Explanations of Intra-industry Trade in Differentiated Products

1. Explanations of Intra-industry Trade in Differentiated Products • Economies of Scale • The Product Cycle • Overlapping Demands

2. Types of Imperfect Competition • Monopolistic Competition = A market structure in which many firms produce slightly differentiated goods but each firm maintains some control over its own price. Examples = Fast food restaurants, gas stations. • Oligopoly = A market structure in which a few firms produce all of the output for an industry, and each firm has some control over its own price. Examples = Autos • Monopoly = A market structure in which one firm supplies the entire industry for a particular good and maintains considerable control over its own price. Examples are electricity, patented goods (e.g., pharmaceuticals).

3. Economies of Scale • Economies of scale occur when average costs fall as a firm’s plant size (its scale) increases. • Also sometimes referred to as decreasing costs or increasing returns to scale

4. Average Cost A AC0 B AC1 C AC 50,000 200,000 250,000 Number of Cars Economies of Scale continued Figure 4.1: Economies of Scale as a Basis for Trade Currently, a domestic firm is producing at a level below its minimum cost • Domestic demand for the product increases Its production increases thereby decreasing costs Making it cheaper than other countries and allowing it to export 0

5. Economies of Scale continued Another Example • Suppose that the U.S. and Germany both produce full-size and compact cars. • Assume both countries have same cost structures • Initially each country produces 75,000 of each type of car • After trade, combined demand for each type of car is greater. • U.S. increases output of full-size cars due to increased demand.

6. Average Cost Average Cost AC0 AC0 A’ A B’ B AC1 AC1 Number of Full-Size Cars Number of Subcompact Cars 75,000 75,000 150,000 150,000 AC AC’ Economies of Scale continued Figure 4.2: Economies of Scale as the Basis for Intra-industry Trade And Germany can increase output of compact cars due to increased demand U.S. trades full-size cars for compact cars. US increases output of full-size cars due to increased demand. Costs decrease in both types of cars as production increases

7. Economies of Scale continued • U.S. trades full-size cars for compact cars. • US increases output of full-size cars due to increased demand. • Germany increases output of compact cars due to increased demand (A to B).

8. Sources of Economies of Scale • Internal economies of scale • Occur when an increase in output causes a decline in average costs of production. • Typical whenever fixed costs are a significant share of percentage of total costs • Examples are capital-intensive goods • Or firms with high fixed costs due to R&D such as autos, steel, software development

9. Sources of Economies of Scale • External Economies to Scale • Occur when firms’ average unit costs fall as output in the whole industry increases. • Often associated with increased competition among suppliers or availability of a large pool of labor with necessary skills • Often associated with geographic clustering as in software (Silicon Valley)

10. Explanations of Intra-industry Trade in Differentiated Products

11. Technology-based theories of trade The product cycle

12. Under HOM- all countries access to and use the same technology • This implies that isoquant map identical cross countries • However, countries may use different capital-labor ratios in their production process –because of different factor prices – that reflected differences in factor endowments • under unrestricted trade – factor prices equalized across countries • Thus all firm use identical production techniques

13. Understanding Different technologies • Some industries probably satisfy the assumption of identical technologies • Some other less viable • Eg. The electric power industry • Countries endowed with large flowing river –access to technology for production of electric power • But this technology not available in desert countries • Thus natural endowment of resources can be one possible of differences in technologies

14. Other sources –include technologies kept secret for security reasons • Eg. Nuclear power and some computer capabilities, legal restrictions (patents, IPR)

15. Product cycle hypothesis • economist suggested a number of ways that cross country differences in technology affect international trade • Product cycle hypothesis – first by Raymond Vernon (1960s) • Certain countries tend to specialize in making new technologically innovative products • While other countries specialize in producing already establish goods

16. Technological innovation and new product development tend to occur in a few major industrialized economies • Countries that have highly educated and skilled workforces and the relatively high level of expenditures R&D • this process is followed by product stabilization in design and production, and finally complete standardization and production in a developing country.

20. Early production • Small scale • Innovation take place 1 • Small scale --- produce at domestic level • Only technology firm own the new technology • Production occurs in firm's home country Refines both product and production process • R&D and production improvements require inputs in developed countries. • New products need high-income markets as prices are relatively high. • May export to other developed countries

21. technology gap and Product cycle hypothesis Quantity D Consumption A B C Masa Stage 1: Introduction (new-product phase) the product is produced and consumed only in the innovating country

22. Product becomes more standardized. • Production may move to other developed countries instead of exporting to those countries. • Country where product was developed may begin to import the good from the new production country. Domestic production & consumption ↑ Production rise more rapidly to accommodate growing export demand The innovating firm still controls the new technology Firm amend and make the product perfect --for domestic then export 2

23. STAGE 2: (PRODUCT GROWTH PHASE) Production is perfected in the innovating country and increases rapidly to accommodate rising demand at home and abroad. (EKSPORT) Consumption Qty D Production Innovating country EXPORT IMPORTS A B C Time At this stage not yet any foreign production of the product, so that the innovating country has a monopoly in both the home and export markets.

