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Chapter 6 - Economies of Scale, Imperfect Competition,

and International Trade


November 1, 2010
What weve learned so far
We have now covered two key models of trade: the Ricardian model and the Heckscher-Ohlin
model. The Ricardian model theorizes that countries will specialize and export the good for which
they are more ecient at producing. The HO model suggests that rms will simply export the
good that uses its abundant good intensively. From these two models, the standard trade model
allowed us to look at welfare implications from changes in international supply and demand.
The models suggest that countries trade according to their comparative advantage. The mod-
els have been rather successful at explaining trade between developed and developing countries.
For example, the U.S. has a tendency to export high skilled goods and import low skilled goods
from lesser developed countries.
But what about trade between two developed countries, such as the United States and Ger-
many. Developed countries have very similar relative productivities since they have access to the
same technology. They also tend to possess the same relative factor endowments as they typically
exist in the Northern Hemisphere or on the same continents. The Ricardian and HO models would
predict that these countries would not conduct much trade with each other. This is not what we
nd in the data - there is signicant trade between developed countries. We need to develop a new
model to explain this.
Types of Industrial Trade
There are two types of trade that can occur.
1. Inter-industry trade: trade in which a countrys exports and imports are in dierent in-
dustries. Example: Home exports labor-intensive cloth while Foreign exports land-intensive food.
Such trade reects comparative advantage and is described by the Ricardian and Heckscher-Ohlin
models.
2. Intra-industry trade: trade in which a country exports and imports in the same industry.
Typical examples of this is automobile, food/beverage, computers, and mineral trade.
Intra-industry trade is very common. In 2002, Europe exported 2.6 million automobiles and
imported 2.2 million. Japan exported 4.7 million vehicles and imported 0.3 million. Approxi-
mately 25% of world trade consists of intra-industry trade and occurs predominantly in developed
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countries.
To date, we do not have a very good explanation for intra-industry trade.
Finger (1975) argued that there was nothing particularly special about intra-industry trade.
The reason it looked like so much trade fell into this category was because of the existing classi-
cation system. Even though goods were dierent, they were getting lumped together in the same
category. Thus, it looked like developed countries were both exporting and importing the same
good(s). With better data, this argument has been invalidated. IIT still occurs within extremely
disaggregated data.
Krugman, many argue, has the best theory on intra-industry trade. Rather than trading ac-
cording to factor endowments as in the HO model, he argues that economies will specialize to take
advantage of increasing returns to scale. Countries wil specialize in the production of few products
to benet from increasing returns to scale. This is the model well be studying.
Economies of Scale
Economies of scale describes the cost advantages that a rm obtains from expanding its pro-
duction. If a rms costs per unit decrease when it increases its production, we say that the rm is
experiencing economies of scale. Economies of scale usually occur when the rm buys inputs in
bulk, managers become more specialized, borrowing can be done at lower interest rates, and when
the rm takes advantage of returns to scale in their production function.
Suppose an existing rm wants to produce pencil crayons. To get started, they need to purchase a
plant and equipment. These are considered lump sum xed costs, F. A rm can purchase these
items, but they alone do not produce any pencil crayons. In order to produce the pencil crayons,
the rm needs wax, wood, and dyes (among other ingredients) to do the productions. The costs
associated with these inputs are called marginal costs and well assume that the total marginal
cost is given by a constant, c. By adjusting how these inputs (and subsequently their output), the
rm is able to adjust its marginal costs.
The rms total costs can then be formulated as
TC = F +cQ
TC: Total Cost of producing Q pencil crayons.
F: Fixed Cost associated with the plant and equipment purchase. These are a one-time
purchase.
c: Marginal Cost of producing a single pencil crayon. This is the cost associated with the wax,
wood, and dyes.
Q: number of pencil crayons produced by the rm. ie. their output.
We can then write the rms average costs as simply the total cost divided by the total quantity:
AC =
TC
Q
=
F
Q
+c
2
As Q increases (ie. more is produced), the average cost of a unit falls:
AC
Q
=
F
Q
2
< 0
More production means that the burden of the xed cost is being spread over more units. Each
unit costs relatively less to produce.
For example: Suppose that the xed cost of the rm are F = $100 and the marginal cost of
producing a pencil is $1.
The total cost of producing 1 pencil crayon is TC = F +cQ = 100 +1(1) = $101. The average
cost of producing one pencil crayon is:
AC =
TC
Q
=
100
1
+ 1
= $101
Now suppose 2 pencil crayons are produced. The total cost will rise since more is produced:
TC

