CASE STUDY

Facts:

The analysis of monopolistic competition focuses on the market for a type of differentiated
product and examines the number of variants or models and the price of a typical variant.

We can also picture what is happening to an individual firm—say, Ford—and its unique
model— say, the Focus. By analyzing an individual firm in a monopolistically competitive
market, we add depth to the analysis. We can better understand both the effects of entry and how
the number of models is linked to the price of the typical model.

FROM MONOPOLY TO MONOPOLISTIC COMPETITION

Consider Ford and its model the Focus. We presume that moderate scale economies are of some
importance, so the (long-run) average cost (AC) curve for producing the Focus is downward
sloping, as shown in the graphs in this box. If average cost is falling, then we know that marginal
cost is less than average cost. The exact shape of the marginal cost (MC) curve depends on
production technology, and a reasonable shape for the MC curve is shown in the graphs.

To get started on the analysis, let’s assume that the Ford Focus is the only compact car model
offered in this market, so Ford has a pure monopoly. The demand for the Focus as the only
compact car is strong, with the demand curve D0 shown in the graph on the left at the top of the
facing page. We assume that Ford sets one price to all buyers of the Focus during a period of
time.

Then, the marginal revenue for selling another car during this time period is less than the price
the buyer pays for this car because Ford must lower the price to all other buyers to sell this one
additional car. The marginal revenue curve (MR0) is below the corresponding demand curve D0.

How will Ford use its monopoly power to maximize its profit? Profit is the difference between
revenue and cost, so Ford should produce and sell all units for which marginal revenue exceeds
marginal cost. Maximum profit occurs when marginal revenue equals marginal cost, at point F in
the graph, so Ford should produce and sell 1.2 million cars per year. Using the demand curve at
point G,

Ford should set a price of $31,000 per car to sell the 1.2 million cars. The price of $31,000 per
car exceeds the average cost of producing 1.2 million cars, shown in the graph as $15,000 per
car. Ford earns total economic profit of $19.2 billion (equal to $16,000 per car times 1.2 million
cars).

Will this high profit last? Other firms can see Ford’s sales and its high profit. If entry is easy,
then other firms will offer new, similar models. Here comes the competition part of monopolistic
competition.
As other firms offer similar models, some of what had been demand for the Focus is lost as some
buyers shift to the new rival models. In addition, the increased availability of close substitutes
probably increases the price elasticity of demand for the Focus. As a result of the entry of new
competing models, the demand curve for the Focus shifts down and becomes somewhat flatter. If
entry of new models is easy, then this process continues as long as there are positive profits that
continue to attract entry. Entry stops only when economic profit is driven to zero, for Ford and
its Focus (and for other firms producing competing models).

The graph on the top right side shows both the initial demand curve D0 for the Focus monopoly
and the new shrunken and flatter demand curve D1 for the Focus after the entry of rival models.
The Focus is still a unique model, and Ford still has some pricing power (the demand curve D1 is
still downward sloping). However, the best that Ford can do in the new longrun equilibrium of
this monopolistically competitive market is to operate at point J. Ford sells 0.8 million cars at a
price of $19,000 per car.

Price equals average cost, and Ford earns zero economic profit.

FROM NO TRADE TO FREE TRADE

Assume that the monopolistic competition equilibrium for Ford shown in the top right-hand
graph is part of the U.S. market equilibrium with no trade. What happens to Ford and its Focus
when the U.S. market is opened to free trade with the rest of the world? Ford can now export
Focuses to foreign buyers, and Ford faces new competition from imports of foreign models.
Essentially, with free trade Ford is now part of a larger and more competitive world market for
compact cars With even more substitute models now available, demand for the Ford Focus
becomes even more price elastic. And in the new long-run monopolistically competitive
equilibrium with free trade, Ford still earns zero economic profit.

The graph at the right shows both the no-trade equilibrium for Ford and the new free-trade
equilibrium. The new demand curve D2 shows the combined U.S. and foreign demand for the
Focus with free trade. In comparison with the no-trade demand curve D1, the free-trade D2 is
somewhat flatter because of the larger number of competing models that are available (both U.S.
and foreign models).

In the new free-trade zero-profit equilibrium, the price of the Ford Focus is down to $17,000 per
car, and Ford produces and sells 1 million cars per year, some to U.S. buyers and some to foreign
buyers. With price equal to average cost at point L, Ford earns zero economic profit.
Rather, in this setting a country’s trade is based on product differentiation.

• The basis for exporting is the domestic production of unique models demanded by some
consumers in foreign markets.

• The basis for importing is the demand by some domestic consumers for unique models
produced by foreign firms.

• Intra-industry trade in differentiated products can be large, even between countries that are
similar in their general production capabilities.
Scale economies play a supporting role, by encouraging production specialization for different
models. Firms in each country produce only a limited number of varieties of the basic product.

In addition to intra-industry trade, this product may also have some net trade—that is, the United
States may be either a net exporter or a net importer of compact cars.

The basis for the net trade can be comparative advantage.

Figure below provides an example of how net trade and intra-industry trade can coexist. We
modify the world that we used in previous chapters slightly, so the two products are wheat and
compact cars. Wheat is relatively land-intensive in production, and compact cars are relatively
labor-intensive in production. Wheat is assumed to be a commodity, with no product
differentiation, and compact cars are differentiated by model. The United States is relatively
land-abundant and labor-scarce. Here is the pattern of trade that we predict. First, the Heckscher–
Ohlin theory explains net trade, with the United States being a net exporter of wheat ($40 billion)
and net importer of compact cars (also $40 billion, equal to the difference between the $30
billion of U.S. exports and the $70 billion of U.S. imports). Second, intra-industry trade is driven
by product differentiation.

