International Economics Vienna University of Technology

Summer Semester 2006 Lecturer: Walter H. Fisher Economies of Scale, Imperfect Competition, and International Trade, Chapter #6, Krugman & Obstfeld

Krugman and Obstfeld, Chapter 6, 6th ed: Economies of Scale, Imperfect Competition, and International Trade (all equations and …gures refer to the 6th edition.) Economies of Scale and Trade

Previously, we have assumed that …rms have constant returns to scale technology

In this chapter Krugman and Obstfeld consider the implications of economies of scale.

1.

furthermore, economies of scale can provide an incentive for greater international trade.

Imagine that there are many goods subject to economies of scale in the US and the UK, numbered as 1, 2, 3, 4,...

To take advantage of economies of scale, countries must concentrate on producing only a limited number of goods. U S : 1; 3; 5; :::

U K : 2; 4; 6; :::

If each country produces only some of the goods, then each good can be produced at a larger scale than would be the case if each country tried to produce everything— and the world economy can produce more of each good.

Consumers in both countries want both goods.

International trade makes it possible for each country to produce a restricted range of goods and to take advantage of economies of scale without sacri…cing variety in consumption. – International trade leads to market structures other than perfect competition

External economies of scale – in this case the cost per unit depends on the size of the industry – a larger industry may permit more e¢ cient provision of specialized services or equipment – the size of the individual …rms would be the same as before.

Internal economies of scale – in this case the cost per unit depends on the size of the …rm; a …rm is more e¢ cient if its output is larger.

Market Structure Implications

Under external economies of scale, the industry will consist of many small …rms and tend toward competition.

Under internal economies of scale, large …rms have a cost advantage over small …rms and lead to an imperfectly competitive market structure. – both are important causes of international trade; we will discuss …rst the case of internal economies of scale.

Theory of Imperfect Competition

Perfect competition: – there are many buyers and sellers and …rms are price-takers, i.e., …rms can sell as much as they want at the current price.

Imperfect competition: – in this market structure …rms can in‡uence the prices of products they sell. They can sell more only by reducing price, These …rms are known as price-setters.

Monopoly

A monopolist faces a downward sloping demand curve.

Marginal revenue is the gain from selling an extra unit – marginal revenue is always less than price— M R < P — because to sell an additional unit, the …rm must lower the price on all units.

The demand curve of a monopolist (see Figure 6-1) : Q=A

BP

– we can rewrite (6-1) as P = A=B

Q=B:

(6-1)

Figure 6-1. Monopolistic Pricing and Production Decisions

Cost, C, Price, P

Monopoly Profits

PM AC AC D MC MR

QM

Quantity, Q

– thus, total revenue equals: R = (A=B )Q

Q2=B:

Di¤erentiating the latter expression by Q, we obtain the following expression for the marginal revenue, M R M R = (A=B )

2Q=B = (A=B )

Q=B

Q=B = P

Q=B

(6-2)

so that: P

M R = Q=B

– clearly, the “price–marginal revenue gap” depends positively on Q (initial sales) and the (absolute value) of the slope of the demand curve.

Average (AC ) and Marginal Cost (M C ).

Consider the following linear cost function C = F + cQ

(6-3)

where F are …xed and cQ are variable costs. – Average Cost AC =

F C = + c: Q Q

(6-4)

Fixed costs in this example lead to economies of scale, because the larger the …rm’s output, the less is the …xed cost per unit. Thus, AC falls, as is illustrated in Figure 6-1, since …xed costs are spread over a larger output

– Marginal Cost MC =

@C = c > 0; @Q

according to (6-3) marginal costs are constant, i.e., independent of the level of output. further, since AC

MC =

F > 0; Q

average cost is greater than marginal cost. see Figure 6-2, which illustrates the case: C = 5 + c:

Figure 6-2: Average vs Marginal Cost

Cost per Unit

Average and Marginal Cost for the Cost function: C=5+x

Average Cost

1 Marginal Cost

Output

Monopolistic Competition: a Special Case of Oligopoly

Here, we deal with the case of internal economies of scale, where …rms are large enough to a¤ect prices.

Assumptions of Monopolistic Competition – Di¤erentiated product product di¤erentiation assures that each …rm has a monopoly in its particular product within an industry and is, therefore, somewhat insulated from competition. – Monopolistic competitors take the prices of rivals as given. They ignore the impact of their prices on the prices of other …rms. so even though each …rm is in reality facing competition from other …rms, it behaves as if it were a monopolist.

Let the demand curve for a monopolistically competitive …rm take the following form: h

Q = S 1=n

where

b(P

P)

i

(6-5)

– Q = …rm demand (sales), – S = total industry demand, – n = number of …rms in the industry, – b = parameter measuring the responsiveness of …rm sales to changes in its price, – P = …rm’s price, – P = average price charged …rms in the industry.

If all …rms charge the same price, P = P , each …rm will have the same market share n 1.

