ECONOMIES OF SCALE, IMPERFECT COMPETITION, AND ...



ECONOMIES OF SCALE, IMPERFECT COMPETITION, AND INTERNATIONAL TRADE

LECTURE 4

✓ THE H-O MODEL AND NEW TRADE THEORIES

▪ RELAXING THE ASSUMPTIONS ON WHICH THE H-O THEORY RESTS, THUS REPRESENTS AN EXCELLENT WAY TO INTRODUCE NEW TRADE THEORIES AND TO EXAMINS THEIR RELATIONSHIP WITH THE BASIC H-O MODEL

▪ 1ST ASSUMPTN: 2 NATIONS, 2 COMMODITIES, 2 FACTORS; H-O MODEL WILL STILL BE VALID WITH HAVING MORE THAN 2 NATIONS, 2 COMMODITIES AND 2 FACTORS AS LONG AS THE NO OF COMMODITIES IS EQUAL TO OR LARGER THAN THE NO. OF FACTORS.

▪ 2ND ASSUMPTION: BOTH NATIONS USE THE SAME TECHNOLOGY; NATIONS OFTEN DO USE DIFFERENT TECHNOLOGIES IN THE REAL WORLD. TECHNOLOGY CAN BE REGARDED AS A FACTOR OF PRODUCTION, AND TRADE BASED ON GIVEN TECHNOLOGICAL DIFFERENCES AMONG NATIONS CAN BE VIEWED AS FALLING WITHIN THE REALM OF THE H-O THEORY

▪ 3RD ASSUMPTION: X IS L-INTENSIVE WHILE Y IS K-INTENSIVE; SUCH ASSUMPTION IMPLIES THE ABSENCE OF FACTOR INTENSITY REVERSAL. EMPIRICAL STUDIES HAVE SHOWN THATH FACTOR INTENSITY REVERSAL IS NOT VERY COMMON IN THE REAL WORLD.

▪ 4TH ASSUMPTN: CRS ; INTERNATIONAL TRADE CAN BE BASED ON INCREASING RETURNS TO SCALE (IRS)

▪ 5TH ASSUMPTN: INCOMPLETE SPECIALIZATION IN BOTH NATIONS; IF TRADE BRINGS ABOUT COMPLETE SPECIALIZATION IN PRODUCTN IN ONE OF THE NATIONS, RELATIVE COMMODITY PRICES WILL BE EQUALIZED BUT FACTOR PRICES WILL NOT.

▪ 6TH ASSUMPTN: EQUAL TASTES; TASTES ARE CERTAINLY NOT SUFFICIENTLY DIFFERENT ACROSS NATIONS TO OVERCOME DIFFERENCES IN THE RELATIVE PHYSICAL AVILABILITY OF FOP IN EXPLAINING DIFFERENT RELATIVE COMMODITY PRICES AND TRADE AMONG NATIONS

▪ 7TH ASSUMPTN: PERFECT COMPETITION IN ALL PRODUCT AND FACTOR MARKETS; TROUBLESOME ASSUMPTION.

▪ 8TH ASSUMPTN: NO INTERNATIONAL FACTOR MOBILITY; MODIFIES BUT DOES NOT INVALIDATE THE H-O MODEL.

▪ 9TH ASSUMPTN: NO TRANSPORTATION COSTS AND ONSTRUCTIONS TO INTL TRADE; ONLY MODIFY RATHER THAN REJECT THE H-O AND FACTOR EQUALIZATION THEOREM

▪ 10TH ASSUMPTN: FULLY EMPLOYED RESOURCES; INCORRECTLY PREDICT THE PATTERN OF TRADE

▪ 11TH ASSUMPTN: BALANCED TRADE; COULD LEAD A NATION WITH A TRADE DEFICIT TO IMPORT SOME COMMODITIES IN WHICH IT WOULD HAVE A COMPARATIVE ADV AND THAT IT WOULD INFACT EXPORT WITH BALANCED TRADE.

✓ ECONOMIES OF SCALE AND INTERNATIONAL TRADE

▪ ONE OF THE ASSUMPTIONS OF THE H-O MODEL WAS THAT X AND Y WERE PRODUCE UNDER CONTANT RETURNS TO SCALE (CRS) IN THE TWO NATIONS.

▪ WITH INCREASING RETURNS TO SCALE (IRS) MUTUALLY BENEFICIAL TRADE CAN TAKE PLACE EVEN WHEN THE TWO NATIONS ARE IDENTICAL IN EVERY RESPECT.

▪ IRS REFERS TO THE PRODUCTN SITUATION WHERE OUTPUT GROWS PROPORTIONATELY MORE THAN THE INCREASE IN INPUTS

▪ IRS MAY OCCUR BECAUSE AT A LARGER SCALE OF OPERATION, A GREATER DIVISION OF LABOUR AND SPECIALIZATION BECOMES POSSIBLE.

