Feenstra Taylor Econ CH06

INCREASING RETURNS TO SCALE

AND IMPERFECT COMPETITION

61

Basics of Imperfect Competition

2 Trade under Monopolistic

Competition3

Empirical Applications ofMonopolistic Competition

and Trade4

Imperfect Competition withHomogeneous Products

5 Conclusions

2 of 111© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Introduction

• We will look at trade in golf clubs, a good that the U.S. imports and exports in large quantities.

• Many countries that sell to the U.S. are also buying from the U.S. The total value of imports is close to the total value of

exports.

• Why does the U.S. export and import golf clubs to and from the same countries? We observe intra-industry trade. A new explanation for trade will be discussed here.


Introduction

Table 6.1 U.S. Imports of Golf Clubs, 2005


Introduction

Table 6.1 U.S. Exports of Golf Clubs, 2005


Introduction

• We will look at a model of monopolistic competition where goods are differentiated. Gives a degree of market power

• Firms tend to specialize because in monopolistic competition we have increasing returns to scale

• The imperfect competition model also predicts that larger countries will trade more with each other. This is called the gravity equation.


Trade Under Monopolistic Competition

• We begin this section with a few assumptions

Assumption 1: each firm produces a good that is similar to, but differentiated from, the goods that other firms in the industry produce.

Assumption 2: there are many firms in the industry.

Assumption 3: firms produce using a technology with increasing returns to scale (decreasing AC, fig. 6.3).

Assumption 4: firms can enter and exit the industry freely, so that monopoly profits are zero in the long run.



Figure 6.3



• Numerical Example Using the cost curve in figure 6.3, we get:

Fixed costs = $100 Marginal costs = $10/unit

Q VC=Q*MC TC=FC+VC AC=TC/Q

10 $100 $200 $20

20 200 300 15

30 300 400 13.3

40 400 500 12.5

50 500 600 12

100 1000 1100 11

Large Q 10Q 10Q+100 Close to 10



• Equilibrium Without Trade

Short-Run Equilibrium Figure 6.4 shows our monopolistically competitive firm. Each firm maximizes profits by producing Q0, where MR=MC.

Price is from the demand curve at P0.

Since price is greater than average cost, the firm is earning positive monopoly profits.

Long-Run Equilibrium Since firms are making positive profits, firms will enter the

industry. The demand for existing firms will fall until no firm is earning

positive profits; the demand curves also becomes flatter (more elastic).



Price

Quantity

MC

AC

Demand curve facing each firm, d0

mr0

P0

Q0

Figure 6.4

Short run equilibrium here is the same as for a monopolist. MR = MC with price from demand. Since P > AC, firm is making a profit.



Price

Quantity

MC

AC

d0

D/NA

P0

Q0

Figure 6.5

d1mr1

Equilibrium is at A, producing Q1, where mr1 crosses MC. This gives price, PA, from the demand, d1

PA A

Q1

Firm demand when all firms charge the same price

At Q1, the no-trade price PA = AC so the firms are all earning zero monopoly profits and there is no entry or exit

Drawn by the profits in the industry, firms enter. The demand for this firm drops to d1 with corresponding mr1. d1 is more elastic, due to competition, and therefore flatter than d0



• Equilibrium With Free Trade Assume Home and Foreign are exactly the same.

Same number of consumers Same technology and cost curves Same number of firms in the no-trade equilibrium (NA)

If there were no economies of scale, there would be no reason for trade.

• Short-Run Equilibrium with Trade When trade opens, the number of customers available to each firm

doubles, but the number of product varieties available to each consumer also doubles.

With the greater number of varieties available, the demand for each individual variety will be more elastic.



• Short-Run Equilibrium with Trade After trade, demand is no longer tangent to the AC.

Each firm now produces at Q2 charging P2.

Firms are making positive monopoly profits. This shows the firm’s incentive to lower its price

Every firm in the industry has the same incentive.

If all firms lower prices, though, the quantity demanded from each firm increases along D/NA, instead of d2. Remember D/NA is the demand if all firms had the same price.

In the short run, firms lower their prices expecting to make profits at B, but end up with losses at B′.



