Modern Trade Theories

Introduction
Technology Theories of Trade
Imitation lag hypothesis Product cycle theory

Economies of Scale and Trade Intra industry trade

Product differentiation, monopolistic competition & intra industry trade Oligopoly & intra industry trade Linders Demand-based Theory

Imitation Lag Hypothesis Posner 1961

Same technology not available in all countries. R&D results in new product in Country A. Demand lag before consumers in country B want to buy. Imitation lag before firms in country B start to produce. During net lag (i.e. imitation lag - demand lag) country A can export to Country B without competition.

Product Life Cycle Theory Vernon 1966

3 stages of product life-cycle: New Product Stage
produced & consumed only in home country

Maturing Product Stage

standardisation of production & exports to other high-income countries

Standardised product Stage

production may shift to LDCs with lower labour costs

Theory of dynamic comparative advantage

Product Life Cycle Theory Vernon 1966

Production/ Consumption of product

Economies of Scale External to Firm

AC ACi Aci(Q0)

H0 H0=F0

Q0 Industry level

Qi

q0 Firm level

qi

Economies of Scale External to Firm

AC ACi Aci(Q0) Aci(Q1) H0 H1 H0=F0

H1
Q0 Q1 Qi q0 Firm level qi

Industry level

Economies of Scale External to Firm

Internal Economies of Scale: Monopoly

PH

AC E C DH qH MR q0

MC

Internal Economies of Scale: Monopoly

PH
C G MC qH

A B

AC
DH=MRH+F DH+F

MRH

qW

Internal Economies of Scale: Monopoly

PH
C G MC qH

A B

AC
DH=MRH+F DH+F

MRH

qW

Intra Industry Trade

What is intra industry trade? The aggregation problem Why does intra industry trade occur? Product differentiation, monopolistic competition & intra industry trade Oligopoly & intra industry trade Linders demand-based theory

What is Intra Industry Trade?

Insulin Insulin

Country H

Country

Bacon

Bacon

Inter-industry trade only

Intra-industry trade only

What is Intra Industry Trade?

Insulin

Country H

Country

Bacon

Partly inter-industry trade & partly intra-industry trade

What is Intra Industry Trade?

Grubel & Lloyd measured intra industry trade as:
Bi = (Xi + Mi) - |Xi - Mi| . 100 % (Xi + Mi) where (Xi + Mi) is total trade in industry i and |Xi - Mi| is the degree of non-overlap

Values range from

0% (no intra industry trade) to 100% (pure intra industry trade)

The Aggregation Problem

Firms are grouped into industries using the SITC (Standard International Trade Classification). Controversy centres on 2 issues
industry definition how much is substantial intra industry trade?

Why does Intra Industry Trade Occur?

Several minor cases
Entrepot trade Seasonality Transport costs

Transport Costs & IIT

Country A
FA

Country B
CB

CA

FB

Why does Intra Industry Trade Occur?

Several minor cases
Entrepot trade Seasonality Transport costs

Differentiated products
monopolistic competition

Oligopoly Overlapping demand

Product Differentiation, Monopolistic Competition & IIT

Krugmans model Assume:
identical firms with each firm facing downward sloping demand curve and differentiated products.

In a closed economy:
No. of firms = Industry demand Profit max. output of a firm

Oligopoly & IIT: Reciprocal Dumping (Brander & Krugman 1983)

Assume 2 countries with identical monopoly producers. In fully integrated international market there would be a duopoly. In a simple Cournot model, free trade will cause each to increase production, so price will fall

Oligopoly & IIT: Reciprocal Dumping (Brander & Krugman 1983)

Country H Producer H Country F Producer F

3
1

4 2

Consumers

Consumers

Oligopoly & IIT: Reciprocal Dumping (Brander & Krugman 1983)

In practice, full market integration doesnt happen. Producer in H will export if: PF > MC + transport costs
( given market segmentation PH not affected)

A parallel argument applies to producer in F, who exports if: PH > MC + transport costs So 2-way IIT occurs

Oligopoly & IIT: Reciprocal Dumping (Brander & Krugman 1983)

PH Country H PF Country F

PH0

PF0 PF1

MCH
DH qH0 MRH qH
Imports

MCH+TC

MCF DF
qF1

qF0

MRF

MRHF

qF

Linders Demand-based Theory 1961

Steffan Linder distinguished sharply between:
Trade in primary goods (explained by Heckscher-Ohlin); Trade in manufactures (explained by demand factors).

Main determinant of demand in a country was income /head. With high income average consumer buys better quality goods.

Linders Demand-based Theory 1961 (continued)

Empirical tests support Linders analysis, but countries with similar per capita incomes are often close geographically. Linder doesnt predict direction of trade flows (could be 2-way). Growth of travel & communications since he wrote may have changed factors he stressed.

Empirical Work
Typically industrialised countries have a high GL index of 60-80%
(e.g. see Culem & Lundberg 1986)

Japan is exceptionally low (40-50%) Little IIT between industrialised & developing countries IIT increases with economic development

Porters Diamond
Business strategy, market structure & competition

Factors of production

Domestic demand

Suppliers & affiliated companies

Porters Diamond
Government
Business strategy, market structure & competition

Factors of production

Domestic demand

Suppliers & affiliated companies

Summary
We have looked at various modern theories of international trade Technology based theories
from Posner & Vernon

Economies of scale & trade Theories on intra industry trade

Imperfect competition theories from Krugman Linders demand-based theory

Porters Diamond

Summary
Trade between industrialised countries can be explained by a combination of comparative & competitive advantage. Modern theories can add to our understanding of international trade, but we shouldnt reject the more traditional theories