Chap006

Chapter 06 - Scale Economies, Imperfect Competition, and Trade Chapter 6 Scale Economies, Imperfect Competition, and Trade Overview For the 14th edition, this chapter has a new name, and much of it has been rewritten to be clearer and more accessible to students. 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, including a new Figure 6.1 that shows the average cost function with scale economies, as well as an explanation of 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 intraindustry 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 a new 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. The new Figure 6.3 provides original information on the overall importance of IIT. 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 free entry drives each firm to earn a normal profit (the average cost curve is tangent to the demand curve). If a monopolistically competitive market is opened to international trade, then a domestic consumer has access to additional varieties of the product—those that can be imported. A domestic producer has access to additional buyers—foreigners who prefer its variety. 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. 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. If instead they restrain their competitive thrusts, then they may be able to earn high profits. However, they may be caught in the prisoners dilemma of competing aggressively, unless they can find some way to cooperate. 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 national gains from trade for the exporting country, in the form of better terms of trade, but 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—history, luck, 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 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 questions and problems (in textbook) 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. 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 with 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). 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 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. 8. 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 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 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. We can use a graph like Figure 6.7 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. 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, as shown in the answer to question a. The positive profits attracted the entry of additional firms who 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. c. 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. 10. 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 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). $/washer 600 P1 Q0 Q1 MR0 MR1 MC D0 D1 AC Quantity (washers) H0 H1 G0 G1 G0 H0 Quantity (washers) AC D0 MC MR0 Q0 Q( $/washer MR( D( H( G( P( 600 C Z $/washer 600 40 N1 Number of models P = Price UC0 UC1 K R P1 PAGE 6-5