For the commodity wheat, there is no intra-industry trade. For compact cars, differentiated by
models, there is $60 billion of intra-industry trade, equal to the difference between the $100
billion of total trade in compact cars and the $40 billion of net trade.

The share of intra-industry trade in total compact car trade is 60 percent ($60 billion of intra-
industry trade as a percentage of the $100 billion of total trade).

Once we recognize product differentiation and the competitive marketing activities that go with
it (for instance, styling, advertising, and service), net trade in an industry’s products can also
reflect other differences between countries and their firms. Net trade in a product can be the
result of differences in international marketing capabilities.

Or it can reflect shifting consumer tastes, given the history of choices of whichspecific varieties
are produced by each country. For instance, Japanese firms focusedon smaller car models, and
they benefited from a consumer shift toward smaller carsin the United States following the oil
price shocks of the 1970s. Japanese auto producersalso marketed their cars skillfully and
developed a reputation for high qualityat reasonable prices. Japan developed large net exports in
automobile trade with theUnited States during the 1970s and 1980s. Some of this was the result
of comparative cost advantages, but another part was the result of focusing on smaller cars at the
right time and skillful marketing. The United States has net exports of wheat of $40 billion and
net imports of compact cars of $40 billion. There is also substantial intra-industry trade in
compact cars, with the IIT share equal to 60 percent of total trade in compact cars.
Product differentiation, monopolistic competition, and intra-industry trade add major insights
into the national gains from trade and the effects of trade on the well-being of different groups in
the country. A major additional source of national gains from trade is the increase in the number
of varieties of products that become available to consumers through imports, when the country
opens to trade. For instance, the economic wellbeing of U.S. consumers increases when they can
choose to purchase an automobile not only from the domestic models such as the Ford Focus but
also from imported foreign models such as the Mini Cooper because some may prefer the Mini
Cooper.

How large might the gains from greater variety be? Broda and Weinstein (2006) look at very
detailed data on imports into the United States during 1972 to 2001 to develop an estimate. They
conclude that the number of imported varieties more than tripled during this time period. They
use estimates of how different the new varieties are to determine how much U.S. consumers
gained from access to the new varieties. (The more different, the more the gain.) By 2001 the
gain to the United States was about $260 billion per year, close to an average gain of $1,000 per
person.

Feenstra (2010) estimated that, as of 1996, the greater product variety obtained through
international trade increased world well-being by an amount equal to about 12.5 percent of
global GDP. If that 12.5 percent is still roughly correct, the increase in world well-being
currently is about $10 trillion per year.

These national gains from greater variety accrue to consumers generally. They can be added to
trade’s other effects on the well-being of different groups within the country. Two additional
insights result.

First, the opening (or expansion) of trade has little impact on the domestic distribution of factor
income if the (additional) trade is intra-industry. Because extra exports occur as imports take part
of the domestic market, the total output of the domestic industry is not changed much. There is
little of the inter-industry shifts in production that put pressures on factor prices. Instead, with the
expansion of intra-industry trade, all groups can gain from the additional trade because of gains
from additional product variety. A good example is the large increase of trade in manufactured
goods within the European Union during the past halfcentury.

Much of the increase was expansion of intra-industry trade, so the rapid growth of trade actually
led to few political complaints.

Second, gains from greater variety can offset any losses in factor income resulting from
interindustry shifts in production that do occur. Groups that appear to lose real income as a result
of Stolper–Samuelson effects will not lose as much; and they could actually believe that their
well-being is enhanced overall if they value the access to greater product variety that trade
brings. For instance, many people would be willing to give up a few dollars of annual income to
continue to have numerous models of imported automobiles available for purchase.

Research pioneered by Melitz (2003) and Bernard et al. (2003) indicates yet another source of
additional gains from trade, assuming (realistically) that firms in each country differ somewhat
by cost levels (or quality levels) for their product models.

With no trade, firms with different levels of cost can coexist, with lower-cost firms having lower
prices and larger market shares. When the country opens to trade in this type of product, the
increased global competition causes the demand curve facing a typical firm to become flatter and
the typical price declines. In the more competitive global market, high-cost (or low-quality)
national firms cannot compete and go out of business. Lower-cost firms can compete and export,
so their production levels increase. Thus, opening to trade favors the survival and expansion of
firms with lower cost levels (or higher levels of product quality).
We see a new way in which international trade drives national production toward firms with low
opportunity costs. For comparative advantage trade (Ricardian or Heckscher–Ohlin), the
restructuring is across different industries. For monopolistic competition trade, the restructuring
is across firms of differing capabilities within the industry.

DISCUSSION QUESTIONS

With help of trade theories, concepts and illustrations, discuss the following questions in
detail.

(Maximum: 2000 words each)

Q1. How can we say that opening to trade favors the survival and expansion of firms with lower
cost levels (or higher levels of product quality)? Explain.

Q2. ―A major additional source of national gains from trade is the increase in the number of
varieties of products that become available to consumers through imports, when the country
opens to trade.‖ Explain this statement in the context of Indian economy.

Q3. How are the revenues of a domestic monopoly owner impacted when the economy moves
from monopoly to monopolistic competition? Discuss in the context on Indian economy.