Intra-Industry A country

simultaneously exporting and importing

Trade the same / similar goods and services

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Intra-industry trade patterns

• Pharmaceutical products
• Vehicles (other than railway
and tramway)
• Articles of iron and steel
• Ship / boats and floating
structures
Increasing
• Furniture linings
returns to scale
• Power generating machinery
• Electrical machinery
• Organic chemicals
• In-organic chemicals
• Telecom equipment
Variety • Clothing and apparel
• footwear

2
Fixed costs, increasing returns to scale and falling average costs

Total cost
= FC + VC
AC
= F + c.Q

So Av. Cost = F/Q + c

capacity
AC

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Why IIT?
1. Transport costs
(geographical distance between domestic supplier and domestic consumer > that between foreign supplier
and domestic consumer)
Country A Country B

Customers of
Factory
country A
of B

Factory Customers of
of A country B

4
Why IIT?
2. Need for Variety
Consumers like to choose from a variety of the same good. Some varieties
produced at home; some varieties may be imported.
Larger range of variety can also be produced by domestic firms if the
consumers want so. But not often observed.
Why cannot the domestic firms provide many varieties?
• Costs of establishing (fixed costs) needed to launch different varieties of
the same product requires a minimum scale of the business for the
business to be profitable.
• It should be more cost effective for a firm to market its few varieties of the
product in different countries, to enjoy the economies of scale.

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• Grubel-Lloyd index for industry i
GLI = 1 - |Xi-Mi|/(Xi+Mi)

• Grubel-Lloyd index for a country

GLI = 1 - ∑|Xi-Mi|/∑(Xi+Mi)

• Intra industry trade index 1985

US : 0.1371
West Germany : 0.1473
UK: 0.1495

Spain: 0.0807

India: 0.0305
Thailand: 0.0286
Kenya: 0.0052
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Increasing returns
technology:

Costs, prices and variety

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Increasing returns, non-competitive markets and pricing (1)

P,
AC, • Fixed costs give rise to IRS
MC, (falling AC)
MR • Increasing returns in
production gives rise to
supernormal profits
Pm A • If entry of new firms is
MC
restricted the market tends
ACm to be monopolistic
B
MR AC

AR or
E Demand

Qm Q

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How the demand curve changes for the firm
when another firm enters the market

When the products of the two When the products of the two
firms are homogenous firms are differentiated

P P

10 10

Q Q
What changes in the individual firm’s (firm i) demand when firms enter

Effect of increased competition In monopolistic competition,

P (higher number of firms) firms may offer differentiated
quality.
C* Attracted by the supernormal
D profit many other firms enter
with different varieties.
Differentiated varieties allow
D’
them to charge prices that are
Q slightly different from others.

Given the average price charged by other firms, if firm i reduces price , i‘s
market share increases, and vice versa. If Pi falls to 0 firm gets almost the
entire market.

Because of differentiated products and associated loyal customers, even if a

firm increases (or reduces) price while others keep it unchanged it does not
lose (or gain) the entire market.
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 Increasing returns, non-competitive markets and pricing (2)
P,
AC, • As more firms enter the
MC, market demand curve for
MR EACH firm flattens.
• This leads to fall in profits for
each of them.
Pm A • If two many firms enter,
MC
demand curve for each
ACm flattens so much that each
B make loss.
MR AC

AR or
E Demand

Qm Q

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Increasing returns, non-competitive markets and pricing (3)
P,
AC, • When each firm makes loss,
MC, some move out of the
MR market.
• Competition reduces and the
demand curve for each of
A them swings back.
Pm MC
• The demand curve, after
ACm swinging back and forth,
B finally settles where there is
MR AC no supernormal profit. That
is at the tangency of the AC.
AR or • That is the equilibrium for
E Demand the market = > where every
firm makes P = AC
Qm Q

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Increasing returns, non-competitive markets and pricing (2)
P,
AC, Element of
MC, Monopolistic competition monopoly

MR • The profit maximising quantity

is fixed by MC=MR

• P = AC. No supernormal profit.

