CH 06

CHAPTER S I X
6 International Economics
Tenth Edition
Economies of Scale,
Imperfect Competition, and
International Trade
Dominick Salvatore
John Wiley & Sons, Inc.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
In this chapter:
 Introduction
 The Heckscher-Ohlin Model and New Trade
Theories
 Economies of Scale and International Trade
 Imperfect Competition and International Trade
 Trade Based on Dynamic Technological Differ-
ences
 Costs of Transportation, Environmental Stan-
dards, and International Trade
6.1 Introduction
 Two difficulties with the H-O theory:

(1) Some questions remain regarding the empirical va-
lidity of the theory.
(2) This implies that a great deal of today's interna-
tional trade still left unexplained.
 This chapter fills this gap with some new trade

theories, which base international trade on
economies of scale, imperfect competition, and
differences in the development and spread of new
technologies over time among nations.
Introduction
 Heckscher-Ohlin theory based comparative

advantage on differences in factor endow-
ments among nations.
 Leaves significant portion of international

trade unexplained.
 Need complementary trade theories to fill in
the gaps.
The Heckscher-Ohlin Model and New Trade
Theories
 Relaxing most assumptions of H-O theory

modifies but does not invalidate the theory.
 However, relaxing assumptions of perfect
competition and constant economies of scale
require complementary theories to explain
trade.
 Additional trade model required to explain
trade based on differences in technological
changes over time.
Economies of Scale and International Trade
 Increasing returns to scale

 Production situation where output grows
proportionately more than the increase in
inputs (doubling inputs more than doubles output).
 With increasing returns to scale, mutually

beneficial trade can occur even if nations are
identical in every way.
6.3 Economies of Scale and International
6.3A. Assumptions
(1) There are two nations (N1, N2) two commodities (X,
Y)
(2) Both nations use the same technology in production.
(3) Both nations have the same amount of resources.
(4) Neither commodity is labor intensive or capital inten-
sive.
(5) Both commodities are produced under increasing re-
turns to scale in both nations.
- i.e., Output grows proportionately more than the increase in inputs
of production. (eg., If all inputs are doubled, output is more than
doubled: Economies of scale.)
FIGURE 6-1 Trade Based on Economies of Scale.
6.3B. Explanation
 Some aspects of the analysis:
(0) With trade, each nation becomes completely specialized in the
production of one commodity.
(1) Which of the two commodities each nation becomes specialized
may result from historical accident.
(2) In real world, the nations need not be identical in every respect.
(3) Eventually, one or a few firms in the nation will capture the
entire market for a given product, leading to monopoly or
oligopoly.
(4) The nations may trade similar products in the same industry (i.e.,
intra-industry trade)
6.3C. Related Sources of International Trade

(1) International economies of scale (Case Study 6-1)
- Products manufactured by international corporations
have parts and components made in many different
nations.
- During the past decade or so, there has been a sharp
increase in international trade in parts and
components, as well as in setting up of production
facilities abroad, and these have been the source of
new and significant international economies of scale.
- E.g., The New International Economies of Scale
(Case Study 6-1)
Economies of Scale and International Trade
 Increasing returns to scale

 Significant international economies of scale
from:
 Outsourcing – purchase by firm of parts and
components abroad in order to keep costs

down.
 Offshoring – firm producing in its own plants

abroad some of the parts and components used
in its products.
6.4 Imperfect Competition and International
Trade
6.4A. Trade Based on Production Differentiation
(1) Product differentiation and monopolistic competition
- Differentiated products: "Neither identical products, nor

different products". E.g., Cars, TV sets, etc.
- Cf: Standardized (homogeneous) products: "Identical
products."E.g., Most of the agricultural products and
labor intensive products.
- Monopolistic competition: The market organization
where there are many firms selling a differentiated
product and entry into or exit from the industry is easy.
Trade
6.4A. Trade Based on Production Differentiation
- Cf: Perfect competition vs. Monopoly
 Thus differentiated products are usually produced un-
der monopolistic competition.
(2) Product differentiation and intra-industry trade

- Intra-industry trade: a phenomenon of international
exchanging of differentiated products of the same
industry. (As a result of economies of scale, product
differentiation under monopolistic competition.)
- Inter-industry trade: a phenomenon of exchanging
completely different products. (H-O model)
Imperfect Competition and International
Trade
 International trade can involve the exchange

of differentiated products of the same indus-
try or broad product group.
 Leads to intra-industry trade in differentiated
products, as opposed to inter-industry trade
in completely different products.
 Allows economies of scale in production.
Trade
 Contrasts to H-O Model

1. Trade in H-O model based on factor endow-
ment differentials, but intra-industry trade is
based on product differentiation and economies
of scale, and will likely be larger for nations of
similar size and factor proportions.
2. With differentiated products produced under
economies of scale, pretrade-relative commodity
prices may not accurately predict patterns of
trade as they do under H-O model.
Trade
 Contrasts to H-O Model

