky prices (arising from
technology or factor endowment differences across countries)
• Implications:
üDifferent countries should trade more. (US and Ghana)
üDifferent countries should specialise in different goods. (Cheese for Wine)
• In the real world, however:
üMost trade takes place between similar countries (US and EU)
üThese countries tend to trade similar goods. (Cars for Cars)
Trade Fact 1
Large volumes of trade between countries with similar technologies
and factor proportions.
Trade Fact 2
• Large volumes of intra-industry trade. (Cars for cars, not Cheese for
Wine)
• The relative importance of intra-industry trade is measured by the
Grubel-Lloyd Index:
|𝐸𝑋𝑃! − 𝐼𝑀𝑃! |
𝐼𝐼𝑇! = 1 −
𝐸𝑋𝑃! + 𝐼𝑀𝑃!
• No intra-industry trade: 𝐼𝑀𝑃! = 0 or EXPg= 0, so 𝐼𝐼𝑇! =0.
• No inter-industry trade: 𝐸𝑋𝑃! = 𝐼𝑀𝑃! so 𝐼𝐼𝑇! =1.
• IIT indices for selected industries of Germany:
Indices of Intra-Industry Trade for U.S. Industries, 2009

Industry IIT
Inorganic Chemicals 0.99
Power Generating Machines 0.86
Medical and Pharmaceutical Products 0.85
Iron and steel 0.76
Telecommunications equipment 0.46
Footwear 0.10
Technological Differences
• Trefler (1995) shows trade data can be explained by adding arbitrary
productivity differences across countries and sectors.
• Model differences in production structure across countries.
• “New” Trade Theory: Increasing Returns to Scale (IRS) drives international
trade and provides an explanation for the previous facts.
• IRS: A 1% increase in inputs leads to a more than 1% increase in output, so
average costs tend to fall with the scale of production.
• Similar countries specialize in different varieties of a good, but these
varieties can have similar technologies and factor content. (BMWs and
Toyotas)
• Can provide new sources of gains from trade from increase in product
variety and lower average costs from higher production.
Increasing Returns to Scale
• IRS can be internal to the firm (average cost of a firm falls with its
production) or external to the firm (average cost of a firm falls with
industry output).
• Focus on Internal IRS today
• Model of IRS: Krugman 1979
Paul Krugman
American Economist born in
1952.

Winner of the 2008 Nobel

Price in Economics for his
contribution to the New
Trade Theory.
Internal Economies of Scale
• Internal economies of scale imply that a firm’s average cost of
production decreases the more output it produces. E.g. 𝐴𝐶 𝑄 "#$% =
𝑐 + 𝑓/𝑄 "#$% .
• If firms have internal economies of scale, markets cannot be perfectly
competitive.
• Large firms have a cost advantage over smaller firms, causing the
industry to become uncompetitive.
• Perfect competition that drives the price down to marginal cost
would imply losses because firms would not be able to recover the
higher costs incurred from producing the initial units of output.
Market Power
• A firm has market power if it can set the price at which it sells.
• Firms are aware that they can influence the prices of their products and
that they can sell more only 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 rivals.
• While a price – taking firm faces an infinitely elastic demand at the given
market price, a price setting firm faces a downward sloping demand with
finite elasticity.
• “Downward-sloping demand” means that a firm with market power faces a
trade-off between selling less at a higher price and selling more at a lower
price.
Monopolistic Firm
• We are interested in understanding how prices and quantities are
determined in a market with internal economies of scale.
• In the next few slides, we will introduce a monopolistic firm with
internal economies of scale.
• A monopolistic firm has market power and we will determine price
and quantity of this firm.
Monopoly: Demand
• Assume that there is only one firm in an industry (monopoly)
• Technology is characterized by a constant marginal cost c.
• The monopolist maximises profits, taking the inverse demand P(Q) as
given:
𝜋 = 𝑃 𝑄 −𝑐 𝑄
• Profit is maximised when marginal revenue equals marginal cost.
𝜕𝜋 𝜕𝑃 𝑄
=𝑃 𝑄 −𝑐+ 𝑄=0
𝜕𝑄 𝜕𝑄

