Selected Post-HeckscherOhlin Trade Models

Appleyard & Field (& Cobb): Chapter 10 Krugman & Obstfeld: Chapter 6

Todays Lecture
1. Economies of Scale (the Krugman model) 2. Domestic monopolies 3. Imitation Lag and The Product Cycle Model 4. The Linder Model 5. Gravity Models 6. Geography and Trade

The Krugman Model: Assumptions

1. 2. 3. 4. 5. 6.

Internal economies of scale Monopolistic competition (non-homogeneous goods) One factor of production (labour) Identical preferences Large number of goods produced with the same technology Full employment
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Paul R. Krugman (1979): Increasing returns, monopolistic competition, and international trade. Journal of International Economics, Vol. 9(4): 469-479

Key assumption 1: Economies of Scale

External: cost per unit depends on the size of the

industry, not the firm (Silicon Valley, Hollywood...) Internal: cost per unit depends on the size of the firm, not industry (Nokia, Phillips, GE...)
o

Krugman models technology: L=a+b*Q the amount of labour required (L) to produce amount of input (Q) depends on b*Q and constant a (fixed cost)

Doubling the inputs more than doubles the output (increasing internal economies of scale)
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Production Possibilities Frontier with Economies of Scale

Good Y

Good X

Key assumption 2: Monopolistic Competition

Each firm produces a different brand of the
substitutes for one another) strategic pricing)

good (goods that are not exactly the same, but that are

Each firm takes prices of rivals as given (=no

Each firm behaves as if it were a monopolist However, we assume easy entry and exit zero-profits in the long run
o

as long as (average cost < price) more firms enter the market
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Long-Run Market Equilibrium of Monopolistically Competitive Market

The more firms there are: 1. the less each firm produces higher average cost (due to increasing returns to scale) upward sloping cost curve 2. the harder the competition decreasing price downward sloping price curve
Price AC

p* P

n* Number of firms
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Introducing Trade to the Monopolistic Competition Model

Trade increases market size

firms exploit more of the returns to scale average cost decreases price decreases number of firms increases i.e. a larger variety of products is available for smaller price everybody are better off even if the countries are identical

Price ACA ACFT

pA pFT P

nA

nFT
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Number of firms

Intra- and Inter-industry Trade

Inter-industry trade: countries export goods of one

product category and imports goods of other product category as in the Ricardian as well as in the Heckscher-Ohlin model
o

e.g. Finland exports capital-intensive and imports labour intensive goods

Intra-industry trade: countries export and import

products of the same products category as in the Krugman model

o o

e.g. the U.S. exports and imports cars constitutes about of the world trade
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Explaining Trade Patterns

Inter-industry trade reflects the comparative

advantage
o

the pattern of trade is determined by relative factor endowments / technological differences

Intra-industry trade reflects economies of scale o the pattern of trade is unpredictable The relative importance of the two kinds of trade

depend on how similar the countries are

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Other Explanations of Intra-Industry Trade

Transport costs in large countries (e.g. a buyer in Maine buys the Canadian rather than the Californian product) Dynamic economies of scale: product differentiation + learning-by-doing Problems with statistics
o o

Aggregation: the categories are too wide (e.g. beverages

and tobacco)

Different quality of goods inside a product category

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Domestic monopolies
Domestic monopoly entering world markets Single monopoly & price discrimination Two domestic monopolies entering world

markets (reciprocal dumping model)

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Domestic Monopoly Entering World Markets

Price Domestic monopoly is able to get Pint from the world market Pint = minimum marginal revenue MC PD PA MRT Pint D MRA QDQA QT exports Quantity
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The monopolists maximizes profits by selling QD at home for price PD and QT-QD abroad for Pint

Single world supplier: Price Discrimination

Price Country 1 Price Country 2

P1

P2 MC

MR1 Quantity

D1

D2 MR2 Quantity P1>P2

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Profit maximizing monopolist, constant marginal cost, separate markets and a more price-elastic demand in country 2

Dumping

One of the most heated & active debates on trade concerns dumping. Roughly, this means that domestic producers complain that foreign competitors are selling at unfairly low prices and hence there should be antidumping measures (tariffs/quotas). There are (at least) two definitions what dumping means: o

Economics definition: Price discrimination in the context of international trade (a firm is charging
lower/higher price for its exports)