The model assumes that S is una¤ected by P . – …rms can gain customers only at the expense of others. – this is an unrealistic assumption, according to Krugman and Obstfeld, but permits us to focus on competition among …rms.

Market Equilibrium

Firms are symmetric: demand and cost functions are the same for all …rms

The goal is to solve for the average industry price, P , and the number of …rms in the industry, n.

The relationship between AC and n: – there is a positive relationship between the number of …rms and AC : the more …rms in a monopolistically competitive industry, the lower is the output for each …rm, which implies that average cost, AC , depends positively on n. – The positive relationship between AC and n is illustrated in Figure 6-3 by the CC locus.

Figure 6-3: Equilibrium in a Monopolistically Competitive Market Cost, C, Price, P

CC AC3 P1

E P2 AC2 AC1 P3

PP

n1

n2

n3 Number of firms, n

The relationship between P — which all …rms charge in equilibrium— and n: the greater is n, the more intensive is the competition among …rms, the lower is the average price in the industry. – The negative relationship between P and n is illustrated in Figure 6-3 by the P P locus.

If P > AC , then …rms enter the industry; if P < AC , then …rms leave the industry.

To derive the CC locus, assume that all …rms charge the same price: P =P

)

S Q= : n

Substituting into the average cost curve yields: F nF AC = + c = + c; Q S

)

@AC > 0: @n

– so that the more …rms in an industry, the higher is the average cost.

(6-6)

– in other words, economies of scale cannot be take advantage of.

To derive the P P locus, rewrite the demand curve of the monopolistically competitive demand curve: S Q = + SbP SbP n treating P as given. Re-express as: P =

1 +P bn

Q Sb

so that total revenue equals 1 +P Q R= bn with marginal revenue, M R, corresponding to: MR =

1 +P bn

2Q 1 = +P Sb bn

Q2 Sb Q Sb

Q =P Sb

Q : Sb

(6-8)

Under pro…t-maximization, marginal revenue equals marginal cost MR = P

Q = c = M C: Sb

Solving this expression for P , we obtain the pricing decision of the typical …rm: P =c+

Q : Sb

(6-9)

Substituting for the common market share, given by Q = S=n, we obtain an expression in terms of the number of …rms, n: 1 P =c+ : (6-10) nb – thus, as the more …rms in a monopolistically competitive industry, the lower the price. As indicated, this is illustrated in Figure 6-3 by the downward-sloping P P locus. – In Figure 6-3 n2 is the equilibrium number of …rms in an industry: their common pro…t-maximizing price is P2, which is equal to the average cost, AC2.

Limitations of the Monopolistic Competition Model

1. The monopolistic competition model describes relatively few industries; more common is small group oligopoly in which …rms are aware that their actions in‡uence the behavior of the other …rms in the oligopolistic industry.

2. Collusive behavior is excluded in the monopolistic competition model.

3. Strategic behavior is also excluded. An example of strategic behavior would be a …rm that builds extra capacity to deter entrants, even though it has no intension to actually use the additional capacity.

Monopolistic Competition and Trade

Consider again the CC curve F nF AC = + c = + c: Q S

What happens if total sales increases? – sales per …rm will increase and the average cost of each …rm will decline – as a consequence the CC locus will shift down, which is illustrated in Figure 6-4. – the number of …rms n rises from n1 to n2, while the equilibrium price falls from P1 to P2. Consumers would prefer to be part of a large market rather than a small one, since a greater variety of products is available at a lower price at point 1.

Figure 6-4: Effects of a Larger Market Cost, C, Price, P

CC1

1 P1

2

CC2

P2

n1

n2

Number of firms, n

The general point is that international trade creates a world market larger than any of the national markets that comprise it. Integrating markets through international trade has the same e¤ects as the growth of a market within a single country.

Economies of Scale and Comparative Advantage

Consider again Home and Foreign in the a two-factor and two-good framework.

Home has a higher capital-labor ratio than Foreign, i.e., Home is capital abundant..

Now, however, manufacturing is no longer a perfectively competitive industry, instead, it is monopolistically competitive in which a number of …rms produce di¤erentiated products.

Krugman and Obstfeld, Ch.. 6, p. 137: – Because of economies of scale, neither country is able to produce the full range of manufactured products by itself: thus, although both countries may produce some manufactures, they will produce di¤erent things.

If manufactures were not a di¤erentiated product sector, we recall from chapter 4: – Since Home is capital abundant and manufactures capital intensive, Home has a relatively greater supply of manufactures and would, thus, export manufactures and import food. See Figure 6-6 for the pattern of trade in this case.

If, instead, manufactures is monopolistically competitive, then Home would still be a net exporter of manufactures and an importer of food.

However, Foreign will also produce di¤erentiated manufactured goods, distinct from those produced by Home. The pattern of trade will look like Figure 6-7 if manufactures are monopolistically competitive.

The exchange of manufactures for manufactures is called intra-industry trade, while the exchange of manufactures for food is inter-industry trade.