!"($)
• Recall: 𝑀𝑅 = 𝑃 𝑄 + !$
𝑄 = 𝑐 = 𝑀𝐶
Cannibalization
• When the firm sells an additional unit of output, there are two effects
on revenue:
• Direct effect [P(Q) >0]: revenue increases by the price of the
additional unit produced and sold.
&' (
• Indirect effect [ &( 𝑄<0]: Revenue decreases because the unit
increase in supply makes the price fall for all other units already
produced (‘cannibalization’).
Monopolistic Competition
• We now want to set up a model where firms have internal economies of scale,
are imperfectly competitive, and sell at home and abroad.
• To tie imperfect competition into a trade model, we will use monopolistic
competition.
• Most industries have more than one firm.
• Monopolistic competition models assume that:
• Firms freely enter and exit the market.
• Each firm faces decreasing AC due to a fixed cost. TC 𝑞 !"#$ = 𝑐𝑞 !"#$ + 𝑓
𝐴𝐶 𝑞 !"#$ = 𝑐 + 𝑓/𝑞 !"#$
• Each firm can differentiate its product from the product of competitors.
• Each firm ignores the impact that changes in its price have on the prices that
competitors set: even though each firm faces competition, it behaves as if it were
a monopolist.
Free entry
• Assume free entry of firms.
• 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 in the industry, firms have no
incentive to enter or exit the industry.
• If the number of firms is greater than or less than the equilibrium number,
then firms have an incentive to exit or enter the industry.
• Firms have an incentive to exit the industry when price < average cost.
• Firms have an incentive to enter the industry when price > average cost.
New Trade Theory
Reading: Krugman, Paul R., 1979. "Increasing returns, monopolistic
competition, and international trade," Journal of International
Economics, Elsevier, vol. 9(4), pages 469-479, November.
Model
• Assumptions:
• Two identical countries: Home and Foreign (*).
• Single factor of production: L workers in each country.
• Each agent is endowed with 1 unit of labour.
• Single industry with many differentiated varieties.
• Identical technologies across countries and across varieties.
 New trade Theory: Krugman
• There are two identical countries.
• Labour is the only factor of production. Endowments are L and L*.
• Many firms, producing differentiated products indexed by i.
• Preferences are 𝑈 = ∑)&'( 𝑣(𝑞& )
with v’()>0 and v’’()<0. These preferences incorporate “love of variety”.
(/+ (/+ (/+
• Suppose n =2 and 𝑣 𝑞& = 𝑞& . Then 𝑈 = 𝑞( + 𝑞+
• If I have 1 dollar and prices are the same for varieties 1 and 2, then I will
%
want%to
( & ( &
buy ½ of each variety rather than spend on only 1 variety because + >
+ +
0+1
Production
Technology is 𝑇𝐶 𝑞# = 𝑐𝑞# + 𝑓.
Note that the production function has internal economies of scale as 𝑞#
is the output of firm i.
Firms are monopolistically competitive, i.e they ignore the effects of
their decisions on others and set prices like a monopolist.
The intuition behind the model
• Consider first one country
• How many different varieties will be produced?
• The “love of variety” preferences imply that all available varieties will
be consumed (in equal proportions in equilibrium).
• However, production of a further variety requires fixed costs.
• The tension between exploiting IRS and love of variety will lead to an
equilibrium number of varieties with zero profit for all firms.
Intuition
• Now suppose there is a second identical country.
• In a classical world there would be no trade.
• What happens if trade is allowed?
• Initially, domestic consumers switch half of their spending to foreign
goods.
• The same applies to foreign consumers and demand for each firm is
unchanged.
• The first gain from trade: variety has increased.
Intuition
• There is a second gain from trade.
• Stronger competition in the larger market forces firms to lower prices
relative to wages.
• This induces some firms to exit and the remaining firms grow in size.
• The second gain from trade: lower prices from lower costs.
• Note that we have pure intra-industry trade in this model.
The Formal Analysis
We proceed in three steps:
• Consumer maximization
• Producer maximization
• Zero profit condition
 Consumers (not examinable)
• Consumer utility maximization:
, ,