Price

Quantity

MC

AC

D/NA

Figure 6.6

d2

mr2

PA A

Q1

B’

Q’2 Q2

BP2

Long-run equilibrium without trade

Short-run equilibrium with trade

Opening trade makes the firm’s demand even more elastic, shown by d2. The firm chooses to produce at Q2, where MR=MC, selling at P2. At this price the firm makes monopoly profits as P2>AC

As all firms lower their price to P2, the relevant demand is D/NA at B’ selling only Q’2. At this point firms are incurring losses and some firms will be forced to exit the industry



• Long-Run Equilibrium with Trade Since firms will exit the industry, increasing demand for

the remaining firms’ products and decrease the available product varieties to consumers.

We now only have NT firms which is fewer than the NA firms we had before.

The new demand D/NT lies to the right of D/NA.

Long-run equilibrium with trade is at point C.

The demand for each firm d3 is tangent to AC.



Price

Quantity

MC

AC

D/NT

Figure 6.7

d3

mr3

PA A

Q1 Q3

CPW

Long-run equilibrium without trade

Since some firms have exited the industry, we are left with T firms which gives each firm a share of the demand shown by D/NT

The demand faced by each firm is d3 with mr3. mr3=MC shows that each firm produces Q3 at a price PW

Since PW = AC, firms are making zero monopoly profits, no firms exit or enter the industry, and C is the long run equilibrium with trade

Long-run equilibrium with trade



• Long-Run Equilibrium with Trade The world number of products is greater than the

number available in each country before trade. Fewer firms remain in each country, but each is bigger. As quantity increases, average costs fall due to

increasing returns to scale, therefore so do prices.

• Gains From Trade There are two sources of gains for consumers:

Price is lower after trade. Consumers obtain higher surplus when there are more product

varieties from which to choose.



• Adjustment Costs from Trade There are adjustment costs as some firms shut down and

exit the industry.

Workers in those firms experience a spell of unemployment.

Over the long run however, we expect those workers to find new positions. Temporary costs

Compare short-run and long-run adjustment costs.

We will look at evidence form Mexico, Canada, and the U.S. under the North American Free Trade Agreement (NAFTA).


Empirical Applications of Monopolistic Competition and Trade

• Gains and Adjustment Costs for Canada 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.

Studies in Canada as early as the 1960s predicted substantial gains from free trade with the U.S. Firms would expand their scale of operations to service

the larger market and lower their costs.

Studies by Harris in the mid-80s influenced Canadian policy makers to proceed with the free trade agreement with the U.S.

The article described next looks at what happened in Canada after the implementation of NAFTA.

HEADLINES


What Happened When Two countries Liberalized Trade?

• 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.

HEADLINES


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. The difference of 1.2%/year is an estimate of how free trade with

the U.S. affected the Canadian industries over and above the impact on other industries.

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

• These findings support the monopolistic competition model.



• Gains and Adjustment Costs for Mexico Joining NAFTA was a way to ensure the permanence

of economic 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 (figure 6.8) Panel A shows productivity over time. Panel B shows what happened to real wages and real

income over time.



Figure 6.8



• 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.



• Real Wages and Income From 1994 to 1997, there was a fall of over 20% in real wages

in both sectors, even with increase in productivity. Why did it happen?

Shortly after joining NAFTA, Mexico suffered a financial crisis that led to a large devaluation of the peso. Mexican CPI went up leading to a fall in real wages.

The decline was, however, short lived. Real wages in both sectors began to rise again in 1998. By 2003, real wages were almost back to their 1994 value.

Since real wages were not higher than in 1994, any productivity gains from NAFTA were not shared with workers.



• Real Wages and Income If we look at real monthly income, the picture is a little

better. This includes other sources of income beside wages, especially

for higher-income persons.

In the maquiladora sector, real incomes were higher in 2003 than in 1994. Some gains for workers in plants most affected by NAFTA.

Higher-income workers fared better than unskilled workers in Mexico. Higher-income workers in the maquiladora sector are principal

gainers due to NAFTA in the long run.



Figure 6.8



• 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. 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.



• Adjustment Costs in Mexico Increasing volatility due to trade can be counted as

adjustment costs. 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.



• Gains and Adjustment Costs for the U.S. 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.