= F +cQ = 101 + 1(2) = 103, but the average cost of each pencil crayon will decrease:
AC =
TC
Q
=
103
2
= $51.50
As output rises, the marginal cost doesnt change. It stays xed at, in this example, $1. But
as more is produced, the cost to produce a single unit falls.
Monopolistic Competition
We will make 4 assumptions about monopolistically competitive rms.
1) Each rm can reduce its average cost by producing more output - ie. faces economies of
scale.
2) Each rm is able to dierentiate its product from its rivals - ie. has its own variety.
3) Each rm is able to take the prices set by its rivals as given. It ignores the impact of its own
price on the prices of other rms. ie. Each rm is signicantly small such that it doesnt aect
the price other rms set.
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4) Firms can enter and exit each industry freely. If there are any excessive prots, new rms
will enter the industry and drive prots down to zero. In this case, the monopolistically competi-
tive rm will set its price equal to its average cost.
Monopolistic competition is not an unreasonable assumption. The automobile industry in Eu-
rope is considered to be monopolistically competitive. They oer substantially dierent yet com-
peting automobiles. Personal products such as shampoos and conditioners, or computers/laptops
fall can be considered monopolistically competitive goods.
Assumptions of the Market Demand
1) A rm sells more if the total demand for its industrys product is larger. (Example: If more
people want automobiles, every car variety will be able to sell more output).
2) A rm sells more if any of their rivals prices increase. Consumers will substitute away from
the rivals automobile towards cheaper automobiles.
From 1) and 2), we can describe such a rms demand curve as:
Q
D
= S
_
1
n
b
_
P

P
_
_
Q
D
: rms sales
S: total sales of the industry
n: number of rms in the industry.
b: a constant term representing the responsiveness of a rms sales to its price
P: the price charged by the rm itself

P: the average price charged by its competitors.


Suppose all rms were to charge the exact same price, ie. P =

P. Then consumers would
be approximately indierent between which variety they purchase. Each rm in the industry will
have an equal market share,
1
n
, and its sales would be Q =
S
n
. If a rm charges more than the
average price of its rivals, P

P > 0, its market share - everything in the square brackets - as well
as its sales would decrease. Q <
S
n
.
We are making a very strong and unrealistic assumption: total industry sales S are unaected
by the average price

P charged by rms in the industry. We make this assumption only because
it simplies the analysis. S is thuen simply a measure of the size of the market. In a sense, you
can think of all the consumers as having inelastic demand (eg. they MUST buy!), but they will
prefer to buy the cheapest variety.
Assumptions of the Industry
1) All rms are symmetric in that the demand and cost funtions are identical for all rms -
EVEN THOUGH they are producing slightly dierentiated goods.
By making this assumption, all we really need to know to understand the industry is how many
rms are operating and what price the typical rm charges. To see what the eects of international
trade are on a particular industry, we need to determine the number of rms, n, and the average
price they are charging

P.
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How to Determine n and

P
1) First we need to derivat a relationship between the number of rms and the average cost
of a typical rm. We will see that this relationship is upward sloping - that is, as there are more
rms in the industry, each rm supplies to a relatively smaller share of the market. This results
in higher costs per unit of output.
We have made the assumption that all rms are identical (symmetric) - which means that they
will all set the same price. In other words the price of a single rm is equal to the average price,
P =

P. But when this happens, we know that
Q
D
= S
_
1
n
b
_
P

P
_
_
=
S
n
Each rms output Q is a
1
n
share of the total industry sales S. Thus, a rms output Q
deecreases when there are more rms in the industry. This will have a direct eect on a rms
average costs, since AC =
F
Q
+c. We can plug in for Q as follows:
AC =
F
S/n
+c
=
Fn
S
+c
Thus, when the number of rms increase, each rm will produce less. This causes their average
costs to rise.
2) Next we show that there exists a negative relationship between the number of rms and the
price each rm charges.
Recall that in the monopolistic competition model, rms take each others prices as given.
They ignore the possibility that if it changes its price, other rms will also change their prices. In
other words, they take

