Increasing Returns and Home Markets. Edward Chamberlin. Doris Lessing (left) and Paul Krugman (right). Challenges to neoclassical trade theory:.
Doris Lessing (left) and
Paul Krugman (right)
Where is a vector of external effects that affect the productivity of firms in sector I and country k.
We know that the bold is larger than 1, indicating that Home is better off relative to autarchy. Foreign may be worse off if Home is an inefficient place for the IRS sector:
Suppose there are i = 1,…,N product varieties, where N is endogenous.
There are L consumers, each of whom has identical utility from consumption:
Each consumer recieves labor income w, so the consumer can only consume
Consumers maximize Utility, generating FOC:
Totally differentiate and we get that the effect of a change in price is
Define as the elasticity of demand.
Notice that Elasticity depends on Consumption!
Firms require labor to produce:
Full employment, denoting demand for each good by Lc:
We further assume CES preferences with a continuum of varieties.
Procedure: Solve utility maximization for each variety, proceed to maximize total production.
Solving demand for each variety:
where P is the ideal price index,
Increasing Returns Technology (Fixed Cost) with new notation:
Each firm maximizes profits subject to the above.
Each firm is too small to affect wL or P, and so prices with a constant markup over marginal cost:
Free entry means profits are 0:
Labor market clearing:
denotes country I’s production of good k, with prices normalized to one.
is share of country j’s share of world expenditure.
Exports from country i to country j of product k are:
Summing over all products k
Bilaterally, we can write the equation in logs:
Normalize wages and prices to 1.
Demand for domestic residence of domestic products is:
Goods market clearing: