INTERNATIONAL ECONOMICS

1. INTERNATIONAL ECONOMICS Lecture 11 | Lucía Rodríguez| Scale, Competition and Trade

2. SCALE, COMPETITION AND TRADE:MOTIVATION • The observed importance of intra-industry trade: • Traditional Trade Theory is no longer able to explain these patterns Exports and Imports within sectors exhibit a tendency towards equalization rather than national specialization Grubel-Lloyd index indicates the relative importance of inter (tends to 0) vs. intra-industry (tends to 1) trade • A new Trade Theory was needed to explain why similiar countries (in terms of technology, endowments,…) gain from trading with each other and why a significant part of that trade is made within the same industries. Intra-Industry Trade: Balassa (1966) showed that the trade share of the dominant suppliers in an industry during the implementation of the EEC decreased in practically all industries

3. SCALE, COMPETITION AND TRADE:BASIC ASSUMPTIONS Increasing Returns to Scale: Output grows proportionately more than the increase in inputs. Expanding output to serve a world market rather than a national market allows cost per unit to fall. • Economies of Scale: CA is no longer the driving force behind International Trade The actual pattern of trade often reflectsa created CA attributable to historical accidents or government intervention. • External Economies of Scale. • Firms continue to face rising marginal costs. • However, if all firms in an industry expand output, costs for all of them, as a group, will go down • Internal Economies of Scale. • As a firm expands its production, cost per unit declines. • As a result it may gain an advantage over other firms, both domestic and foreign, in producing a particular good or a particular variety of good.

4. SCALE, COMPETITION AND TRADE:BASIC ASSUMPTIONS • External Economies of Scale: Causes • Specialized Inputs: can allow • Common Pool of skilled Labor Productivity to rise Costs to fall • A localized industrial cluster provides a large enough market for specialized services suppliers to stay in business. • The availability of this network of suppliers (example: Silicon Valley), keeps key inputs cheaper and more easily available. No labor shortages Better matching and less unemployment • The concentration of firms in a single location makes it easier to switch employers • “It wasn’t that big a catastrophe to quit your job on Friday and have another job on Monday…You didn’t even necessarily have to tell your wife.”

5. SCALE, COMPETITION AND TRADE:BASIC ASSUMPTIONS • External Economies of Scale: Causes • Spillovers of Knowledge: spread new technology • Geographical concentration makes it easier to stay near the technological frontier • “If one man starts a new idea, it is taken up by others and combined with suggestions of their own, and thus becomes the source of further new ideas.” • A. Marshall Unit cost The learning curve: unit cost is lower the greater the cumulative output of a country’s industry. A country that has extensive experience in an industry may have lower unit cost than another with little or no experience. Co C1 L L* Cumulative Output Q

6. SCALE, COMPETITION AND TRADE:BASIC ASSUMPTIONS • External Economies of Scale: Consequences. • Production with decreasing opportunity cost: inward bending Y IncreasingReturnstoScale: B’ DecreasingOpportunitycost: Decreasing MRT B X

7. SCALE, COMPETITION AND TRADE:BASIC ASSUMPTIONS • External Economies of Scale: Consequences. • Trade with decreasing opportunity cost. • Pre-Trade Equilibrium: A. With identical technology, endowment and preferences. • Trade allows complete specialization [B, B’] • If we allow a 1 to 1 exchange ratio, we reach a higher indifference curve. (otherwise the gains from trade will not be symmetrical: different barter lines and policy debates). Y B’ II A I B X

8. SCALE, COMPETITION AND TRADE:BASIC ASSUMPTIONS • External Economies of Scale: Consequences. • The pattern of trade is not determined. Price, cost • Thailand could potentially supply the world market more cheaply than Switzerland. • If the Swiss industry gets established first, it may be able to sell watches at price P1 which is below the cost Co that an individual Thai firm faces when beginning production. Demand Co 1 P1 AC Swiss 2 AC Thai Watches Q1

9. SCALE, COMPETITION AND TRADE:BASIC ASSUMPTIONS • Internal Economies of Scale: Figure 1. Unit Cost of Production IncreasingReturnstoScale: Output growsproportionately more thantheincrease in inputs. Common in real-lifesituations: Existence of fixedcosts, thatgetdistributedover a largernumber of units, as the output levelincreases. Source: WTO World Trade Report 2008

10. SCALE, COMPETITION AND TRADE:BASIC ASSUMPTIONS • Previous theories anticipated the main concepts: • Vernon Product Cycle • Product development and sales at home. • Locating production close to buyers. • R&D spending. • Risk taking • Growth in X as foreign demand is cultivated. • Cultivate foreign markets among similar consumers. • Start outsourcing. • Decline in X as production abroad begins to serve its markets. • Sales in some countries reach a threshold level. • A certain degree of standardization has occurred. • Home country becomes a net importer as foreign prices fall. • Foreign firms master production processes and their cost fall as they increase production Domestic Production; Exports Dom Prod t X-M I II III IV For Prod Imports; Foreign Production

11. SCALE, COMPETITION AND TRADE:BASIC ASSUMPTIONS • Vernon Product Cycle: • International Trade is seen as a dynamic process, closely linked to technological progress and firm behavior. • There is no CA linked to a specific relative factor endowment. • Different specialization patterns might imply different value added. • Policy decisions might shape the trade pattern via subsidies, trade promotion,…

