INCREASING RETURNS TO SCALE AND IMPERFECT COMPETITION

1. 6 1 Basics of Imperfect Competition 2 Trade under Monopolistic Competition 3 Empirical Applications of Monopolistic Competition and Trade 4 Imperfect Competition with Homogeneous Products 5 Conclusions INCREASING RETURNS TO SCALE AND IMPERFECT COMPETITION

2. 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.

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

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

5. 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.

6. 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.

7. Trade Under Monopolistic Competition Figure 6.3

8. Trade Under Monopolistic Competition Numerical Example Using the cost curve in figure 6.3, we get: Fixed costs = $100 Marginal costs = $10/unit

9. Trade Under Monopolistic Competition • 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).

10. Trade Under Monopolistic Competition Figure 6.4 Price 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. P0 AC MC Demand curve facing each firm, d0 mr0 Q0 Quantity

11. Trade Under Monopolistic Competition A PA d1 mr1 Q1 Figure 6.5 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 Price Equilibrium is at A, producing Q1, where mr1 crosses MC. This gives price, PA, from the demand, d1 At Q1, the no-trade price PA = AC so the firms are all earning zero monopoly profits and there is no entry or exit P0 AC MC Firm demand when all firms charge the same price d0 D/NA Q0 Quantity

12. Trade Under Monopolistic Competition • 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.

13. Trade Under Monopolistic Competition • 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′.

14. Trade Under Monopolistic Competition Long-run equilibrium without trade Short-run equilibrium with trade B P2 B’ Q2 Q’2 Figure 6.6 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 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 Price A PA d2 AC MC mr2 D/NA Q1 Quantity

15. Trade Under Monopolistic Competition • 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.

16. Trade Under Monopolistic Competition D/NT Long-run equilibrium with trade C PW Q3 Figure 6.7 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 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 Price The demand faced by each firm is d3 with mr3. mr3=MC shows that each firm produces Q3 at a price PW Long-run equilibrium without trade A PA AC d3 MC mr3 Q1 Quantity

17. Trade Under Monopolistic Competition • 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.

18. Trade Under Monopolistic Competition • 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).

19. 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.

20. 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.

21. 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.

22. Empirical Applications of Monopolistic Competition and Trade • 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.

23. Empirical Applications of Monopolistic Competition and Trade Figure 6.8

24. Empirical Applications of Monopolistic Competition and Trade • 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.

25. Empirical Applications of Monopolistic Competition and Trade • 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.

26. Empirical Applications of Monopolistic Competition and Trade • 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.

27. Empirical Applications of Monopolistic Competition and Trade Figure 6.8

28. Empirical Applications of Monopolistic Competition and Trade • 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.

29. Empirical Applications of Monopolistic Competition and Trade • 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.

30. Empirical Applications of Monopolistic Competition and Trade • 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.

31. Empirical Applications of Monopolistic Competition and Trade • 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

32. Empirical Applications of Monopolistic Competition and Trade • 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.

33. Empirical Applications of Monopolistic Competition and Trade • 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.

34. Empirical Applications of Monopolistic Competition and Trade • 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.

35. Empirical Applications of Monopolistic Competition and Trade • 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.

36. Empirical Applications of Monopolistic Competition and Trade • 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

37. Empirical Applications of Monopolistic Competition and Trade • 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.

38. Empirical Applications of Monopolistic Competition and Trade Table 6.4 Index of Intra-Industry Trade for the U.S.

39. Empirical Applications of Monopolistic Competition and Trade • 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.

40. Empirical Applications of Monopolistic Competition and Trade • 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.

41. Empirical Applications of Monopolistic Competition and Trade • 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.

42. Empirical Applications of Monopolistic Competition and Trade • 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:

43. 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.

44. The Gravity Equation for Canada and the United States • 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.

45. The Gravity Equation for Canada and the United States Figure 6.9

46. 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.

47. Trade with Canada Figure 6.9

48. 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

49. 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.

50. Imperfect Competition with Homogeneous Products: The Case of Dumping • 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?