International Economics 16th Edition Thomas Pugel Solutions Manual 1

International Economics 16th Edition
Thomas Pugel Solutions Manual

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Chapter 6
Scale Economies, Imperfect Competition, and Trade
Overview
Standard trade theory presented in Chapters 3-5 is based on perfect competition, with constant
returns to scale at the level of the individual firm and constant or increasing cost of expanding
production at the level of the industry. Comparative advantage predicts that countries will trade
with other countries that are different (the source of the comparative cost differences) and that
each country will export some products and import other, quite different products. While much
international trade conforms to these patterns, a substantial amount does not. Most obviously,
industrialized countries trade a lot with each other, and in much of their trade each is exporting
and importing similar products.
This chapter looks at three theories of trade based on market structures that differ from the
standard theory. Each of these theories includes a role for scale economies, so that unit costs tend
to decline as output increases. The first section of the chapter defines and examines scale
economies, and it explains the difference between scale economies that are internal to the
individual firm, and scale economies that are external to the firm but apply to a cluster of firms
in a geographic area.
The next section of the chapter defines intra-industry trade (IIT), in which a country both exports
and imports the same product or very similar product varieties. It explains how IIT is measured
for an individual product, with examples shown in Figure 6.2. The importance of IIT in a
country’s overall trade is the weighted average of the IIT shares for each of the individual
products. Figure 6.3 provides original estimates of the overall importance of IIT.
40
© 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
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The remainder of the chapter presents the three additional trade theories. The first is based on
monopolistic competition. While there may be a number of explanations of intra-industry trade,
product differentiation seems to be the major one. The market structure of monopolistic
competition is useful for analyzing the role of product differentiation. Each producer faces a
downward-sloping demand curve for its product variety. If scale economies (internal to the firm)
are moderate (relative to the size of the total market for all varieties of this product), then easy
entry drives each firm to earn zero economic profit (the average cost curve is tangent to the
demand curve). If a monopolistically competitive national market is opened to international
trade, then domestic consumers have access to additional varieties of the product—those that can
be imported. Domestic producers have access to additional buyers—foreigners who prefer their
varieties. Product differentiation in this monopolistically competitive global market is the basis
for intra-industry trade, as some varieties are imported while others are exported. (The box on
“The Gravity Model of Trade” examines an empirical approach that is consistent with trade
based on product differentiation and monopolistic competition. It discusses some of the key
findings about national economic size, geographic distance, and other impediments to trade.)
With this kind of trade based on product differentiation and monopolistic competition, an
additional source of gains from trade for the country is the increase in varieties that become
available. Furthermore, trade may also lead to lower prices for the domestic varieties. These
benefits accrue to consumers generally. The implications of trade for the well-being of different
groups in the country are also modified. First, if most trade is intra-industry, then there may be
little pressure on factor prices caused by inter-industry shifts in factor demand. Second, the gains
from increased variety reduce the loss to factors that suffer income losses due to Stolper-
Samuelson effects. Some may believe they are better off even though they appear to lose income.
In addition, increased international competition drives national production toward domestic firms
with lower costs, a process of restructuring within the national industry.
The second theory is global oligopoly. In some industries, a few large firms account for most
global sales, perhaps because internal scale economies are large. Although we do not have a
single dominant full theory of oligopoly, we can make several observations about oligopoly and
trade. First, scale economies tend to concentrate production in a few production sites. When they
were chosen by the firms, these may have been the lowest-cost sites. Over time production tends
to continue in these sites, even though they may not remain the lowest cost sites if all sites could
achieve the same production scale.
Second, in an oligopoly each large firm should recognize interdependence with the other large
firms—its actions and decisions are likely to elicit responses from the other firms. Competition
then resembles a game, but it is still not clear how the firms should play the game. If they
compete aggressively, then they may earn only normal profits. They may be caught in the
prisoners dilemma of competing aggressively, unless they can find some way to cooperate. If
instead they restrain their competitive thrusts, then they may be able to earn high profits.
The fact that oligopoly firms can earn high profits means that it matters where these firms are
located (or who owns them). The high profit earned on export sales creates another source of
41
national gains from trade for the exporting country, in the form of better terms of trade, at the
expense of foreign buyers of the imports.
Our third theory is based on scale economies that are external to the individual firm but arise
from advantages of having a high level of production in a geographic area. With external scale
economies (also called agglomeration economies), an expansion of demand (such as that caused
by increased exports) can result in a lower unit cost for all producers in the area and a lower
product price. With free trade production tends to be concentrated in one or a few locations. In
the shift from no trade to free trade, production in some locations would increase so that their
unit costs and prices fall, while production in other locations would decrease or cease. It is not
easy to predict which locations become dominant—luck, a large domestic market, or government
policy may be important. The importing countries gain from trade, even if local production
ceases, because consumers benefit from the lower prices of the imported product. A key
difference from the standard model is that with external scale economies consumers in the
exporting country also gain surplus as trade leads to lower costs and prices, because production
is concentrated in few locations that can better achieve the external economies.
The chapter concludes with a summary that pulls together the sweep of the analysis of
international trade covered in Chapters 2-6.
Tips
The analysis in the text of the chapter is at the level of the market and uses the graph with the
price curve and the unit cost curve. The analysis of the individual firm in a monopolistically
competitive market is in a concise Extension box. An instructor has the option to omit this box
from the assigned required reading—students will still be able to follow the discussion in the
text. If you omit the extension box, also omit end of chapter question 10.
The link of global oligopoly to trade policy—often called strategic trade policy—is presented in
Chapter 11. An analysis of global cartels is presented in Chapter 14.
The country assignment included as a Suggested Assignment for Chapter 5 includes a question
referring to the country's intra-industry trade. If appropriate, you could ask a more specific
question, which might include calculations of the intra-industry trade shares for individual
products using the formula in the text, or the calculation for the country of the weighted average
of these IIT shares.
Suggested answers to end of chapter questions and problems