For U.S. we will compare the long-run gains to consumers due to expanded product varieties with the short-run adjustment costs from exiting firms and unemployment.



• Expansion of Variety to the U.S. To understand how NAFTA affected the range of products

available to U.S. customers, we will look at imports from Mexico in 1990 and 2001.

Focus on the number of different types of products Mexico sells to the U.S. compared to the total the U.S. imports from all countries.

Table 6.3 Mexico’s Export Variety to the United States



• Expansion of Variety to the U.S. 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.

Using an average $90 billion in U.S. imports per year and the 1.2% reduction in prices to U.S. consumers, $90(1.2%) = $1.1 billion per year in savings to consumers.

These consumer savings are permanent and increase over time as export varieties grow.

In 2003, the 10th year of NAFTA, consumers would gain $11 billion as compared to 1994.



• 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.

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.

Compare to the annual number of workers displaced in manufacturing or 444,000 workers per year.

The NAFTA layoffs of 58,000 workers were about 13% of total displacement—this is a substantial amount.



• Adjustment Costs in the U.S. Another way to measure effects is to compare the loss in

wages from the displaced workers to the consumer gains.

Suppose the average length of unemployment for laid off workers is 3 years.

Average yearly earnings for manufacturing workers was $31,000 in 2000 so each displaced worker lost $93,000 in wages. total losses were $5.4 billion.

These private costs of $5.4 billion are nearly equal to the average welfare gains of $5.5 billion.

However, gains continue to grow over time and job loss was only temporary.



• Summary of NAFTA We have been able to measure in part the long-run

gains and short-run costs from NAFTA for Canada, Mexico, and the U.S.

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.



• Intra-Industry Trade Countries will specialize in producing different varieties

of a differentiated good and will trade those varieties back and forth.

The index of intra-industry trade tells us what proportion of trade in each product involves both imports and exports. 100 = equal quantities of exports and imports 0 = only exports or imports

ImportsExports

Exports&ImportsofMinIITofIndex

21



• Index of Intra-Industry Trade For the golf clubs, we can use data from Table 6.1. The minimum of imports and exports is $305.8. Using the other data, we have

Index of IIT = 305.8/[.5(305.8+318.7)] = 98%. In Table 6.4 there are other examples of intra-industry

trade in other products for the U.S. To obtain a high index of intra-industry trade, it is

necessary for the good to be differentiated and for costs to be similar in the Home and Foreign countries, leading to both imports and exports.



Table 6.4 Index of Intra-Industry Trade for the U.S.



• The Gravity Equation To explain the value of trade, we need a different equation

called the gravity equation.

Dutch economist and Nobel laureate, Jan Tinbergen was trained in physics and thought the trade between countries was similar to the force of gravity between objects. Objects with larger mass or those that are close together have

greater gravitational pull between them.

The force of gravity between these two masses is:Fg = G[M1M2/d2]

G is the constant that tells the magnitude of the relationship. M1 and M2 are the two objects’ masses.



• The Gravity Equation in Trade We use a similar equation to measure the trade

between two countries.

Instead of mass, we use the GDP of each country.

The distance still matters, but we are not sure of the precise relationship between distance and trade.

There is also a constant term that indicates the relationship between the gravity term and trade.

ndist

GDPGDPBTrade 21



• The Gravity Equation in Trade

The constant term can also be interpreted as summarizing the effects of all factors, other than distance and size, that influence the amount of trade between two countries.

The effect of size is an implication of the monopolistic competition model we studied in this chapter. Larger countries export more because they produce more

product varieties, and import more because their demand is higher.



• Deriving the Gravity Equation Start with Country 1, which produces a differentiated

product. Other countries’ demand for Country 1’s goods depends on:

The relative size of the importing country The distance between the two countries

Relative size, is a country’s share of world GDP. Share2 = GDP2/GDPw

Exports from Country 1 to Country 2 will equal the goods available in Country 1 times the relative size of country 2, divided by the transportation costs:

n

W

n distGDPGDP

GDPdistShareGDP

Trade 21211

==

APPLICATION


The Gravity Equation for Canada and the United States

• Figure 6.9 shows data collected on the value of trade between Canadian provinces and the U.S. states in 1993.