12. SCALE, COMPETITION AND TRADE:BASIC ASSUMPTIONS • Preference Similarities: • As a rule, a nation will export manufactured products for which it has a large and active domestic market, in order to achieve economies of scale and be competitive internationally. • The most receptive markets for exports will found in those countries with comparable income levels and tastes. Intuition:Incomepercapitashapesdomestic taste, which in turn sets thedomesticdemandthatwill determine the final production. Iftradeisallowed, therewillbeexchange of goods in whichtheereisanoverlap in demand: IntraindustryTrade

13. SCALE, COMPETITION AND TRADE:BASIC ASSUMPTIONS DifferentiatedProducts: Thesomewhatdifferentproductsproducedbydifferentmanufacturers in thesameindustry • Product Differentiation: • We do not observe complete specialization because consumers prefer to choose from different variaties: 'love of variety' This leads to Intra-Industry Trade, which arises to take advantage of economies of scale in production. • Intra-industry trade benefits consumers because of the wider range of choices available, and the lower prices due to Ec of Scale. • Both types of trade (inter and intra-industry) occur today and are backed by different theories. International competition forces each firm in industrial countries to produce just a few varieties and styles of the same product in order to keep unit costs low.

14. SCALE, COMPETITION AND TRADE:ASSIGNMENT • Evaluate the relative importance of economies of scale and comparative advantage incausing the following: • Most semiconductors are manufactured in either the US or Japan. • Most of the world's aluminium is smelted in Norway or Canada. • Much of the world's best wine comes from France. • Half of the world's large jet aircraft is assembles in Seattle. • Most Scotch whiskey comes from Scotland

15. SCALE, COMPETITION AND TRADE:MARKET STRUCTURE • External and Internal Economies of Sclae have different implications for the structure of industries • Internal Escale give large firms a cost advantage over small ones and thus will imply imperfect competition. • In a Perfect Competition set-up: • Firms are price-takers (no influence on prices). • Any individual firm represents only a tiny fraction of World Market. • In Imperfect Competition: • Firms are aware of their influence on prices (Boeing-Airbus) • Whenever there are only a few firms or produts are seen as differentiated. • Different market structures emerge…

16. SCALE, COMPETITION AND TRADE:MONOPOLISTIC COMPETITION • Production: • A firm faces a downward-sloping demand curve, as it has market power to set prices. • Price is no longer an indicator of the extra revenue from selling one more unit. • Optimal level of output where MC=MR. • The price consumers are willing to pay is given by their demand and represents mark-up over marginal costs. • P=ATC ensures no positive economic profit is made, because they would attract new entrants. Price P* Avg Total cost MC MR D Quantity Q*

17. SCALE, COMPETITION AND TRADE:MONOPOLISTIC COMPETITION • Assume the same initial conditions: technology, endowments and preferences. • All firms will have the same costs and prices initially and the same number of producers will exist in autarky. • As we allow them to trade, industry rationalization will occur due to greater competition in an integrated market: • Fewer total firms in each country. • Their Average output will be bigger. • AC of production falls, as D increases. • International Price will be smaller. • Trade: Pr, AC P C C’ P1 P2 PP line: Represents the relationship between the number of firms and their ability to compete. CC line: Represents the AC per firm increases with the number of firms as their size will decrease. C’C’ line: As trade is allowed, the size of the market expands and more firms can exist without losing economies of scale C C’ P Number of firms

18. SCALE, COMPETITION AND TRADE:EMPIRICAL EVIDENCE • The Gravity Equation: • Developed by Timbergen (1962), to predict the pattern of International Trade in absence of distortions. • The value of Bilateral Trade between two countries was an increasing function of GNP of both countries (via export supply capacity and import demand). • Trade flows were influenced negatively by the 'distance' between 2 countries, as a measure of transportation costs, language barriers, cultural factors and trade barriers. • Useful in explaining bilateral flows and trade policies such as the creation of Free-Trade areas, yet it did not appear to offer any role to CA. • Monopolistic approach was the first to provide a theoretical basis for this equation.

19. SCALE, COMPETITION AND TRADE:CASE STUDY: DUMPING • Focus on the consequences of imperfect competition for international trade: • The most common form of price discrimination in international trade is Dumping: the export price is lower than theone charged domestically. • For Dumping to occur, two conditions must be met: • Imperfect competition: firms are price-setters • Market segmentation: domestic residents cannot easily buy goods intented for exports Firms do notnecessarilychargethesamepriceforgoodsthat are exportedthanforgoodsthat are solddomestically.

20. SCALE, COMPETITION AND TRADE:CASE STUDY: DUMPING • Graphical example: • A monopolistthat faces a domesticdownward-sloping D. • It can sell as much as itlikes at theexportprice. • Sinceanadditionalunit can alwaysbesold at For P, thefirmincreasesits output untilFor P=MC (1). • Thequantitysold in thedomesticmarketisgivenbytheintersection of DomMR and For P (2). • Qdomimplies a Dom P (3) higherthantheexportprice. • General conditionforprice-discrimination: chargehigherpricesthehighertheelasticity Pr, C 3 Dom P MC 2 1 For P For D= For MR Dom MR Dom D Qdom Qmp Q Dom Sales Exports

21. SCALE, COMPETITION AND TRADE:CASE STUDY: DUMPING • Dumping is often seen as an unfair competitive practice: • Is price discrimination legitimate? Airlines discount to students, senior cityzens, and so on. • In practice, since the 70s international complaints about Dumping have been reported with increased frequency. • US Companies that claim to have been injured by firms that dump their products, can appeal to the Commerce Department for relief. • The International Trade Commission has to decide if there is unfair pricing that has caused injury. • If the complaint is ruled valid, an antidumping duty is imposed, equal to the difference between the actual and 'fair' price of imports.