1. Disagree. The Heckscher–Ohlin theory indicates that countries should export some
products (products that are intensive in the country’s abundant factors) and import other
products (products that are intensive in the country’s scarce factors). Heckscher–Ohlin
theory predicts the pattern of interindustry trade. It does not predict that countries would
engage in a lot of intra-industry trade, which involves both exporting and importing
products that are the same (or very similar).
42
2. Scale economies exist when unit (or average) cost declines as production during a period
of time is larger. (1) The key role of scale economies in the analysis of markets that are
monopolistically competitive is to provide an incentive for larger production levels of
each variety of the industry's product. The product is differentiated, but it is not fully
customized to each individual consumer's exact desires. Larger production runs of each
variety of the product can benefit from scale economies. Still, these scale economies
apply mainly to relatively small levels of production, so that a large number of firms and
product varieties can exist and compete in the market. (2) The key role of scale
economies in the analysis of oligopoly is that they drive firms to become large, so that a
small number of firms come to dominate the market. These scale economies apply over a
large range of output, so that firms that are large relative to the size of the market enjoy
cost advantages over any smaller rivals.
3. There are two major reasons. First, product differentiation can result in intra-industry
trade. Imports do not lead to lower domestic output of the product because exports
provide demand for much of the output that previously was sold at home. Output levels
do not change much between industries, so there are (1) little shift between industries in
factor demand and (2) little pressure on factor prices. There are likely to be fewer losers
from Stolper–Samuelson effects. Second, there is a gain from trade that is shared by
everyone—the gain from having access to greater product variety through trade. Some
groups that otherwise might believe that they are losers because of trade can instead
believe that they are winners if they place enough value on this access to greater product
variety.
4. If the government is going to permit free export of the pasta (no export taxes or export
limits), then the government should choose to form the industry as a monopoly. The
country is likely to gain more from trade if it charges a higher price to foreign buyers,
because the country benefits from higher export prices and better terms of trade. A
monopoly will charge higher prices (in order to maximize its profits), in comparison with
the equilibrium price for a comparable but competitive industry. Because all of the
product is exported, there is no concern about charging domestic consumers high prices.
The goal is to charge foreign buyers high prices. The gains from better terms of trade
accrue mainly to the monopoly as higher profits. This benefits the country as long as the
monopoly is owned by the country's residents (or the country's government can gain
some of these profits through taxation).
5. Disagree. External scale economies are cost or quality advantages to firms in an industry
that locate close to each other, that is, in the same small geographic area. The key
influence of external scale economies on the pattern of international trade is that they lead
to a small number of locations producing much of the world output of the industry’s
product because firms in these locations benefit from the external scale economies.
Countries that have such centers of large production become the exporting countries, and
countries without them, the importing countries. The activities of firms in these centers
could include the creation of product varieties, but they need not. Variety is not necessary
to the explanation of why external scale economies affect the pattern of trade.
43
6. a. The market equilibrium price depends on how intensely Boeing and Airbus compete in
order to gain sales. A low-price equilibrium occurs if Boeing and Airbus compete
intensely to gain extra sales, including attempts to use price-cutting to "steal" sales from
each other. A high-price equilibrium occurs if Boeing and Airbus recognize that price
competition mainly serves to depress the profits of both firms, so that they both restrain
their urges to compete using low prices.
b. From the perspective of the well-being of the United States or Europe, a high-price
equilibrium could be desirable because it involves setting high prices on export sales to
other countries. This equilibrium also results in sales to domestic buyers at high prices, so
there is some loss of pricing efficiency domestically. But the benefits to the country from
charging high prices on exports and improving its terms of trade can easily be larger, so
that overall the high-price equilibrium can be desirable.
c. The low-price outcome is desirable for a country like Japan or Brazil that imports all of