• An exponent of 1.25 is used on the distance variable based on other research studies.

• The horizontal axis is the log of the gravity equation The higher the value means either a large GDP for the trading province and state or a smaller distance between them

• The vertical axis shows the 1993 value of exports between a Canadian province and U.S. state or vice versa, again in logarithms.

APPLICATION



• Each of the points in panel A represents the trade flow and gravity term between one state and one province.

• We can see that a pair with a high gravity term also has more trade. This supports the gravity equation theory.

• We can also estimate a best fit line through the data points which gives a constant term of 93. When the gravity term equals 1, then the predicted amount of

trade between that state and province is $93 million.

APPLICATION



Figure 6.9

APPLICATION


Trade with Canada

• The gravity equation should also work well at predicting trade within a country, or intra-national trade.

• Panel B of figure 6.9 graphs the value of exports and the gravity term between any two Canadian provinces.

• There is a strong positive relationship between the gravity term between two provinces and their trade.

• The best fit line gives a constant term of 1300. When gravity term is 1, the predicted amount of trade is $1.3

billion.

APPLICATION


Trade with Canada

Figure 6.9

APPLICATION


Trade with Canada

• Taking the ratio of the constant terms (1300/93 = 14), means on average there is 14 times more trade within Canada than occurs across the border.

• The number is even higher if we consider an earlier year before the free trade agreement. In 1988, intra-national trade within Canada was 22 times higher.

• The fact that there is so much trade within Canada reflects all the barriers to trade that occur between countries. Tariffs and Quotas Other administrative rules and regulations Geographic an cultural factors


Imperfect Competition with Homogeneous Products: The Case of Dumping

• While product differentiation is a good assumption for many goods, it does not hold for unprocessed goods traded between firms. Chemicals, lumber, minerals, steel, can all be treated as

homogeneous.

• However, in many of these goods, the markets are not perfectly competitive. We want to assume imperfect competition here even though the

goods are homogeneous.

• With imperfect competition, firms can charge different prices across countries and will do so whenever it is profitable.



• A Model of Product Dumping Dumping occurs when a firm sells a product abroad at

a price that is either less than the price it charges in its local market, or less than its average cost to produce the product.

Under the rules of the WTO, am importing country is entitled to apply a tariff, called an antidumping duty any time a foreign firm dumps its product on a local market.

Why do firms dump at all?



• Discriminating Monopoly Assume a foreign monopolist sells both to its local

market and exports to Home.

The monopolist is able to charge different prices in the two markets. Discriminating monopoly

Firm has a monopoly at home but faces a competitive export market Downward sloping demand curve in home market. Horizontal demand curve in export market.

Consider the following example:



Price

Foreign Quantity

MC*

Local Demand, D*

Local Marginal Revenue, MR*

AC*

Export Price, P

Export Demand, D, and export marginal revenue, MR

C

Local Price, P*

Q2

B

Q1

Local Sales Exports

The export monopoly maximizes profits at point B where local marginal costs, MC*, equal export marginal revenues, MR

AC1

The monopolist sells Q2 to its local market and (Q1-Q2) to its export market

The quantity sold in the local market is at point C where local marginal costs, MC*, equal local marginal revenues, MR*. They can then charge a local price, P*, from the local demand curve

Notice the local price, P*, is greater than AC*; but, the export price, P, is less than AC*. This means the firm is dumping into the export market

Figure 6.10



• The Profitability of Dumping The Foreign firm charges P* selling Q2 in the local

market.

The local price is higher than the export price. It is dumping its product into the export market.

The average costs are lower than the local price but higher than the export price.

Since AC is above the export price, the firm is also dumping according to this cost comparison.



• Numerical Example of Dumping Suppose the following data:

Fixed costs = $100; Marginal costs = $10/unit Local price = $25; Local quantity = 10 Export price = $15; Export quantity = 10

Profits from the local market are: $25(10) - $10(10) - $100 = $50

Average costs for the firms are $20.

Profits in the export market are: [$25(10) + $15(10)] - $10(20) - $100 = $100

The export price is below AC but above MC.



• Reciprocal Dumping It can happen that firms in both countries are accused

of dumping in the other—this is reciprocal dumping.

