Economies of Scale, Imperfect Competition, and ...€¦ · Economies of Scale, Imperfect...

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TOPICS ON GLOBALIZATION

(code 910012-ENG)

Economies of Scale, Imperfect Competition, and

International Trade

Academic Year 2018/2019 Anna M. FALZONI

Shape of the global trade network

International merchandise trade flows are to a large extent transcontinental. In 2016, some of the largest flows ran between China, the United States of America, and

Germany, jointly accounting for US$990 billion, 6 per cent of world imports. Considerable trade was recorded also between the United States of America and its neighbours,

Canada and Mexico, as well as between mainland China and surrounding economies, including the Republic of Korea, Japan, Taiwan Province of China and Hong Kong

Special Administrative Region of China (Hong Kong SAR). In some regions, economies have developed stronger ties for mutual exchange of goods than in others. In 2016,

in Europe more than two thirds and in Asia more than half of all exports were delivered to trading partners in the same region. In Oceania, Latin America and the Caribbean

and in Africa this was the case for less than one fifth. Source: UNCTAD, 2018

Source:

UNCTAD, 2018

Types of Economies of Scale

• External economies of scale may result if a larger industry allows for more efficient provision of services or equipment to firms in the industry.

– Many small firms that are competitive may comprise a large industry and benefit when services or equipment can be efficiently provided to all firms in the industry.

• Internal economies of scale result when large firms have a cost advantage over small firms, causing the industry to become

uncompetitive.

Internal Economies of Scale

b. Demand

Consumers benefit from increased variety

Q = S[1/n – b(P – Pavg)]

– Q is an individual firm’s sales

– S is the total sales of the industry

– n is the number of firms in the industry

– b is a constant term representing the responsiveness of a firm’s

sales to its price

– P is the price charged by the firm itself

– Pavg is the average price charged by its competitors

• To make the model easier to understand, we assume that all firms

face the same demand functions and have the same cost functions:

– Thus in equilibrium, all firms should charge the same price:

P = Pavg

• In equilibrium

– Q = S/n + 0

AC = F/Q + c (1)

Hypothetical example of gains from trade

in an industry with monopolistic competition

Domestic

market before

Foreign

market

before trade

Integrated

market after

Industry sales

Number of

Sales per firm

Average cost

900,000

150,000

10,000

1,600,000

200,000

2,500,000

250,000

Inter-industry and Intra-industry Trade

1. Gains from inter-industry trade reflect comparative advantage.

2. Gains from intra-industry trade reflect economies of scale (lower costs) and wider consumer choices.

3. The monopolistic competition model does not predict in which country firms locate, but a comparative advantage in producing the differentiated good will likely cause a country to export more of that good than it imports.

Inter-industry and

Intra-industry Trade

4. The relative importance of intra-industry trade depends on how

similar countries are.

– Countries with similar relative amounts of factors of production

are predicted to have intra-industry trade.

– Countries with different relative amounts of factors of

production are predicted to have inter-industry trade.

5. Unlike inter-industry trade in the Heckscher-Ohlin model, income

distribution effects are not predicted to occur with intra-industry

trade.

Empirical Applications of

Monopolistic Competition and Trade

Empirical Applications of Monopolistic

Competition and Trade*

• The idea that free trade expands the range of products available to customers is not new—Ricardo even mentions it.

• The ability to model the effects of trade under a monopolistically competitive model is new.

– Developed by Helpman, Krugman, and Lancaster.

• The research was used to shed light on free trade agreements, which guarantee free trade among a group of countries.

• The potential for Canadian firms to expand output was a key factor in Canada’s free-trade agreement with the U.S. in 1989 and entry into NAFTA (along with Mexico) in 1994.

• NAFTA is a good example to illustrate gains and costs predicted by the monopolistic competition model.

* The following slides are based on the book by Feenstra and Taylor (2008).36

What Happened When Two Countries Liberalized Trade?

• Gains and Adjustment Costs for Canada

• Data from 1988–1996 was used by Daniel Trefler of University of Toronto to estimate effects of the Canada-U.S. Free Trade Agreement.

• Some findings:– Short-run adjustment costs of 100,000 jobs, or 5% of

manufacturing employment.– Some industries that had very large tariff cuts saw employment

fall by as much as 12%– Over time, however, these job losses were more than made up

for by creation of new jobs elsewhere in manufacturing.– There were no long run job losses due to NAFTA.

What Happened When Two Countries Liberalized Trade?

• In the long run, large positive effects on productivity were found.

– 15% over eight years in industries most affected by tariff cuts—

compound growth of 1.9%/year.

– 6% for manufacturing overall—compound growth of 0.7%/year.