Pragmatic (lawyers) definition: the price is less than production cost. This could be an indicator of predatory pricing
where the aim is to drive the domestic competitor out of the market and afterwards the foreign firm would use its monopoly power and increase prices (and hence hurt the consumers).
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Reciprocal Dumping Model

Two countries, two firms producing identical

goods, transportation costs First, both are domestic monopolies Then, both enter each others markets
other when choosing prices and quantities)

duopoly (two firms taking into account the behaviour of each

In the (Nash) equilibrium price and output are determined in each

market for each firm (getting the result requires some knowledge of game-theory, so we will not derive it here)

The point is that the price is different in home and

16 Brander (1981): Intra-Industry Trade in Identical Commodities. JIE 11(1) Brander & Krugman (1983): A Reciprocal Dumping Model of International Trade. JIE 15(3/4)

foreign markets (hence dumping)

Imitation Lag
Assume that it takes time for new technology to spread Imitation lag: the time between products introduction in

country 1 and appearance of a version of that product produced in country 2 Demand lag: time between products appearance in country 1 and its acceptance in country 2 Net lag: imitation demand lag

Trade focuses on new products

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The Product Cycle Theory

The product cycle consists of three stages (new,

maturing, standardized) 1. A new product is introduced in a rich country

o o

High-income demands, labour-saving production technique The firms operate only in the domestic markets and learn production techniques and consumer responses

2. Maturing product o Economies of scale start to realize o Demand in other rich countries starts to emerge o Part of the production may be shifted to these countries and they might even start exporting to the original country
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The Product Cycle Theory

3. Standardized
Production, consumption (in the developed country)
exports imports

Consumption1

product
o

Product is well know to consumers and producer Production may shift to the developing counties
new product stage maturing product stage

Production1

Vernon (1966): International Investment And International Trade in the Product Cycle. Quarterly Journal of Economics 80(2).

time standardized product 19 stage

Dynamic Comparative Advantage

Dynamic comparative advantage: source of

exports shift throughout the life cycle of the good (e.g. electronics, cars) Resulting from economies of scale, factor mobility and innovation

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The Linder Model

Demand-oriented model to explain trade in

manufactured goods Preferences depend on the level of income tastes yield demands for products demands lead to production the kinds of goods produced depend on the per capita income level of a country

Trade occurs if there is overlapping demand

Trade will be more intense the more

similar the countries are

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The Linder Model: Example

Let A be the lowest quality and J the highest quality good Let country 1 be the poorest and country 3 the richest (see graph) Then country 1 consumes and produces goods AD, country 2 goods CF and country 3 good E J Countries 1 and 2 may trade goods C,D; countries 2 and 3 may trade goods E,F and countries 1 and 3 have no basis for trade
Goods J H G F E D C B A
S.B Linder (1961): An Essay on Trade and Transformation. John Wiley & Sons. Country 1 Country 2 Country 3

Income levels

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Gravity Models
Focus to explain the volume (not the composition) of

trade between two countries Popular framework in econometrics: Typically the volume of exports and imports is modelled as a function of countries national incomes, distance and other observable characteristics such as population size and institutional dummies (e.g. free trade area)

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Geography and Trade

Firms decide the location of production in the

presence of
o o

economies of scale rationale for concentrating production, imperfect competition transportation cost rationale for decentralizing production

coincidence that has set off a cumulative process Trade often takes place as a result of arbitrary specialization based on increased returns Policies may influence the beginning of such an cumulative process
P. Krugman (1991): Geography and Trade. MIT Press.

Dynamic comparative advantage may be based on

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Basis for Trade

Comparative Advantage
o o

Technology (Ricardian Model) Factor endowments (Heckscher-Ohlin Model)

Internal economies of scale (Krugman Model)

Dynamic Comparative Advantage o Innovation and product cycle o Cumulative process due to e.g. external economies of scale or learning-by-doing

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Impact of Trade
Ricardian Model o complete specialization o increase of countrys consumption possibilities Heckscher-Ohlin Model o shift of production towards commodity that uses intensively countrys abundant factor of production o real income of the abundant factor increases and the real income of scarce factor decrease o increase of countrys consumption possibilities Krugman Model o more firms and more varieties of goods o lower cost of production lower price
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