Chapter

Imperfect
Competition,
Increasing
Returns, and
Product Variety

Slides prepared by Thomas Bishop

Difference

Ricardian Model: Technological difference

Heckscher-Ohlin Model: Endowment different, identical tech.
Specific Factor Model: Endowment different, factor immobile.
But all assume market structure is perfect competitive
Imperfect competition matters
International competition between large firms.
The role of government: it will pass on a strategic advantage to
domestic firms

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Index to measure intra-industry trade

Previous models based on comparative advantage imply that a
traded good is either importer or exported, but not both.
Index=1-(|X-M|)/(X+M)
The index ranges from zero, in which no intra-industry trade
occurs, to one when exports and imports are balanced and
intra-industry trade is at its maximum.

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Table 7.1 Average Levels of Intra-Industry

Trade, All Commodities, Selected Countries,
1964-1985 (percentages)

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Stylized Facts of Intra-industry Trade

Low for simple, undifferentiated products in which the U.S.
has either a strong comparative advantage (corn) or
disadvantage (crude petroleum).
High for nearly all complex, differentiated goods
(photographic equipment) whatever the apparent state of the
comparative advantage of the U.S.
High for some simple goods (fertilizers, inorganic chemicals)
for which the U.S. seems to neither have a strong comparative
or disadvantage.

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Love of Variety

Individuals may exhibit a love for variety.

Demand side
Each countrys variety is distinct from that in the other country.
Individuals consume a given amount of clothing and have
available two variety of food.
The indifference curve for these two varieties hits the axes,
showing that individuals can survive consuming only quantity
C or D An Ideal Variety
If restricted to consuming only one variety, and if the relative
price of the first variety is higher than that of the second one,
then individuals consume only the second variety.
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Figure 7.2 Love of Variety

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Love of Variety
However, for given prices of the two varieties, a mixture of
varieties shown by A or by B could be obtained more cheaply
and yield the same level of utility.
Intra-industry trade could improve real incomes even in the
absence of any inter-industry trade.
There need to be no losers with trade everyone benefits by
having a wider selection of each type of commodity.

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Increasing Returns to Scale

Internal IRS
the scale of a firm increases. Accordingly, the fixed cost of
each product decreases.
Fixed cost could include management cost, designing cost,
R&D.
External IRS
It happens within an industry. The number of firms increases,
which cause the scale of an industry expand.

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Production and Trade under IRS

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Production and Trade under External IRS

Industry: demand and supply curves are regular.

At P1, no trade since price is too high in intl market
LRAC is downward sloping due to the external IRS.
MC1 and AC1 in the right figure denotes firms case in
Autarky.
Since external IRS, more firms enter the industry.
Market supply increases to S.
Also, IRS makes each firms AC and MC decrease
Due to the decrease AC and MC of each firm, the industrys
AC and MC will decrease as well.
S shift right to S2.
The cost advantages cause trade.

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Production and Trade under External IRS

The increased foreign demand shift aggregate demand right
from D1 to D2.
New equilibrium at a lower price
Firms earn zero profit in the long run.
Consumers welfare increase due to a lower price.
Therefore, it exists gains from trade.

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Production and Trade under Internal IRS

Internal IRS Monopolistic Competition

The demand curve is downward sloping
Firms produce differentiated products
Firms also face competition
Free Entry
MR=MC

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Monopolistic Competition

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Monopolistic Competition with Trade

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Monopolistic Competition with Trade

Before trade: demand is D1 and price is P1.
AC is higher than MC due to the fixed cost
Optimal quantity to produce is Q1.
After trade: foreign demand increases
D1 D2, MR1 MR2
Excess Profit exists in the short run as the shaded area.

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Monopolistic Competition with Trade

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In the long run, excess profit disappears.

New firms entry, which would absorb part of consumers
Demand curve D1 shift down first.
However, due to international trade, more quantity demanded
under trade once price falls.
D1 shift to D3
Demand curve D3 is more elastic than that before trade, D1.

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Monopolistic Competition with Trade

P3=LAC3, zero profit.
Effects of trade in the short run

Output up,
AC down
SR positive profit.
Price could down (as shown), consumers better off
Price could up, consumers worse off.

Effects of trade in the long run

Output up (but not necessarily higher than that in the SR)

AC=P down
Consumers better off
Firms zero profit
The whole society gains from trade.

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Chapter
Krugman (1979)
Internal IRS

Slides prepared by Thomas Bishop

Assumptions

Supply Side
Firms face monopolistic competition
Production input requirement:
Labor is the only input, no capital
Assume each firm is symmetric

Li=a +by

C=Lw=w(a+by)=aw + bwy
AC=aw/y+bw
MC=bw
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Cost Curve

AC

MC

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Increasing Returns in Production

Assume that each variety entails two different types of costs: a
fixed-cost and constant marginal production costs.
Therefore, to produce each variety, the average costs of
production decline.
Monopolistic competition
Free Entry, zero profit
MR=MC
Assumptions: each firm produces a separate variety in which
the cost structure is the same for all firms.
Demand is identical for all varieties.