max 6 𝑣 𝑞# + 𝜆[𝑤 − 6 𝑝# 𝑞# ]
)!
#*+ #*+
• First order condition: 𝑣 - 𝑞# = 𝜆𝑝#
• If firms are small relative to the market, 𝜆 can be treated as fixed 𝑝# = 𝑣 - 𝑞# /𝜆
.! &)! /-()! )
• The price elasticity of demand is 𝜀# = − =− and we assume that
)! &.! )! / "" )!
&2!
< 0 (important!)
&)!
 Firms
• As all consumers are identical, demand for variety i is 𝑞# L.
• Firms maximise profits: 𝑚𝑎𝑥 π# = 𝑝# 𝑞# 𝑞# 𝐿 − 𝑤𝑐𝑞# 𝐿 − 𝑤𝑓
)!
&3! &.! )!
• The first order condition is: &)!
= &)!
𝑞# 𝐿 + 𝑝# 𝑞# 𝐿 − 𝑤𝑐𝐿 = 0
2 )!
• Substitute for the demand elasticity to get: 𝑝# = 2 )! 4+
𝑤𝑐
Firm pricing
2 )!
The optimal price is: 𝑝# = 𝑤𝑐 under monopolistic competition
2 )! 4+
Note that under perfect competition this price would have been
𝑝# =wc
2 )!
As 2 )! 4+
>1,
in our monopolistic competition setting prices are higher
than marginal costs and firms charge a mark-up.
Profit maximization
• Assume a symmetric equilibrium, 𝑝# = p and 𝑞# = q for all firms i.
• Therefore, each firm chooses
. 2 )
5
=2 ) 4+
𝑐 (PP)
• Intuition: With downward sloping demand firms charge a mark-up
over marginal costs.
• As q increases, the elasticity of demand falls (by assumption) and
2 )
hence the mark-up increases.
2 ) 4+
Average costs
• There is free entry of firms and in equilibrium profits π# = 0.
• For π# = 0, it must be the case that price = average cost:
.
= 𝑐 + 𝑓/𝑞𝐿 (ZZ)
5
• Intuition: as qL increases average costs fall. So p/w has to fall for firms
return 𝜋 = 0.
General equilibrium
• General Equilibrium: From PP and ZZ, we can determine the real wage
w/p and per capita consumption of each variety q.
. 2 ) .
Here = 𝑐 (PP) and = 𝑐 + 𝑓/𝑞𝐿 (ZZ)
5 2 ) 4+ 5
• We can work out the equilibrium number of varieties n=L/(cqL+f) at
the optimal q (determined from the intersection of PP and ZZ)
General Equilibrium
. 2 ) .
= 𝑐 (PP) and = 𝑐 + 𝑓/𝑞𝐿 (ZZ)
5 2 ) 4+ 5
where
• PP is upward-sloping because a higher q implies a higher mark-up.
• ZZ is downward-sloping because a higher q implies a lover average
cost.
Effects of Free Trade
• Trade increases market size. Equivalent to an increase in the labour
force L or population size.
. 2 ) .
= 𝑐 (PP) and = 𝑐 + 𝑓/𝑞𝐿 (ZZ)
5 2 ) 4+ 5
• PP is unaffected, but ZZ shifts to the left to ZZ’.
Effects of Free Trade
• What are the effects of trade? A lower p/w and a lower q.
• Bigger firms: qL rises (recall ZZ implies p/w = c+f/qL)
• At the new equilibrium we have:
• Pro-competitive effects. Lower p/w.
• Increase in product variety. Higher n because n=1/(cq+f/L) and q and
f/L have fallen.
• New Gains from Trade through Lower Prices and Increased Variety.
Summary
• The New Trade Theory sets out to explain the large amount of trade
in similar products between similar countries.
• In this model trade is not driven by comparative advantage.
• Instead the reason for trade is the tension between love of variety
preferences and increasing returns to scale in production.
• Trade allows consumers to both consume more variety and enjoy
higher real wages.