its large passenger jet airplanes (e.g., for use by its national airlines). The country's terms
of trade are better if import prices are lower.
d. Yes, Japan or Brazil still gains from importing airplanes. Some amount of "consumer
surplus" is obtained by these countries—that is why they import even at the high price.
But their surplus would be even greater if airplane prices were low.
7. a. Consumers in Pugelovia are likely to experience two types of effects from the opening of
trade. First, consumers gain access to the varieties of products produced by foreign firms, as
these varieties can now be imported. Consumers gain from greater product variety. Second,
the additional competition from imports can lower the prices of the domestically produced
varieties, creating an additional gain for domestic consumers.
b. Producers in Pugelovia also are likely to experience two types of effects from the opening
of trade. First, imports add extra competition for domestic sales. As we noted in the
answer to part a, this is likely to force domestic producers to lower their prices, and some
sales will be lost to imports. Second, domestic producers gain access to a new market, the
foreign market. They are likely to be able to make additional sales as exports to
consumers in the foreign market who prefer these producers’ varieties over the ones
produced locally there.
8. Yes, it is possible. (a) If the product is undifferentiated and has a perfectly competitive
market, the extra demand in the rest of the world is likely to result in an increase in the
world price of the product. Essentially, the shift to the right in the world demand curve
moves the equilibrium along an upward-sloping world supply curve, resulting in an
increase in the world equilibrium price for the product. As an individual consumer, you
are likely to be worse off—you pay a higher price and may buy less, so you lose personal
consumer surplus. (b) If, instead, the product is differentiated and has a monopolistically
competitive market, it is more likely that you will benefit from the increase in demand in
the rest of the world, especially if there is enough time for the global market to adjust to a
new long-run (zero-profit) equilibrium. The increase in global demand creates the
44
incentive for firms to offer new varieties of the product. The extra varieties intensify
competition and increase the elasticity of demand for each variety, so the typical price of
a product variety tends to decline. As an individual consumer, you are likely to be better
off—you pay a lower price for the product and you have access to more varieties.
9. We can use a graph like Figure 6.5, as shown on the next page, to examine the change in
the number of models. In the initial situation, the global market was in equilibrium with
40 models and a typical price of $600 per washer. The increase in global demand shifts
the unit cost curve from UC0 to UC1. Here is one way to see why the unit cost curve shifts
this way. For any given number of models, each firm would be able to produce more
units of its own version with greater demand, so each firm would be able to achieve
additional scale economies that would lower its unit cost. Therefore, the unit cost curve
shifts down. With the new unit cost curve UC1, the new long-run equilibrium is at point
R, with a typical price P1 less than $600 and the number of models N1 larger than 40.
How did we get from the initial equilibrium to the new long-run equilibrium? With the
increase in global demand, the firms producing the initial 40 models began to earn
economic profits. The positive profits attracted the entry of additional firms that offered
new models. With the entry of new firms and new models, the demand for each of the
established firms’ models eroded. In addition, the arrival of new close substitute models
increased the price elasticity of demand for each model. The decrease in demand for each
model and the increase in the price elasticity forced each firm to lower the price of its
model. The new long-run equilibrium occurs when the typical firm is back to earning
zero economic profit on its model. This occurs with a larger total number of models
offered, and with a lower price for the typical model.
10. a. In the initial free-trade equilibrium, the typical firm was earning zero economic profit. At
the price of $600 per washer, the downward-sloping demand curve D0 for this firm’s
model was just tangent to the firm’s average cost curve for producing the model. When
global demand increases by about 15 percent, the typical firm’s demand curve shifts up
or to the right, to D, in the short run just after the general demand increase. The firm’s
marginal revenue curve also shifts up to MR with the shift in the demand curve. The new
marginal revenue curve intersects the firm’s marginal cost curve at point H. In
45
comparison with the initial situation, the firm produces a larger quantity (Q rather than
Q0) and charges a higher price (P rather than $600). The firm earns positive economic
$/washer
P G
G0
600
C Z
AC
H0 H
MC D
D0
Q0 Q MR0 MR Quantity

(washers)
46
profit, equal to the difference (P − C) between price and average cost at the output level
Q, times the output level Q. The economic profit is the area of rectangle PGZC.
b. In the new long-run equilibrium, the typical firm faces a more elastic demand curve D1
and earns zero economic profit. This occurs at the price P1 and the quantity Q1.
$/washer
600 G0
G1
P1
AC
H0 H1
MC D1
D0
Q0 Q1 MR0 MR1 Quantity

(washers)
11. a. Here is the calculation for perfumes: IIT share = 1 - [|3 - 234|/(3 + 234)] = 0.025 (or
2.5%). Using the same type of calculation for the other products, here are the IIT shares
for each product:
b. For Japan, total trade in these seven products is $157,676 million. The weighted average
of the IIT shares is:
(6/157,676) * 2.5 + (2,366/157,676) * 95.6 + (6/157,676) * 0.6 + (34,912/157,676) *

76.8 + (21,764/157,676) * 20.1 + (22/157,676) * 59.5 + (192/157,676) *
55.3 = 37.6%
The United States has relatively more IIT in these products.
47
12. There are a small number of firms that produce electric railroad locomotives and two
countries (Germany and China) account for most world exports. Global oligopoly that
results from internal scale economies that extend over a large range of output is the
economic model that fits best. A few firms dominate the global industry as they achieve
low cost through scale economies. These firms produce in only a few location to achieve
low costs through scale economies. It is also possible that there are some external scale
economies that help to explain the concentration of most production in two countries, but
the industry structure is not a large number of competitive firms, so the situation for
electric railroad locomotives does not completely fit the model for external scale
economies presented in the chapter.
13. a. External scale economies mean that the average costs of production decline as the size of
an industry in a specific geographic area increases. With free trade and external
economies, production will tend to concentrate in one geographic area to achieve these
external economies. Whichever area is able to increase its production can lower its
average costs. Lower costs permit firms in this area to lower their prices so that they gain
more sales, grow bigger, and achieve lower costs. Eventually production occurs in only
one country (or geographic area) that produces with low costs.
b. Both countries gain from trade in products with external economies. The major effect is
that the average cost of production declines as production is concentrated in one
geographic area. If the industry is competitive, then the product price declines as costs
decline. In the importing country, consumers’ gains from lower prices more than offset the
loss of producer surplus as the local industry ceases to produce the product. In the
exporting country, producer surplus may increase as production expands, although this
effect is countered by the decrease in the price that producers charge for their products. In
the exporting country, consumer surplus increases as the product price declines. Thus the
exporting country can gain for two reasons: an increase in producer surplus and an
increase in consumer surplus.
14. a. Among the strong arguments are the following. First, freer trade brings gains from trade,
even for products that can be produced locally. With freer trade resources can be
reallocated to producing exports. These exports can be used to buy imports at a cost that
is lower than the cost of producing these products domestically. Because of relatively
cheap imports, the country's total consumption can exceed its abilities to produce
domestically. Second, some products are not produced domestically but can be imported.
The country gains because consumers have access to a wider variety of products. Third,
import competition provides competitive discipline for domestic monopolies and
oligopolies. Prices will be driven closer to marginal costs, so that the efficiency of the
market is enhanced.
b. With respect to short-run pressures on economic well-being, owners of factors employed

in industries that could expand exports are likely to support the policy shift, because the
demand for these factors increases as firms attempt to expand production. Owners of
factors employed in industries that will receive increased competition from imports are
likely to oppose the policy shift (unless they feel that other benefits from such changes as
48
greater product variety more than offset their direct income losses). With respect to long-
run pressures on economic well-being, the Stolper-Samuelson theorem is relevant.
Owners of India's abundant factors of production are likely to support the policy shift,
because they will gain real income. Owners of India's scarce factors are likely to oppose
the shift, because they will lose real income (again, unless other benefits more than offset
the direct income loss).
49

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International Economics 16th Edition

Thomas Pugel Solutions Manual

Solution Manual: https://testbankpack.com/p/solution-manual-for-

Test Bank: https://testbankpack.com/p/test-bank-for-international-

Suggested answers to end of chapter questions and problems

Q0 Q MR0 MR Quantity

Q0 Q1 MR0 MR1 Quantity

(6/157,676) * 2.5 + (2,366/157,676) * 95.6 + (6/157,676) * 0.6 + (34,912/157,676) *

The United States has relatively more IIT in these products.

b. With respect to short-run pressures on economic well-being, owners of factors employed

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