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Firms maximize their profits

MR=MC
It implies p(1-1/e)=bw
TR=P(Q)*Q
MR=P(Q)*Q+P=P[(dP/dQ)*Q/P+1]
Elasticity of demand: e=-(dQ/dp)*(P/Q)
p/w=b*e/(e-1)=b*[1+1/(e-1)]
Assumption: the elasticity of demand is decreasing in
consumption.
Consumption upe downp/w up

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Example: a linear demand curve

o
e
f
elasticity =(ef/de)*(de/oe)=ef/oe=df/ad

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Equilibrium at Autarky

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Firms maximize their profits

P=AC
P=aw/y+bw
Market clear condition for product market:
For each variety: yi Lci
where c is consumption per capita
P/w=a/y+b
P/w=a/(Lc)+b
Number of Variety
N

L li
i 1

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Trade

Consumer Better-off?
Consumer consumes more or less within each variety?
Consumer consumes more or less varieties?
More varieties in each country?
Firms produce more or less?
More varieties in the world?

When labor increases, the inverse of real wages decrease. i.e.,

the real wages increase.
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Diagram Analysis

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p/w

MR=MC

P=AC
c
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From Autarky to Trade

In the H-O model, there is no reason for two identical
countries to trade.
However, now suppose two countries produce
different varieties, then they could trade.
But the key point is: what is the economic
consequence?
Labor increases due to international trade
P=AC shift to the left due to the increase of labor

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Implications
Trade causes the consumption of each variety decrease.
This raises the elasticity of demand, reducing the equilibrium
price and therefore raising real wages.
This is a source of gains for consumers.
But output of each variety increases
This is because the drop of output price makes the output
necessarily increase as moving on the average cost curve.
Any firm that produces both in autarky and under free trade
will be selling more with trade.

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Cost Curve

AC

MC

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Number of Varieties
Market clear condition of the labor market:
L=N*Li=N*(a+byi)=N*(a+bLci)
N=L/(a+bLci)=1/[(a/L)+bci)]
Both the increase of labor endowment and the decrease of the
consumption lead to the increase of the number of varieties.
Consumer enjoy more varieties but consume less on each
variety!

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The Scale Effect v.s. Selection Effect

Scale effect: output of each variety increases

Selection Effect:
Recall L=N*(a+by)
Labor is fixed for each country, but output increases
Number of variety in each country reduces!

Opening trade between countries indeed implies that some

firms must exit in each, while the remaining firms expand their
output and take advantage of scale economics.

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Figure 7.4 Size and Number of Firms

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Size and Number of Firms

Assume same technology, same tastes.
Foreign is a large market (the U.S.) and devotes more
resources to the clothing sectors.
Its firm in autarky will not resemble exactly the firms at home.
The RC curve shows how in each country sharing a common
technology, large firm size goes hand in hand with the
production of a greater number of varieties.
In autarky, the smaller home market is served by firms (at H)
that are fewer in number and smaller in size than in the larger
foreign market (F).

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Size and Number of Firms

With trade, if the same resources are devoted to clothing as in
autarky, producers concentrate (at H and F), all firms are the
same (larger) size, and a larger number of varieties is available
for consumers (at W).

A move toward the southeast represents, for each country a

cutback in the number of varieties produced but an increase in
the scale of operation for each variety.

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Inter-industry Trade
According to the Heckscher-Ohlin model or Ricardian model,
countries specialize in production.
Trade occurs only between industries: inter-industry trade

In a Heckscher-Ohlin model suppose that:

The capital abundant domestic economy specializes in the production
of capital intensive cloth, which is imported by the foreign economy.
The labor abundant foreign economy specializes in the production of
labor intensive food, which is imported by the domestic economy.

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Inter-industry Trade (cont.)

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Intra-industry Trade
Suppose now that the global cloth industry is described by the
monopolistic competition model.
Because of product differentiation, suppose that each country
produces different types of cloth.
Because of economies of scale, large markets are desirable: the
foreign country exports some cloth and the domestic country
exports some cloth.
Trade occurs within the cloth industry: intra-industry trade

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Intra-industry Trade (cont.)

If domestic country is capital abundant, it still has a
comparative advantage in cloth.
It should therefore export more cloth than it imports.

Suppose that the trade in the food industry continues

to be determined by comparative advantage.

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Intra-industry Trade (cont.)

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Inter-industry and Intra-industry Trade

1. Gains from inter-industry trade reflect comparative
advantage.
2. Gains from intra-industry trade reflect economies of
scale (lower costs) and wider consumer choices.

3. The monopolistic competition model does not

predict in which country firms locate, but a
comparative advantage in producing the
differentiated good will likely cause a country to
export more of that good than it imports.

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Inter-industry and
Intra-industry Trade (cont.)
4.

5.

The relative importance of intra-industry trade depend on

how similar countries are.

Countries with similar relative amounts of factors of production are

predicted to have intra-industry trade.

Countries with different relative amounts of factors of production are

predicted to have inter-industry trade.

Unlike inter-industry trade in the Heckscher-Ohlin model,

income distribution effects are not predicted to occur with
intra-industry trade.

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Inter-industry and
Intra-industry Trade (cont.)
About 25% of world trade is intra-industry trade
according to standard industrial classifications.
But some industries have more intra-industry trade than
others: those industries requiring relatively large amounts
of skilled labor, technology and physical capital exhibit
intra-industry trade for the US.
Countries with similar relative amounts of skilled labor,
technology and physical capital engage in a large amount
of intra-industry trade with the US.

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Inter-industry and
Intra-industry Trade (cont.)

Note: an index of 1 means that all trade is intra-industry trade.

An index of 0 means that all trade is inter-industry trade.
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