– There was also a rise of 3% in real earnings over this period.

• These findings support the monopolistic competition model.

Competition and Trade

• Gains and Adjustment Costs for Mexico

– Mexican President Miguel de la Madrid felt that the economic

reforms were needed to boost growth and incomes in Mexico.

– Joining NAFTA was a way to ensure the permanence of the

reforms already underway.

– Under NAFTA, Mexican tariffs on U.S. goods declined from an

average of 14% in 1990 to 1% in 2001.

– In addition, U.S. tariffs on Mexican imports fell as well.

• Productivity in Mexico

– Panel A in figure 6.8 shows the productivity over time for two

types of manufacturing firms:

• Maquiladora plants—close to the border and produce almost

exclusively for export to the U.S.

• Non-Maquiladora plants

– Maquiladora plants should be most affected by NAFTA

Competition and TradeFigure 6.8

Figure 6.8 (a) Labor Productivity and Wages in Mexico Panel (a) shows labor productivity for workers in the

maquiladora Mexican manufacturing plants and for workers in non-maquiladora plants in the rest of Mexico.

• Productivity in Mexico

– For the maquiladora plants, productivity rose 45% from 1994 to

2003—compound growth rate of 4.1%/year.

– For non-maquiladora plants, productivity rose overall by 25%—

compound growth rate of 2.5%/year.

– The difference, 1.6%/year, is an estimate of the impact of

NAFTA on the productivity of maquiladora plants over and above

the increase in productivity that occurred in the rest of Mexico.

• Adjustment Costs in Mexico

– When Mexico joined NAFTA, it was expected that the agricultural sector would fare the worst due to competition from the U.S.

• Tariff reductions in agriculture were phased in over 15 years.

– The evidence to date shows the corn farmers did not suffer as much as was feared. Why?

• The poorest farmers consume the corn they grow, rather than sell it.

• Mexican government was able to use subsidies to offset the reduction in income for other corn farmers.

– Total production of corn in Mexico rose following NAFTA.

– For maquiladora plants, employment grew rapidly following

NAFTA to a peak of 1.29 million in 2000.

– After that, this sector entered a downturn.

• The U.S. entered a recession decreasing demand for

Mexican exports.

• China was competing for U.S. sales by exporting goods

similar to those sold by Mexico.

• The Mexican peso became over-valued, making it difficult to

export abroad.

– Employment in the maquiladora sector fell after 2000 to 1.1

million in 2003.

– The maquiladora sector faces increasing international

competition (not all due to

NAFTA).

– This can be expected to raise the volatility of its output and

employment.

– The volatility can be counted as a cost of international trade for

workers who are displaced.

• Gains and Adjustment Costs for the United States

– Studies on the effects of NAFTA on the U.S. have not estimated

its effects on the productivity of U.S. firms.

• It would be hard to identify the impact since Mexico and

Canada are only two of many trading partners.

– Instead, researchers have estimated the second source of gains

from trade: the expansion of import varieties available to

consumers.

• Expansion of Variety to the U.S.

– The increase in the variety of products imported to the U.S.

under NAFTA is a source of gains to U.S. consumers.

– According to one estimate, the total number of product varieties

imported into the U.S. from 1972–2001 has increased four times.

– That expansion in import variety has had the same effect as a

reduction in import prices of 1.2% per year.

• Adjustment Costs in the U.S.

– These come as firms exit the market due to import competition

and the workers employed there are temporarily unemployed.

– One way to measure this loss is to look at claims under the U.S.

Trade Adjustment Assistance (TAA) provisions.

• Offers assistance to workers in manufacturing who lose their

jobs due to import competition.

– From 1994–2002, about 525,000 workers, or about 58,000 per

year, lost their jobs and were certified as adversely affected by

trade under the NAFTA-TAA program.

• Summary of NAFTA

– The studies have been able to measure in part the long-run gains and short-run costs from NAFTA for Canada, Mexico, and the U.S.

– The monopolistic competition model indicates two sources of gains from trade.

• the rise in productivity due to expanded output by surviving firms.

– Leads to lower prices

– More varieties of products for consumers

– For Mexico and Canada, long-run gains were measured by the improvement in productivity for exporters as compared to other manufacturing firms.

• Summary of NAFTA

– For the U.S., the studies measured the long-run gains using the

expansion of varieties from Mexico, and the equivalent drop in

price faced by U.S. consumers.

– It is clear that for Canada and the U.S., the long-run gains

considerably exceed the short-run costs.

– In Mexico the gains have not been reflected in the growth of real

wages for production workers.

– The real earnings for higher-income workers in the maquiladora

sector have risen and have been the principal beneficiaries of

NAFTA so far.

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