P as given. The demand curve above is written as
Q
D
= S
_
1
n
b
_
P

P
_
_
=
_
S
n
+Sb

P
_
SbP
= (some constant)(some term that includes the rms price)
Remember that b is the arameter that measures the sensitivity of each rms market share to
the price it charges.
We can rearrange this demand curve to be written as P(Q):
Q
D
=
_
S
n
+Sb

P
_
SbP
SbP =
_
S
n
+Sb

P
_
Q
D
5
P =
S/n
Sb
+
Sb

P
Sb

Q
D
Sb
=
1
bn
+

P
Q
D
Sb
=
_
1
bn
+

P
_

Q
D
Sb
Then total revenue is simply calculated as TR = P Q
D
:
TR =
_
_
1
bn
+

P
_

Q
D
Sb
_
Q
D
= Q
D
_
1
bn
+

P
_

Q
D
2
Sb
To obtain the marginal revenue curve (which tells us how a rms total revenue changes when
its sales change), we take the derivative of TR with respect to Q,
TR
Q
:
MR =
TR
Q
=
_
1
bn
+

P
_
2
Q
D
Sb
=
_
1
bn
+

P
_

Q
D
Sb

Q
D
Sb
= P
Q
D
Sb
In a competitive market, the marginal revenue of a rm is equal to its marginal cost. That
means:
P
Q
D
Sb
= c
P = c +
Q
D
Sb
But we know that if each rm charges the exact same price, each will sell Q =
S
n
. Plugging
this into the equation above gives us:
P = c +
S/n
Sb
= c +
1
bn
When the number of rms in the industry increases, each rm will end up charging a lower price.
We can graph these two relationships out. On one hand, when there are more rms in the
industry, the competition will be more intense and so will drive down the industry price. This
negative relationship between n and P is given by the line PP. On the other hand, when there
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are more rms in the industry, each rm sells less and therefore experiences a higher average cost.
This is represented by the line CC.
If price were to exceed average cost (ie. if the PP curve is above the CC curve), the industry
will make prots. This is not an equilibrium situation! If there are positive prots to be made,
new rms will enter the industry and drive down the share each rm receives. If price were less
than average cost (ie. if the CC curve is above the PP curve), the industry is incurring losses.
Again this is not an equilibrium situation. Firms making losses exit the industry.
3) To nd the equilibrium number of rms, we determine the intersection of the CC and the
PP curves. In the graph above, the two curves intersect at point E where the number of rms is
equal to n
2
. This n
2
is where zero prots are made, ie. is the zero-prot number of rms in the
industry since P
2
= AC
2
. When there are n
1
rms in the industry, each rm is making positive
prots since P
1
> AC
1
. When there are n
3
rms in the industry, rms are making losses since
P
3
< AC
3
.
In general, what is the equilibrium number of rms? We simply set the CC and PP curve equal
to one another:
CC = PP
Fn
S
+c = c +
1
bn
Fn
S
=
1
bn
Fbn
2
= S
n
2
=
S
Fb
7
n =