24. As production technology become standardized -- no longer trial and error 3 • It feasible to relocate production to other countries in which the cost of standardized production and development • engineering skills of that labor force, relocation of production becomes economical • Domestic production still continue in innovating country • Low cost foreign producers licensed by the innovating firm capture export market Innovating firm may find it profitable to license the technology to other firms both domestically and abroad • The technology has diffused completely • Any patents that once limited its use have expired • Domestic production ↓ • Domestic industry loses both its domestic & export mkts. Import rather than domestic production To serve the innovating country’s domestic market 4

25. STAGE 3: (product-maturity phase) the product becomes standardized and the innovating firm may find it profitable to license other domestic and foreign firms to also manufacture the product. Consumption Qty Innovating country D Production EKSPORT Production Consumption Imitating country IMPORTS A B C Time The imitating country starts producing the product for domestic consumption.

26. STAGE 4: the imitating country facing lower labor and other costs now. The product has become standardized and no longer require development and engineering skills, begins to undersell the innovating country in 3rd market. Consumption Qty Innovating country D Production EXPORT Production Consumption Imitating country IMPORTS A B C Time Production of the product in the innovating country declines. Brand competition now gives way to price competition.

27. Product complete • Finally product complete its cycle • Although domestic consumption of the good may continue, import satisfy that consumption • Innovating countries – concentrate on new technological innovation

28. STAGE 5: the imitating country starts underselling the innovating country in the latter’s market. production of the product in the innovating country declines rapidly or collapse. Penggunaan Kuantiti IMPORTS D Negara innovatif Pengeluaran Pengeluaran EKSPORT Penggunaan Negara peniru A B C Masa Note: Stage 4 and 5 refer to product-decline stage. Technological diffusion, standardization, and lower cost abroad thus bring the end of the life cycle for the product.

29. Product Cycle Figure 4.4: The Product Cycle

30. It is now the time that the innovating country to concentrate attention on new technological innovations and to introduce new products. • Eg. That have gone through such product cycles are television, radio, handphone…..

31. Overlapping Demands • Consumer demand is likely to be similar across countries with similar income levels. • Domestic producers target at tastes and income levels of the domestic market. • And their products are exported to other countries with similar tastes and income levels. • Products produced in other countries with similar tastes become imports.

32. Overlapping Demands • Automobile trade is a likely example. • U.S. car manufacturers make cars that satisfy tastes and income levels of US market. • Some US consumers may prefer cars produced abroad that target foreign tastes/income levels. • Some foreign consumers may prefer US cars. • This exchange leads to intra-industry trade. • Linder states that high-income countries will trade with other high-income countries since income determines general tastes/preferences.

33. The Welfare Implication of Intraindustry Trade • International trade increases world output and economic welfare. • Welfare gains also occur with intra-industry trade even though processes are different. • Intraindustry trade in homogeneous products • Welfare gains similar to welfare gains under interindustry trade • Goods are provided based on lower opportunity costs due to lower transportation, insurance, financing or seasonal products.

34. The Welfare Implication of Intraindustry Trade • Product differentiation increases choice, but are produced under imperfect competition • P > MC – Price is higher than with perfect competition and firms are characterized by excess capacity so produce less than efficient quantity. • Welfare is improved from increased choice and competition. • Prices tend to be lower with trade in differentiated products. • Quality tends to be higher.

35. The Welfare Implication of Intraindustry Trade • Reduces monopoly power of domestic firms • Firms can produce at higher levels realizing economies of scale leading to lower prices. • Easier for resources to reallocate among industries • Similar industries leads to less adjustment costs • Contracting and expanding industry are both skilled-labor or capital intensive

36. Summary • Intra-industry trade accounts for a growing share of international trade. • Intra-industry trade can occur in both homogeneous and differentiated products. • Intraindustry trade widens the size of the domestic market, permitting firms to take advantage of economies of scale. • Intraindustry trade in differentiated products has two main implications for the gains from trade: • Consumers gain from having a greater variety of goods to choose from • Unit costs and prices decline under increasing returns production functions.