▪ ILLUSTRATION:

o WITH IDENTICAL AND CONVEX TO THE ORIGIN (ECONOMIES OF SCALE) PRODUCTION FRONTIERS AND IC(S), THE NO TRADE EQM RELATIVE COMMODITY PRICE (PX/PY) IN THE TWO NATIONS IS IDENTICAL AND GIVEN BY PA.

o WITH TRADE, NATION 1 COMPLETELY SPECIALIZED IN X AND PRODUCE AT B AND NATION 2 COMPLETELY SPECIALIZED IN Y AND PRODUCE AT B’

o EXCHANGING 60 X FOR 60Y, EACH NATION WOULD END UP CONSUMING AT E ON IC2 THUS GAINING 20X AND 20Y

✓ IMPERFECT COMPETITION AND INTERNATIONAL TRADE

▪ TRADE BASED ON PRODUCT DIFFERENTIATION

o A LARGE PORTION OF THE OUTPUT OF MODERN ECONOMIES INVOLVES DIFFERNTIATED RATHER THAN HOMOGENEOUS PRODUCTS HENCE A GREAT DEAL OF INTL TRADE CAN AND DOES INVOLVE THE EXCHANGE OF DIFFERENTIATED PRODUCTS OF THE SAME INDUSTRY OR BROAD PRODUCT GROUP⋄I.E A GREAT DEAL OF INTL TRADE IS INTRA-INDUSTRY TRADE (IIT) IN DIFFERENTIATED PRODUCTS

o IIT ARIES IN ORDER TO TAKE ADVANTAGE OF IMPORTANT ECONOMIES OF SCALE IN PRODUCTN.

o SEVERAL OTHER INTERESTING CONSIDERATIONS MUST BE PPOINTED OUT W.R.T THE IIT MODELS DEVELOPED BY HELPMAN, KRUGMAN, LANCASTER AND OTHERS

1. IIT IS BASED ON PRODUCT DIFFERENTIATION AND ECONOMIES OF SCALE WHILE TRADE IN THE H-O MODEL IS BASED ON COMPARATIVE ADVANTGE OR DIFFERENCES IN FACTOR ENDOWMENTS

2. WITH DIFFERNTIATED PRODUCTS PRODUCES UNDER ECONOMIES OF SCALE (EOS), PRETRADE RELATIVE COMMODITY PRICES MAY NO LONGER ACCURATELY PREDICT THE PATTERN OF TRADE

3. WITH IIT BASED ON EOS, IT IS POSSIBLE FOR ALL FACTORS TO GAIN

4. IIT IS RELATED TO THE SHARP INCREASE IN INTERNATIONAL TRADE IN PARTS OR COMPONENTS OF A PRODUCT.

▪ MEASURING INTRA-INDUSTRY TRADE

o THE LEVEL OF IIT CAN BE MEASURED BY THE IIT INDEX (IIT)

o [pic]

o IIT RANGES FROM 0 TO 1, IIT=0 (NO IIT) WHEN A COUNTRY ONLY EXPORTS OR ONLY IMPORTS THE GOOD IN QUESTION. IIT=1 (IIT IS MAXIMUM) WHEN THE EXPORTS AND IMPORTS OF A GOOD ARE EQUAL.

o IIT MUST BE USED WITH CAUTION.

▪ FORMAL MODEL OF INTRA-INDUSTRY TRADE

o ILLUSTRATION: The Effects of Trade in a Monopolistically Competitive Industry

o Assume that there are two countries, each with a monopolistically competitive industry producing a differentiated product. Suppose initially that the two countries are in autarky. For convenience we will assume that the firms in the industry are symmetric relative to the other firms in the industry. Symmetry implies that each firm has the same average and marginal cost functions and that the demand curves for every firm's product are identical, although we still imagine that each firm produces a product that is differentiated from all others.

In the adjoining diagram we depict a market equilibrium for a representative firm in the domestic industry. The firm faces a downward sloping demand curve (D1) for its product and maximizes profit by choosing that quantity of output such that marginal revenue (MR1) is equal to marginal cost (MC). This occurs at output level Q1 for the representative firm. The firm chooses the price for its product, P1, that will clear the market. Notice that the average cost curve (AC) is just tangent to the demand curve at output Q1. This means that the unit cost at Q1 is equal to the price per unit, i.e. P1 = AC(Q1) which implies that profit is zero. Thus the firm is in a long-run equilibrium since entry or exit has driven profits to zero.

Keep in mind that this is the equilibrium for just one of many similar firms producing in the industry. Also imagine that the foreign market (which is also closed to trade) has a collection of firms which are also in a long-run equilibrium initially.

o NOW WE CAN EXAMINE THE RELATIONSHIP BETWEEN INTER-INDUSTRY AND INTRA-INDUSTRY TRADE.

o SUPPOSE NATION 1 HAS A RELATIVE ABUNDANCE OF L AND X IS L-INTENSIVE WHILE NATION 2 HAS A RELATIVE ABUNDANCE OF K AND Y IS K-INTENSIVE

o IF X AND Y ARE HOMOGENEOUS, NATION 1 WILL EXPORT X AND IMPORT Y, WHILE NATION 2 WILL EXPORT Y IMPORT X AS POSTULATED BY H-O THEORY⋄ THIS IS INTER INDUSTRY TRADE AND RELECTS COMPARATIVE ADVANTAGE ONLY.

o IF THERE ARE DIFFERENT VARIETIES OF X AND Y (DIFFERNTIATED), NATION 1 WILL STILL BE NET EXPORTER OF X (INTER-INDUSTRY BSED ON COMP-ADV) BUT IT WILL ALSO IMPORT SOME VARIETIES OF X AND EXPORT SOME VARIETIES OF Y ⋄ THIS IS INTRA-INDUSTRY TRADE AND IS BASED ON ECONOMIES OF SCALE.

o HENCE, IF PRODUCTS ARE HOMOGENEOUS WE ONLY HAVE INTER-INDUSTRY TRADE. ON THE OTHER HAND, IF PRODUCTS ARE DIFFERENTIATED, WE WILL HAVE BOTH INTER AND INTRA INDUSTRY TRADE

TO BE CONTINUED,...

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Y

Y

IC2

IC1

E

A

B

B’

0

120

120

40

40

60

60

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