S
Fb
As you can see, the equilibrium number of rms increases as the total sales increase, and
decreases as its xed costs and price-elasticity-of-demand increase.
Is monopolistic competition a realistic modeling assumption?
No. We dont see many cases of true monopolistic competition. Rather, we see more cases
of oligopoly. This is where rms are fully aware that their actions inuence the actions of other
rms. They take other rms reactions to their behavior into account when making decisions.
We prefer to use monopolistic competition because it avoids complex modeling. In particular,
if we were to study the behavior of oligopolies, we have to take the following into account:
1. Oligopolies have an incentive to collude. They can agree on keeping prices higher than
the prot-maximizing level. This can be done through explicit agreements or taciet coordination
strategies (where everyone just watches what the leader rm is doing and responds accordingly.)
2. Fimrs may also behave strategically to lower their prot sbut aect the behavior of com-
petitors. A rm may build extra capacity not to use it but to deter potential rivals from entering
the industry. Also, they may use predatory pricing to drive existing rms out of the market.
Monopolistic Competition and Trade
We can now use the model to determine how trade will aect each economy. We know that
trade essentially makes the total market larger. When a rm can sell more, its average costs fall.
What we will see is that each country can specialize in producing a narrower range of products than
it would in the absence of trade. By specializing in less but selling far more, it can simulatenously
increase the variety of goods available to consumers. There is mutual gain for trade even if the
countries do not dier in resources or technology.
The Eects of Increase Market Size
When two identical markets come together, the total number of sales eectively doubles.
AC =
F
Q
+c
=
nF
S
+c
An increase in total sales, S, will reduce average costs for any given number of rms n. This
can be depicted in the diagram below. When there is an increase in the size of the market, there
is a downward shift from CC
1
to CC
2
, denoting that the average cost has fallen for any level of
rms. This increase in sales leads to a lower equilibrium price and an increase in the number of
rms. Since each rm represents a single variety, consumers who like to have variety are made
better o in an integrated, larger market.
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It is important to note that the PP curve does not shift when there is an increase in sales.
Recall that the PP curve is given by the following function: P = c +
1
bn
. There is no role for S
here. Remember that PP is not a demand curve, but a curve noting that as more rms enter the
market, each becomes more competitive and will charge a lower price.
Numerical Example
Consider the chocolate industry. There are numerous producers who make slightly dierentiated
varieties in a monopolistically competitive industry. The demand curve facing any given producer
of chocolates is described by our standard demand equation, where well set b=1/100. Thus the
demand facing any chocolate producer is
Q = S
_
1
n
1(P

P)
_
Q: number of chocolate bars sold by a given rm
S: total sales for the entire industry
n: total number of producers
P: price a given rm charges

P: average price charged by other rms.


