Economies of Scale, Imperfect Competition, and International Trade

CHAPTERS I X 6 Economies of Scale, Imperfect Competition, and International Trade Raj Kumar, Assistant Professor, College of Vocational Studies, New Delhi. Salvatore: International Economics,

In this chapter: Introduction The Heckscher-Ohlin Model and New Trade Theories Economies of Scale and International Trade Imperfect Competition and International Trade Trade Based on Dynamic Technological Differences Costs of Transportation, Environmental Standards, and International Trade Salvatore: International Economics,

Introduction Heckscher-Ohlin theory based comparative advantage on differences in factor endowments among nations. Leaves significant portion of international trade unexplained. Need complementary trade theories to fill in the gaps. Salvatore: International Economics,

Relaxing the assumptions Relaxing the first assumption (2 nation, 2 factors, 2 commodities) leaves the HO model basically valid, as long as number of commodities is equal to or larger than the number of factors. In general case, we will require the construction of a factor intensity index to predict the pattern of trade. This can be complex but still be possible. Salvatore: International Economics,

Relaxing the assumptions Salvatore: International Economics, Relaxing second assumption-both nation uses same technology. However, technology can be regarded as a factor of production, and trade based on given technological difference among nations could be viewed as falling within the realm of the HO theory. But trade based on change in technology over time among nations is different matter, These are explained by the technological gap and product cycle models. Both models are dynamic extension of HO theory

Relaxing the assumptions Salvatore: International Economics, Third assumption-absence of factor intensity reversal. Factor intensity reversal would lead to the rejection of the HO model. Empirical studies, however, indicates that factor intensity reversal is not very common in the real world. It seems that the Leontief paradox could be eliminated by the inclusion of human capital, the exclusion of commodities intensive in natural resources, and comparing the K/L ratio in production versus consumption rather than in export versus imports.

Relaxing the assumptions Salvatore: International Economics, Forth assumption- CRS. International trade can also be based on increasing returns to scale. Increasing scale can be regarded as complementary to the HO theory in that they try to explain a portion of international trade not covered by the basic HO theory. 5th assumption-incomplete specialization in both nations. If trade bring about complete specialization in production in one of the nations, relative commodity price will be equalized but factor price will not.

Relaxing the assumptions Salvatore: International Economics, 6th assumption- equal tastes has been more or less verified empirically. Tastes are certainly not sufficiently different across nations to overcome difference in the relative physical availability of factors of production in explaining different relative commodity prices and trade among nations. 7th assumption- Perfect competition in all product and factor markets.

Relaxing the assumptions Salvatore: International Economics, It seems that about half of the trade in manufacturing goods among industrialised nations is based on product differentiation and economices of scale, which are not easily reconciled with the HO factor endowment model. To explain Intra-Industry trade, we need new trade theories. 8th Assumption-No international factor mobility but perfect mobility in a nation.

Relaxing the assumptions Salvatore: International Economics, The relaxation of 8th assumption will modifies but does not invalidate the HO model. As we will explain, international factor mobility can be substitute for international trade in bringing about equality of relative commodity and factor prices among nations. With some, but less than perfect international factor mobility, the volume of trade required to bring about relative commodity and factor equalization would be less.

Relaxing the assumptions Salvatore: International Economics, Similarly, transportation costs and other nonprohibitive obstructions to the flow of international trade (Assumption 9) reduce the volume and the benefits of international trade, but they only modify the HO theorem and the factor equalization theorem. 10th assumption-resources are fully utilised. If we relax this assumption, then HO theorem incorrectly predict the pattern of trade. But the full employment assumption is for the most part satisfied, at least in Industrial countries.

Relaxing the assumptions Salvatore: International Economics, 11th Assumption-international trade among nation is balanced. Since most trade imbalance are generally not very large in relation to GNP, the charge that the HO model might be unable to correctly predict the pattern of trade is true only for those commodities in which the nation has only a very small comparative advantage.

Relaxing the assumptions Salvatore: International Economics, Relaxing most assumptions of H-O theory modifies but does not invalidate the theory. However, relaxing assumptions of perfect competition and constant economies of scale require complementary theories to explain trade. Additional trade model required to explain trade based on differences in technological changes over time.