Figure 6-6: Trade in a World Without Increasing Returns

Home (Capital abundant)

Manufactures

Food

Foreign (labor abundant)

In a world without scale economies, there would be simple exchange of manufactures for food.

Figure 6-7: Trade with Increasing Returns and Monopolistic Competition

Home (capital abundant)

Manufactures

Food Inter-industry trade

Intra-industry trade

Foreign (labor abundant)

If manufactures is a monopolistically competitive industry, Home and Foreign will produce differentiated products. As a result, even if Home is a net exporter of manufactured goods, it will import as well as export manufactures, giving rise to intra-industrytrade.

There are 4 things to keep in mind. 1. Inter-industry trade re‡ects comparative advantage: the pattern of this type of trade is that Home— the capital abundant country— is a net exporter of manufactures and a net importer of food, the labor intensive activity. 2. Intra-industry trade— which is about 25% of world trade— does not re‡ect comparative advantage. It is economies of scale that prevents the countries from producing the complete range of manufactures for itself. Thus, economies of scale can be an independent source of trade. 3. The pattern of intra-industry trade is not predictable. All we know is that countries will produce di¤erent products. Nevertheless, we still know the pattern on interindustry trade.

4. The relative importance of intra-industry trade depends on how similar the countries are. If Home and Foreign are similar in their capital-labor ratios— the case for many advanced nations— then there will be little inter-industry trade. Intraindustry trade— based on economies of scale— will be dominant. If, on the other hand, the capital-labor ratios are very di¤erent, so that Foreign completely specializes in Food, then there will be no intra-industry trade based on economies of scale. All trade will then be based on comparative advantage.

Dumping

The practise of charging di¤erent customers di¤erent prices is called price discrimination.

The most common form of price discrimination is called dumping: – a pricing practise in which a …rms charges a lower price for exported goods than it does for goods sold domestically. It is widely regarded as an “unfair” practise.

Two conditions for dumping:

1. The industry must be imperfectly competitive, so that …rms set prices rather than take them as given.

2. Markets must be segmented, so that domestic residents cannot easily purchase goods intended for export.

See Figure 6-8 for an example: a single monopolistic …rm sells in two markets, a domestic market— where it faces the whole demand curve DDOM — and a foreign market— where it can sell as much as it wants at the price PF OR .

To maximize pro…ts, the …rm must set marginal revenue equal to cost in both markets.

To set marginal cost equal to marginal revenue in both markets, it is necessary to produce quantity QM ON OP OLY to sell QDOM on the domestic market, and to export QM ON OP OLY QDOM .

Figure 6-8: Dumping

Cost, C, Price, P 3

PDOM MC 1

2

PFOR

DFOR  MRFOR

MRDOM QDOM

Domestic sales

Total output

DDOM QMONOPOLY

Exports

Quantities produced and demanded, Q

The Theory of External Economies The famous economist Alfred Marshall o¤ered three reasons for external economies of scale. 1. specialized suppliers, re‡ecting the advantages of “clustering” in terms of creating a market of suppliers, 2. labor market pooling— clusters of …rms can create a “pool” of workers with highly specialized skills, 3. knowledge spillovers According to Krugman and Obstfeld, external economies of scale can cause countries to get “locked” into unfavorable patterns of trade and even lead to the loss of international trade. External economies also tend to reinforce the existing patterns of trade.

Assume that economies of scale are entirely external to …rms in the watch industry. – this implies that there are many small …rms operating under competitive conditions, – with competition, in turn, driving down the price to average cost, AC .

Further assume that average cost is higher in Switzerland than it is in Thailand: ACT hai < ACSwiss.

But what happens if the Swiss establish their industry …rst? – world equilibrium would then be at point 1 in Figure 6-9. with production Q1.

If the Thais were to take over the world market, the equilibrium would shift to point 2.

Figure 6-9: External Economies and Specialization

Price, cost (per watch)

C0 P1

1

ACSWISS 2

ACTHAI D

Q1

Quantity of watches produced and demanded

But initial Thai production costs at C0 are greater than the Swiss watch production costs at P1.

So although the Thai industry could produce watches more cheaply than the Swiss, the “headstart” enjoyed by the Swiss industry enables it to hold on to the market.

There is no guarantee that the “right” country will produce a good subject to externalities – trade based on such externalities may even make it worse-o¤.

In the example illustrated in Figure 6-10 the price of the good that Thailand imports would actually be lower if there were no trade and the country were forced to produce the good by it self. – the country is then hurt with trade.

This would seem to give Thailand the incentive to protect its watch industry.

But identifying cases like the one illustrated in Figure 6-10 is di¢ cult. – which is the chief argument against an activist trade policy in this case.

Figure 6-10: External Economies and Lossess from Trade

Price, cost (per watch)

C0 1

P1 P2

2

ACSWISS

ACTHAI DTHAI

DWORLD

Quantity of watches produced and demanded