Well also assume that F = 100, and c = 5. (These are higher quality chocolates!)
We can write a rms total cost function as
TC = F +cQ
= 100 + 5Q
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and their average cost function as
AC =
F
Q
+c
=
100
Q
+ 5
When each country prices identically, then their output is given by Q =
S
n
. Thus, their AC is
given by:
AC =
100n
S
+ 5
Now suppose there are two producers of chocolate, Belgium and Switzerland. Belgium has
annual sales of 1000 chocolates while Switzerland has sales of 2000 chocolates. They face the exact
same costs of production.
We can determine the PP curve , which is given by
P = c +
1
bn
= 5 +
100
n
= 5 +
100
n
We can nd the equilibrium number of rms and price in each country. In Belgium,
AC
B
= P
B
100n
1000
+5 = 5 +
100
n
n
2
=
100(1000)
100
n
2
= 1000
n = 31.6
and the equilibrium price is given by
P
B
= 5 +
100
31.6
= 8.16
and the total output of each of the Belgium rms is:
Q
B
=
S
n
=
1000
31.6
= 31.64
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In Switzerland,
AC
S
= P
S
100n
2000
+ 5 = 5 +
100
n
n
2
=
100(2000)
100
n
2
= 2000
n = 44.7
and the equilibrium price is given by
P
S
= 5 +
100
44.7
= 7.24
and the total output of each of the Swiss rms is:
Q
S
=
S
n
=
2000
44.7
= 44.74
Now suppose that it is possible for Belgium and Switzerland to trade chocolates freely. The
only thing that has changed is that total sales, S, has become 1000 + 2000 = 3000 across the
integrated markets. This will only change the average cost curve, CC.
AC =
100n
S
+ 5
=
100n
3000
+ 5
There is only one average cost curve now for all rms. Setting this equal to P (so that, in a
competitive market, P=AC), we have
100n
3000
+ 5 = 5 +
100
n
n
2
=
100(3000)
100
= 3000
n = 54.77
and the equilibrium price is
P = 5 +
100
n
= 5 +
100
54.77
= 6.82
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The integrated market is now able to support a total of 54.77 rms. ie. Consumers have
access to ~55 dierent varieties of chocolates. This is better than before trade! Belgium consumers
previously only had access to ~32 varieties, while Swiss consumers only had access to ~45 varieties.
Even better, the price of chocolate has fallen to 6.82.
To achieve economies of scale, each rm must concentrate its production in one country, either
Belgium or Switzerland, and sell its chocolate to BOTH countries. This is an example of
intra-industry trade!
Unfortunately, we cant tell with the limited information presented here how many of the 55
rms will be located in Belgium, and how many will be located in Switzerland.
How Signicant is Intraindustry Trade?
Intraindustry trade plays more of a role in the manufactured goods among industrialize coun-
tries. The table below shows the indexes of intraindustry trade for U.S. industries. The index is
given as follows:
I = 1
|exports imports|
exports +imports
If a country exports and imports a single good equally (intra-industry trade), we should
expect I = 1. On the other hand, if it exports one good but imports another (inter-industry
trade as in the Ricardian and HO models), then I = 0.
It appears that highly sophisticated industries experience greater intra-industry trade and are
exported by more advanced nations. Goods like clothing and footwear, on the other hand, ex-
perience greater inter-industry trade. These typically are labor-intensive products imported from
less-developed countries.
Why are there gains from intraindustry trade?
Intraindustry trade allows countries to benet from larger markets. Firms are able to sell to
more customers and customers have access to a greater variety of products.
Intraindustry trade results in a country reducing the number of products it produces and in-
crease the variety of goods available to domestic consumers. The reduction in varieties, n, means
12
that the amount produced by each rm, Q =
S
n
, increases. As a rms output increases, its aver-
age costs decrease. (Economies of scale). Intraindustry trade also means that consumers in both
markets have access to more varieties at a lower price.
In the HO model, the gains (and losses) from trade came because of a change in the relative
price. Some people were made better o, others were made worse o.
In this model of intraindustry trade, countries will only trade if they are similar in their fac-
tor supplies (otherwise, they may prefer to engage in inter-industry trade) AND when increasing
production is eective at reducing average costs. In this case, there are gains from increasing
production and variety. The expected distributional eects (such as rms being forced to drop out
of the industry) are probably small relative to the gains both to producers but also consumers.
Well see intra-industry trade occur more between similarly developed countries. The gains
from trade will be larger when there are greater economies of scale.
One of the best examples of intraindustry trade is the European Economic Community. In
1957, much of continental Europe established a free trade agreement which led to a great expan-
sion in trade. Many had expected that a free trade agreement would have led to specialization
- Belgiums workers would lose out while Italys workers would gain. This didnt happen. Inter-
estingly, almost all this trade was intraindustry. Workers in various sectors in multiple countries
gained from the increased eciency of the integrated environment.
Dumping
One issue that arises in imperfectly competitive market is dumping. That is, when rms do
not charge the same price for goods that are exported and those that are sold to domestic buyers,