Economies of Scale and International Trade Salvatore: International Economics, One of assumption of the HO model was that both commodities were produced under constant returns to scale in the two nations (assumption 4). In this section, we relax this assumption With Increasing returns to scale, mutually beneficial trade can take place when the two nations are identical in every respect. This is type of trade that the HO model does not explain.

Economies of Scale and International TradeType of economic scale Salvatore: International Economics, Economies of scale could mean either that larger firms or a larger industry is more efficient. External economies of scale occur when cost per unit of output depends on the size of the industry. Internal economies of scale occur when the cost per unit of output depends on the size of a firm.

Economies of Scale and International Trade • Increasing returns to scale • Production situation where output grows proportionately more than the increase in inputs (doubling inputs more than doubles output). • We can explain mutually beneficial trade based on increasing returns to scale by fig 6.1 Salvatore: International Economics,

FIGURE 6-1 Trade Based on Economies of Scale. Salvatore: International Economics,

Economies of Scale and International Trade • Increasing returns to scale • Significant international economies of scale from: • Outsourcing – purchase by firm of parts and components abroad in order to keep costs down. • Offshoring – firm producing in its own plants abroad some of the parts and components used in its products. Salvatore: International Economics,

Economies of Scale and International Trade Salvatore: International Economics, Important points It is matter of complete indifference which of the two nations specialises in the production of commodity X or commodity Y. In the real world, this may result from historical accident. It should be clear (at-least intuitively) that the two nations need not be identical in every respect for mutually beneficial trade to result from increasing returns to scale

Economies of Scale and International Trade Salvatore: International Economics, If economice of scale persist over a sufficiently long range of outputs one or a few firms in the nation will capture the entire market for a given product, leading to monopoly or oligopoly. During the past decade or so, there has been a sharp increase in international trade in parts and components, as well as in setting up of production facilities abroad, and these have been the source of new and significant international economic of scale

Economies of Scale and International Trade Salvatore: International Economics, Economic of Scale vs External economics Economic of scale or increasing return to scale refers to the reduction in the average costs of production as firms output expands. Thus, economic of scale or increasing returns to scale are internal to the firm. External economics refer to the reduction in each firm’s average costs of production as the entire industry output expands (for reason external to the firm)

Imperfect competition and international TradeTrade based on Product Differentiation As large portion of the output of modern economic today involves differentiated rather than homogenous products. As a result, a great deal of international trade can does involve the exchange of differentiated products of the same industry or broad product group. Intra-industry trade refers to the exchange of similar products belonging to the same industry. Salvatore: International Economics,

Imperfect competition and international TradeTrade based on Product Differentiation Salvatore: International Economics, Intra industry trade arises in order to take advantage of important economic scale in production. That is, international competition forces each firm or plant in industrial countries to produce only one, or at most a few, varieties and styles of the same product rather than many different varieties and styles. This is crucial in keeping unit costs low.

Imperfect competition and international TradeTrade based on Product Differentiation Salvatore: International Economics, Important features intra-industry trade is based on product differentiation and economic of scale. With differentiated products produced under economics of scale, pre-trade relative commodity prices may no longer accurately predict the pattern of trade, with intra industry trade based on economies of scale it is possible for all factors to gain. Intra industry trade is related to the sharp increase in international trade in parts and components of a product

Imperfect competition and international TradeTrade based on Product Differentiation Salvatore: International Economics, Application This may explain why the formation of the EU and the great postwar trade liberlisation in manufactured goods met little resistance by interest groups. This is to be contrasted to the strong objections raised by labor in industrial countries against liberalising trade with some of the most advanced of the developing countries because this trade, being of the inter-rather than of the intra industry trade type.

Imperfect competition and international TradeTrade based on Product Differentiation Salvatore: International Economics, Conclusion Comparative advantage seems to determine the pattern of inter-industry trade, while economies of scale in differentiated products give rise to intra industry trade. Both type of international trade occur in today’s world.

Imperfect competition and international TradeTrade based on Product Differentiation Salvatore: International Economics, The more dissimilar are factor endowments, the more important are comparative advantage and inter industry trade (as between developed and developing countries). On the other hand, intra industry trade is likely to be dominant the more similar are factor endowments (as among developed countries) So one could say that inter industry trade reflect natural comparative advantage while intra industry trade reflect acquired comparative advantage.