3. H-O model predicts trade will lower returns of
nation’s scarce factor. With intra-industry trade
based on economies of scale, it is possible for all
factors to gain.
4. Intra-industry trade is related to sharp increases
in international trade in parts and components of
a product, or outsourcing.
Trade
 Comparative advantage seems to determine

patterns of inter-industry (H-O Model) trade.
 More likely with dissimilar factor endowments.
 Economies of scale in differentiated products

gives rise to intra-industry trade.
 More likely with similar factor endowments.
Trade
 Intra-industry Trade Index (T):
|X - M|
T=1- X+M
 X = exports
 M = imports
 Numerator is absolute value
 T ranges from 0 to 1
 T=0 when nation only imports or exports the good
 T=1 when exports = imports.
Trade
 Key characteristics of Intra-industry trade:
(1) While inter-industry trade (eg., trade in the H-O

model) is based on comparative advantage among
nations, intra-industry trade is based on product
differentiation and economies of scale.
(2) With intra-industry trade, pretrade-relative
commodity prices may no longer accurately predict
the pattern of trade.
(3) While the H-O model predicts that trade will lower
the return of the nation's scarce factor, with intra-
industry trade it is possible for all factors to gain.
Trade
 Key characteristics of Intra-industry trade:
(4) Intra-industry trade is related to the sharp increase in

international trade in parts and components of a
product.
(5) Intra-industry trade arises more between nations with
similar tastes and income levels.
(6) While most of the trade between developed and
developing countries is inter-industry trade, an
increasing proportion of the trade among industrial
countries is intra-industry trade.
Trade
6.4B. Measuring Intra-Industry Trade
 Intra-industry trade index (Grubel-Lloyd index):
T = 1 - | X M | / (X + M)
 If T = 1, perfect intra-industry trade.
 If T = 0, perfect inter-industry trade.
Case Study 6-2. U.S. Intra-Industry in Automotive Products
Case Study 6-3 Variety Gains with International Trade
6.4C. Formal Model of Intra-Industry Trade (Skip)
6.4D. Another Version of the Intra-Industry Trade Model (Skip)
Trade Based on Dynamic Technological Dif -
ferences
 Product Cycle Model (Vernon, 1966)

 Advanced industrialized countries develop and
introduce new products, with temporary monop-
oly power as the sole exporter of the product.
 As the technology producing the product becomes
more widespread, production will spread to other
nations.
 This moves international trade to a standard com-
parative advantage framework
Trade Based on Dynamic Technological Dif -
ferences
 Product Cycle Model (Vernon, 1966)

 As production becomes standardized, the original
introducer of the product loses its technologically
based comparative advantage in the production
of the product and becomes an importer of the
product.
FIGURE 6-4 The Product Cycle Model.
Costs of Transportation, Environmental Stan-
dards and International Trade
 Transportation costs
 Transport, or logistics, costs are the freight
charges, warehousing costs, costs of loading and
unloading, insurance premiums, and interest
charges incurred while goods are in transit be-
tween nations.
 Homogeneous goods will be traded internation-
ally only if the pretrade price difference exceeds
transport costs.
 Transportation costs
 Nontraded goods and services are goods for
which transport costs exceed price differences
across nations.
 Examples:
 Cement is not traded internationally because of its
high weight-to-value ratio.
 Average people do not travel from New York to
London for a haircut.
 Two ways to analyze transport costs

 General equilibrium analysis
 Uses production frontiers or offer curves, and ex-
presses transport costs in terms of relative commod-
ity prices.
 Partial equilibrium analysis
 Analyze absolute cost by holding constant exchange
rates, income, and all else in the two nations except
amount of good produced, consumed and traded.
 More straightforward method than general equilib-
rium analysis.
FIGURE 6-5 Partial Equilibrium Analysis of Transport Costs.
 Transport costs influence location of production

and industry:
 Resource-oriented industries locate near the source of
raw materials used by the industry.
 Market-oriented industries produce goods that be-
come heavier or more difficult to transport during
production, so they locate near the markets for their
products.
 Footloose industries face neither substantial weight
gains nor losses during production, and can locate
where availability of other inputs leads to lower manu-
facturing costs.
 Environmental standards
 Refers to levels of air, water and thermal pol-
lution resulting from garbage disposal that a
nation allows.
 A nation with lower environmental standards
can use the environment as a resource en-
dowment, achieving comparative advantage
in polluting goods and services.
Appendix to Chapter 6
 External Economies and Specialization

 The Learning Curve and Specialization
FIGURE 6-6 External Economies and Specialization.
FIGURE 6-7 The Learning Curve and Specialization.

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CHAPTER S I X

 Two difficulties with the H-O theory:

 This chapter fills this gap with some new trade

 Heckscher-Ohlin theory based comparative

 Leaves significant portion of international

 Relaxing most assumptions of H-O theory

 Increasing returns to scale

 With increasing returns to scale, mutually

6.3C. Related Sources of International Trade

 Increasing returns to scale

components abroad in order to keep costs

 Offshoring – firm producing in its own plants

- Differentiated products: "Neither identical products, nor

(2) Product differentiation and intra-industry trade

 International trade can involve the exchange

 Contrasts to H-O Model

 Contrasts to H-O Model

 Comparative advantage seems to determine

 Economies of scale in differentiated products

 Intra-industry Trade Index (T):

(1) While inter-industry trade (eg., trade in the H-O

(4) Intra-industry trade is related to the sharp increase in

 Product Cycle Model (Vernon, 1966)

 Product Cycle Model (Vernon, 1966)

 Two ways to analyze transport costs

 Transport costs influence location of production

 External Economies and Specialization

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