an example of price discrimination. When a rm is dumping, it is charging a lower price for
exported goods than it does for the same goods domestically.
Dumping can only occur if the following two conditions are met:
1. The industry must be such that rms are price setters rather than price takers. That is, the
market must be imperfectly competitive.
2. Markets must be segmented, making it dicult for domestic residents to purchase goods
intended for export.
Under these two conditions, a monopolistic competitive rm could gain from engaging in dump-
ing.
Example. A great example of dumping is the U.S. sugar industry. The Agriculture Department
operates a loan program to guarantee sugar producers certain prices through enforced import bar-
riers and domestic production controls. The U.S. sugar industry is relatively small - a cartel of a
small number of rms.
Consider a sugar producer who sells 1000 lbs of sugar at home and 100 lbs abroad. Suppose the
sugar sells for 20cents/lb in the United States while in Canada sugar exports sells at 15 cents/lb.
Firms might conclude that selling to the U.S. market would be far more protable.
Suppose that to expand sales by one unit in either market, the rms would need to reduce its price
13
by 0.01 cents.
In the U.S., total revenue = price x quantity = 20 x 1000 = 20000 cents = $200. To expand
sales by one unit in the U.S. market, the rms would need to reduce its price to 19.99. Total
revenue would equal = price x quantity = 19.99 x 1001 = 20,009.99 cents = $200.10., a marginal
gain of 10 cents.
In Canada., total revenue = price x quantity = 15 x 100 = 1500 cents = $15.00. Reducing
the price in the Canadian. market to 14.99 cents per lb would mean that total revenue = price x
quantity = 14.99 x 101 = 1513.99 cents = $15.14. The gain is 14 cents.
In this example, it would be protable for the U.S. sugar producers to expand exports to Canada
rather than sell to the domestic market, even though the price received on exports is lower.
We could have considered a case where the rm charges less for domestic sales of sugar than
its exports. In general, we dont see this happening too much - and rather, we more frequently
see lowered prices on foreign goods. Why? This is due to imperfectly integrated markets. Due
to transportation costs, trade barriers, etc., there is signicant home bias in that domestic rms
usually control a larger share of domestic markets than foreign rms. In this case, wed expect
U.S. sugar producing rms to control more of the U.S. sugar demand. You can think of this
in terms of elasticities. Consumers in the U.S. are more inelastic (i.e. insensitive) to a change
in the U.S. suppliers prices (assuming they all behave identically). They need the sugar, and
their demand will not change so much because there is few alternative producers of sugar ser-
vicing U.S. demand. On the other hand, consumers in Canada are relatively elastic (ie. more
sensitive) to a change in the U.S. suppliers price. A cut in the price of U.S. exports to Canada
will have a greater eect on demand. In general, a rm with a smaller market share, say 10%,
can cut its price by signicantly less to double its sales than a rm with a market share of 80%.
Thus rms have a greater incentive to keep their prices low on exports than on their domestic sales.
14
Consider a single monopolistic rm that sells in two markets: a domestic market where it faces
demand D
DOM
and an export market. In the domestic market, the rm is a monopolist, and so
faces a downward sloping demand curve. In the Foreign market, however, the rm must compete
with local producers. Well make the extreme assumption that it enters a perfectly competitive
foreign market and cannot supply at a price greater than P
FOR
. We represent the foreign demand
curve as D
FOR
, which is a horizontal line at the price level P
FOR
. This embodies the fact that
foreign demand for domestic exports is EXTREMELY sensitive to changes in price.
We will also assume that markets are segmented. This allows the rm to charge two separate
prices in the two markets without worrying about consumers in the domestic market trying to buy
in the other market. Also, this assumption rules out the possibility that foreign consumers can
buy at a lower price and sell the output back to domestic consumers. The rm will charge a higher
price for domestically sold goods than it does for exports. We will also assume that the marginal
cost of producing the output is the same in both markets. The marginal costs are assumed to be
increasing in the amount produced (hence why it is an upward sloping curve).
If the rm did not have the option to export and could only supply to the domestic market,
they would produce where MR
DOM
= MC. But we are ignoring the possibility of this since the
rm is assumed to be able to export.
The monopoly rm sets marginal revenue equal to marginal cost in each market to determine
15
how much to produce.
1
MR
DOM
= MC
MR
FOR
= P = MC
A greater amount of production takes place where MR
FOR
= MC. The monopolist will pro-
duce a level of quantity, Q
MONOPOLY
, such that MR
FOR
= MC. The cost of producing an extra
unit of output (regardless of which market it is going to) is given by P
FOR
.
Now, not all of this production is going to service the foreign market. A portion of it will go to
service the domestic market. The exact amount will be given by Q
DOM
. Why? In the domestic
market where the rm is a monopolist, it will set MR = MC, and we know that the marginal
cost of producing an extra unit of output is equal to P
FOR
. Therefore, the monopolist will choose
to sell Q
DOM
in the domestic market where MR