For example, shortly after the U.S. ruled that Canadian greenhouse tomatoes were being dumped into the U.S., the Canadian government investigated dumping against American fresh tomatoes.

The final ruling was that there was no harm or injury to the firms in either country, so no antidumping duties were applied.



• Reciprocal Dumping How can it be profitable for both firms to charge prices

for their exports that are below their local prices?

We show that, in fact, it is a common feature of imperfectly competitive markets.

Rather than selling additional units in the local market and depressing its own price, a firm can enter the export market.

It then depresses the price of firms abroad by increasing quantity.

Since both firms have this incentive, equilibrium will have both firms selling abroad.



• Numerical Example of Reciprocal Dumping Assume Home and Foreign have identical demand

curves: P = 100 – Q

Remember, marginal revenue, MR = P – ΔP*Q

The price drops $1 for even extra unit sold, so ΔP=1 and MR = P-Q, this gives: MR = P – Q = (100 – Q) – Q = 100 – 2Q

Home and Foreign have identical MC = $20/unit.

Without trade, we get the monopoly equilibrium Q = 40 and P = $60



(a) Home (b) Foreign

Figure 6.11

Quantity Quantity

Price Price

DMR

D*MR*

$20

$60A A*

40 40

MC

No-trade monopoly equilibrium


As with any monopoly, each firm will choose their profit maximizing output where MR=MC and get their price from the demand curve: Q=40 and P=$60. For the firm to increase production would require lowering price, which is not profitable.



• Trade Equilibrium in the Home Market Foreign has an incentive to export to Home (since price is

still above marginal cost and doing so depresses price for the other firm).

The Foreign firm will export more than one unit since the MR>MC.

We can use the equilibrium condition (MR=MC) from before to determine how much will be exported.

In this case we will assume there are transportation costs for the exports of $10 per unit, so the equilibrium condition is: $20 + $10 = P – QF

QF = P - $30



• Trade Equilibrium in the Home Market In response to the price decline, the Home firm will reduce the

quantity it produces in Home.

Home firm will choose the Home quantity by comparing MR to MC in the Home market: QH = P - 20

The price in the Home market is related to the total quantity sold: P = 100 – Q = 100 – QF – QH

Using the profit maximizing conditions and the demand equation, we get: P = 100 – (P - $30) – (P - $20) = $50

The equilibrium price with trade is $50. Home produces 30 for domestic market and 20 for Foreign.



• Two-way Trade

Since the Foreign firm has an incentive to enter the Home market and both firms are the same, the Home firm has the same incentive in the Foreign market.

Foreign price with trade will also be $50 with Foreign producing 30 units for its own market and importing 20 units from Home. B and B* in figure 6.11

Notice that as each firm sells in the other market, prices fall in both market. Firms are engaged in “reciprocal dumping”



(a) Home (b) Foreign

Quantity Quantity

Price Price

DMR

D*MR*

$20

$60A A*

40 40

MC



30 30 50

B*

50

B$50

Local Sales

Local Sales

Exports=Imports

Exports=Imports

Reciprocal Dumping

Exports equal imports for both Home and Foreign from each other – Reciprocal Dumping

From the previous derivation, we saw that equilibrium with reciprocal dumping will occur at points B and B*, at a price of $50 selling 50. Each country will have 30 in local sales and export 20.

Figure 6.11



• Measurement of Dumping In trade disputes over dumping, the government in

each country compares the price that a Foreign firm earns in the country’s market, net of transportation costs, to the price the Foreign firm earns in its local market.

In our example, Foreign exports at $50 with $10 in transportation costs: net $40.

Since the price in local market is $50, Foreign is dumping in the Home market.

Similarly, Home is dumping into the Foreign market.

Reciprocal dumping is occurring.



• Measurement of Dumping This example has allowed us to illustrate the incentives

for firms to enter markets abroad.

For the first units sold to the export market, the MR for the exporting firm will always be higher than the MR of the local firm abroad. The exporting firm does not lose as much revenue from existing

sales by selling additional units in the export market.

The Foreign firm has an incentive to enter the Home market and the Home firm has an incentive to enter the Foreign market.

We should not be surprised to see two-way trade even with homogeneous products.

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