Imperfect competition and international TradeTrade based on Product Differentiation Salvatore: International Economics, • Contrasts to H-O Model • Trade in H-O model based on factor endowment differentials, but intra-industry trade is based on product differentiation and economies of scale, and will likely be larger for nations of similar size and factor proportions. • With differentiated products produced under economies of scale, pretrade-relative commodity prices may not accurately predict patterns of trade as they do under H-O model.

Imperfect competition and international TradeTrade based on Product Differentiation Salvatore: International Economics, • Contrasts to H-O Model • H-O model predicts trade will lower returns of nation’s scarce factor. With intra-industry trade based on economies of scale, it is possible for all factors to gain. • Intra-industry trade is related to sharp increases in international trade in parts and components of a product, or outsourcing.

Imperfect Competition and International TradeThe Grubel-Lloyd Index (1975) |X - M| T = 1 - X + M • X = exports • M = imports • Numerator is absolute value • T ranges from 0 to 1 • T=0 when nation only imports or exports the good • T=1 when exports = imports. • Intra-industry Trade Index (T): Salvatore: International Economics,

FIGURE 6-2 Production and Pricing Under Monopolistic Competition. Salvatore: International Economics,

FIGURE 6-3 Monopolistic Competition and Intra-Industry Trade. Salvatore: International Economics,

Trade Based on Dynamic Technological Differences Salvatore: International Economics, • Product Cycle Model (Vernon, 1966) • Advanced industrialized countries develop and introduce new products, with temporary monopoly power as the sole exporter of the product. • As the technology producing the product becomes more widespread, production will spread to other nations. • This moves international trade to a standard comparative advantage framework

Trade Based on Dynamic Technological Differences Salvatore: International Economics, • Product Cycle Model (Vernon, 1966) • As production becomes standardized, the original introducer of the product loses its technologically based comparative advantage in the production of the product and becomes an importer of the product.

FIGURE 6-4 The Product Cycle Model. Salvatore: International Economics,

Costs of Transportation, Environmental Standards and International Trade Salvatore: International Economics, • Transportation costs • Transport, or logistics, costs are the freight charges, warehousing costs, costs of loading and unloading, insurance premiums, and interest charges incurred while goods are in transit between nations. • Homogeneous goods will be trade internationally only if the pretrade price difference exceeds transport costs.

Costs of Transportation, Environmental Standards and International Trade Salvatore: International Economics, • Transportation costs • Nontraded goods and services are goods for which transport costs exceed price differences across nations. • Examples: • Cement is not traded internationally because of its high weight-to-value ratio. • Average people do not travel from New York to London for a haircut.

Costs of Transportation, Environmental Standards and International Trade • Two ways to analyze transport costs • General equilibrium analysis • Uses production frontiers or offer curves, and expresses transport costs in terms of relative commodity prices. • Partial equilibrium analysis • Analyze absolute cost by holding constant exchange rates, income, and all else in the two nations except amount of good produced, consumed and traded. • More straightforward method than general equilibrium analysis. Salvatore: International Economics,

FIGURE 6-5 Partial Equilibrium Analysis of Transport Costs. Salvatore: International Economics,

Costs of Transportation, Environmental Standards and International Trade • Transport costs influence location of production and industry: • Resource-oriented industries locate near the source of raw materials used by the industry. • Market-oriented industries produce goods that become heavier or more difficult to transport during production, so they locate near the markets for their products. • Footloose industries face neither substantial weight gains nor losses during production, and can locate where availability of other inputs leads to lower manufacturing costs. Salvatore: International Economics,

Costs of Transportation, Environmental Standards and International Trade • Environmental standards • Refers to levels of air, water and thermal pollution resulting from garbage disposal that a nation allows. • A nation with lower environmental standards can use the environment as a resource endowment, achieving comparative advantage in polluting goods and services. Salvatore: International Economics,

Appendix to Chapter 6 External Economies and Specialization The Learning Curve and Specialization Salvatore: International Economics,

FIGURE 6-6 External Economies and Specialization. Salvatore: International Economics,

FIGURE 6-7 The Learning Curve and Specialization. Salvatore: International Economics,

Economies of Scale, Imperfect Competition, and International Trade