DOM
= P
FOR
. The rm can take advantage of its
monopoly status in the domestic market. It will set the price equal to P
DOM
, which is determined
by the demand curve in the domestic market.
Whatever is left over in terms of production, Q
MONOPOLY
Q
DOM
, will be exported to the
foreign market. The rm will sell these exports at a price of P
FOR
.
Note that P
DOM
> P
FOR
. By denition, the rm is dumping its exports on the foreign mar-
ket. That is, it is selling more cheaply abroad than at home.
If the rm were to increase its sale of exports, it would not have to decrease its price (since
the demand curve in the foreign market is horizontal). On the other hand, if the rm were to
increase its sale of output to the domestic market, the downward sloping demand curve would
imply that the price must fall. Thus, rms will price-discriminate when sales are more elastic
(price-responsive) in one market than in another.
So why is dumping considered so terrible? Well, economically it isnt. Dumping takes ad-
vantage of dierent market conditions for the same industry. In the domestic economy, the rm
holds a monopoly position and can extract monopoly rents. In the foreign market, it faces strong
competition and must price competitively. Theres nothing per-se wrong with this. Nevertheless,
such dumping of output on foreign markets makes the industry even more competitive and can
potentially drive out local producers. Special-interest groups would prefer to see local producers
than a foreign exporter succeed in their local markets. In the U.S. and Canada, foreign rms face
taris if found dumping on domestic markets.
But this does not mean that the U.S. and Canada do not dump their products! Canada
imposes taris on American sugar exports while the U.S. imposes taris on Canadian softwood-
lumber. Both countries have accused the other of dumping.
Reciprocal Dumping
Consider what happens when there are two monopolistic rms in two separate countries (U.S.
and Canada) selling the same product (eg. Maple syrup). For simplicity, suppose both rms have
the same marginal costs. There also exists some transportation costs so that if the rms charge
1
Note that P=MC is the pricing rule under perfect competition.
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identical prices, no trade will occur. When each rm operates under autarky, they are perfect
monopolists and face no competition.
Trade could theoretically occur if we allow for dumping. Each rm could limit the quantity it
sells to its domestic market - acknowledging that as it sells more domestically, it drives down the
price. A rm could make prots by selling a bit in the foreign market. The price in the foreign
market will be less than in the domestic market, but the rm will be able to raid the other market
by setting a price that (net of transportation costs) is higher than its marginal cost.
Thus, we can have a trade outcome if both countries engage in dumping behavior. This
will be the case even if there are no initial dierences in the price of the good in the two mar-
kets. Even stranger, there will be intra-industry trade of the same good. We call this situation
reciprocal dumping.
Arguably, absolutely identical goods are not likely to be exported in both directions. But for
very similar goods, reciprocal dumping appears to increase the volume of trade.
Why on earth would we want to trade nearly identical goods? Wouldnt it be a waste of re-
sources and time, especially when transportation costs are positive? The neat thing here is that
reciprocal dumping breaks up monopoly power in each market. Rather than paying monopoly
prices, consumers can pay below-monopoly prices when a foreign competitor enters the market.
This gain from more-competitive pricing may be large enough to oset the loss associated with
wasteful transportation costs. Thus, the nal outcome is unclear.
The Theory of External Economies
So far weve only looked at how economies of scale give rise to international trade at the rm
level. Essentially, rms benet from an expansion in sales because it lowers their average cost
of production. Not all economies of scale occur at the rm level. It is also possible for rms to
gain - not from an expansion in production - but from producing in one or a few locations. With
limited locations, it can reduce the industrys costs, even if the individual rms in the industry
remain small. This is called external economies of scale, and refer to when a rm can lower its
average cost due to external factors, mostly beyond its control. Examples of industry clustering
include Silicon Valley for the tech industry, New York City for the investment banking industry,
and Hollywood for the entertainment industry.
There are 3 main reasons why a cluster of rms may be more ecient than an individual rm
in isolation:
1. Clusters are able to support specialized suppliers.
The production of goods and services usually requires the use of specialized equipment or
support services (specialized suppliers). A single rm is not large enough to support all
these specialized suppliers. A cluster of rms, however, would suciently demand the services
of specialized suppliers. In Silicon Valley, the availability of dense network of specialized
suppliers gave high tech rms located there an advantage over rms elsewhere. Inputs were
cheaper and more easily available because they were closer by. At the same time, rms were
able to outsource some of their tasks to other nearby tech rms.
Firms setting up in other countries would not benet from the specialized suppliers that
locations like Silicon Valley has.