MC Element of
ACm Competition
A
ACmc • Firms try to differentiate in
= AC
MR variety of the product, face a
Pmc
more elastic demand curve.
AR More the number of firms,
E’ more is the variety of the
Q
product available in the market.
Qm

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What changes in the individual firm’s demand when economies integrate

Effect of market size increase

P
P
C*
C*
Both effects together
D’
D
Q
Effect of increased competition
P (higher number of firms)
D’

C*
D D
D’ Q

Q
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Intra-industry trade
model:
trade under non- p

competitive Does free trade reduce prices?

markets How many varieties of the product can be
expected with free trade?
n
n

Due to Paul Krugman

Under monopolistic competition
• Demand faced by each firm is proportional to the total market size.
• Market size for the firm depends on how different is the firm’s price from the price charged by
the rest of the market.

The Model
Consider a single country market.
1. This demand pattern can be given by Q = S[(1/n) – b(P-Pa)]
S = total sales of the Industry Q = sales of the firm
n = number of firms Pa = average price charged by the rest of the market
b measures elasticity of demand

Q = S[(1/n) – b(P-Pa)]
= [(S/n) + SbPa] – SbP
= A - BP

2. Total cost = F + cQ
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Finding the profit maximising price: From
MR = MC
Q = S[(1/n) – b(P-Pa)]
Finding MR
= [(S/n) + SbPa] – SbP P = (A – Q) / B
P
= A - BP = A/B – Q/B
Or P = [A-Q]/B
TR = P.Q
Equilibrium: MR = MC = AQ/B – Q2/B

MR = P – Q/B MR = A/B – 2Q/B

= P – Q/Sb = A/B – Q/B – Q/B
= P – Q/B
= P – 1/nb
(Since we have symmetric firms, S/n = Q)
MC =c PP

MR = MC implies
P – 1/nb = c n
P = c +1/nb
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Finding the Average cost:

Cost conditions are assumed to AC

be similar (if not identical) for all CC
firms.
TC = FC + VC
= F + c.Q

AC = F/Q + c

If all firms are symmetric, they

will charge the same price and
get equal share of the market.
Q = S/n
Therefore
n
AC = [Fn/S] + c
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 Finding the number of firms: From
P = AC
Average cost pricing under monopolistic competition
: determining the number of firms in the industry AC = P
(hence variety of the product) AC = [Fn/S] + c

P, AC
P = c +1/nb

CC
Number of firms or variety n*
n* = 𝑺/𝑭𝒃
Eq P = P*
P*

PP

n
n*
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 AC = [Fn/S] + c
When trade opens up
International trade integrates the markets P = c +1/nb
Say the total market size is doubled (from S to 2S)
Equilibium:
P
Number of firms or variety n’
= 𝟐. 𝒏∗
CC (pre
trade)
Price P’ < P*

Eq1
P* CC
Eq2 (post
P’ trade)
PP

n* n' n
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 International trade integrates the markets

Say the total market size is doubled (from S to 2S)

Equilibium:
P
Number of firms or variety n’
= 𝟐. 𝒏∗
CC (pre 2n*> n‘ > n*
trade)
Price P’ < P*

Eq1 trade opportunities increase

P* CC number of firms and variety
Eq2 (post available in each market
P’ trade)
PP Each firm’s scale of operation
increases, reducing average
cost and hence price.

n* n' n
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Price changes in trading nations A and B

Average post-trade Average pre-trade Average pre-trade

price level in A and B price level in B price level in A

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Costs of trade:
• Some of the firms have to exit the market

Conditions for the benefits:

• IRS, but entry not restricted.
• Similar cost conditions between firms.
• Dissimilar cost conditions would cause natural monopolisation of the
market.

Conditions should be conducive to keep the market structure as

competitive as possible, so that consumers benefit from reduced prices.

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Reading

From reading material on module 1-

“Economies of Scale, Imperfect Competition and International trade”
and
“Gains from trade when firms matter”[page 97-104]

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