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2. Clusters allow for labor market pooling.
By clustering nearby each other, rms in the same industry can benet by having a larger
pool of skilled labor. Workers are less likely to experience long-term employment. Since their
skills are transferable from one rm to the next, they can easily nd work in a location with
many similar rms.
3. Clusters help foster knowledge spillovers.
Knowledge is an essential input in most innovative industries. By being geographically close
to other competitors, rms can learn and improve from their competition. They can study
the competitions products, reverse engineer their designs and output. Being closeby also
allows for a greater informal exchange of information and ideas. There is more socialization
between rms when they are in close proximity.
Now, a country cannot have a large concentration of rms in an industry unless it possesses a large
industry! When these external economies are important, a larger industry will be more ecient
in that industry than a country with a small industry. Another way to say this is that external
economies can lead to increasing returns to scale at the level of the national industry. Average
costs decline with total industry output.
Assuming perfect competition, a larger industry implies lower industrial costs. In this case, the
industrys supply curve will be forward falling: larger output implies a lower price at which rms
are willing to sell their output.
External Economies and International Trade
Because of external economies of scale, a larger national output will imply lower costs of produc-
tion. Strong external economies tend to conrm existing patterns of interindustry trade: Countries
that start out as large producers in certain industries tend to remain large producers. They may
even do so if other countries could potentially produce the goods more cheaply. In other words,
because of external economies of scale, production may take place in the wrong country. In partic-
ular, we could come up with some examples where a higher-cost country will hold onto an industry.
Consider the economy drawn below. Two countries, Switzerland and Thailand, produce watches.
On the horizontal axis is the total number of watches produced annually by each country. On the
vertical axis is the cost of producing each watch, as well as price level. The average cost of pro-
ducing a watch in Switzerland is given by the curve AC
SWISS
, while the average cost in Thailand
is given by AC
THAI
. D denotes the world demand for watches - and this demand can be satised
by either country.
We will assume each rm is small and perfectly competitive, resulting in prices being driven
down to average cost. By small, we mean each rm produces a nearly negligible amount of product.
Here, we have assumed that the Thai cost curve lies below the Swiss cost curve due to lower
wages in Thailand. For any level of production, Thailand can produce it cheaper and will thus
charge a lower price for the watch. So does this mean that Thailand will supply the entire world
market? Not necessarily!
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Suppose that, for historical reasons, was the rst to supply watches on the world market. Then,
the world watch equilibrium is given by point 1 where demand intersects the AC
SWISS
curve. (You
can think of the AC curve as a downward sloping supply curve in this example). The Swiss will
produce Q
1
watches per year at a price of P
1
.
Now suppose that Thailand begins producing watches as well. If Thailand were to take over the
world market, the market equilibrium would be at point 2 where demand intersects the AC
THAI
curve. Thailand would be able to produce and sell more watches at a lower price.
BUT, if there are no Thai rms in the market to begin with (such that Q = 0), a Thai rm that
chooses to enter will face a cost of C
0
of producing. Remember, a single rm produces a positive
but nearly zero amount of output. The way weve drawn the market here, this cost of producing
exceeds even Switzerlands market clearing price. No Thai rm would, individually, want to enter
the market since its AC would be less than the market price. So, in this case, even though the Thai
industry is more ecient at producing watches, Switzerlands head-start in the industry allows it
to hold on to the industry.
Trade and Welfare with External Economies
It is ambiguous whether countries will be made better or worse o from trade based on ex-
ternal economies. We can outline an example below where a country is made worse o from trading.
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In the previous example, we saw that despite Thailand being a cheaper producer of watches,
because Switzerland entered the market rst, Switzerland maintains control over the market and
prices its watches at P
1
.
Add to the previous example the following: Thailands demand for watches, D
THAI
. If no trade
in watches were allowed and Thailand were forced to be self-sucient, then Thailands equilibrium
is at point 2. The equilibrium price in Thailand is given by P
2
. Notice that P
2
< P
1
. Thai
consumers are able to purchase watches at a lower price when there is no trade than if it were to
import it from the Swiss manufacturers. Trade would leave the Thai consumers worse o than in
the absence of trade.
Despite these horror examples of how external economies can lead to disadvantageous pat-
terns of trade, it is still to the benet of the world economy to take advantage of the gains from
concentrating industries.
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