Chapter 6: Economies of Scale, Imperfect Competition, and ... · Chapter 6: Economies of Scale,...

Chapter 6: Economies of Scale, Imperfect

Competition, and International Trade

• Krugman, P.R., Obstfeld, M.: International

Economics: Theory and Policy, 8th Edition,

Pearson Addison-Wesley, 111-151

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Preview

• Types of economies of scale / Economies of

Scale and Market Structure

• Types of imperfect competition

Oligopoly and monopoly

Monopolistic competition

• Monopolistic competition and trade

• Inter-industry trade and intra-industry trade

• Dumping

• External economies of scale and trade

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Introduction

• When defining comparative advantage, the Ricardian and Heckscher-Ohlin models assume that production processes have constant returns to scale:

When factors of production change at a certain rate, output increases at the same rate.

For example, if all factors of production are doubled then output will also double.

• In practice, many industries are characterized by economies of scale or increasing returns:

Production is more efficient the larger the scale at which it takes place.

Where there are economies of scale, doubling the inputs to an industry will more than double the industry’s production.

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Table 1: Relationship of Input to Output for

a Hypothetical Industry

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Introduction

• How does international trade enter the story? Two countries: Germany and Britain

Each country produces 10 widgets. This requires 15 hours of labor in each country, so that in the world as a whole 30 hours of labor produce 20 widgets.

Suppose that we concentrate world production of widgets in Germany, and let Germany employ 30 hours of labor in the widget industry. In a single country these 30 hours of labor can produce 25 widgets.

Where does Germany find the extra labor to produce widgets and what happens to the labor that was employed in the British widget industry?

• Consumers in each country will still want to consume a variety of goods.

• International trade makes it possible for each country to produce a restricted range of goods and to take advantage of economies of scale without sacrificing variety in consumption.

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Introduction

• Each country specializes in producing a

limited range of products.

• This enables it to produce these goods

more efficiently than if it tried to produce

everything for itself.

• These specialized economies then trade

with each other to be able to consume

the full range of goods.

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Types of Economies of Scale

• 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.

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Types of Economies of Scale

• Imagine an industry that initially consists of 10 firms,

each producing 100 widgets, for a total industry

production of 1000 widgets. Two cases:

1) Suppose the industry were to double in size: so that it

now consists of 20 firms, each if which still producing

100 widgets. It is possible that the cost of each firm will

fall as a result of the increased size of the industry

External economies of scale

2) Suppose the industry’s output were held constant at

1000 widgets, but that the number of firms is cut in half

so that each of the remaining 5 firms produces 200

widgets.

Internal economies of scale

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Types of Economies of Scale and Market

Structure

• An industry where economies of scale are purely external will typically consist of many small firms and be perfectly competitive.

• Internal economies of scale, by contrast, give large firms a cost advantage over small and lead to an imperfectly competitive market structure.

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The Theory of Imperfect Competition

• Perfectly competitive market: Firms are price takers.

• Imperfect competition: Firms are aware that they can influence the prices of their products and that they can sell more only by reducing their price.

• Imperfect competition is characteristic both

of industries in which there are only a few major producers and

of industries in which each producer’s product is seen by consumers as strongly differentiated from those of revival firms.

• Each firm views itself as a price setter, choosing the price of its product, rather than a price taker.

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Monopoly: A Brief Review

• A monopoly is an industry with only one firm. (An oligopoly is an industry with only a few firms.)

• Figure 1 shows the position of a monopolistic firm.

• The firm faces a downward-sloping demand curve, D. The downward slope of D indicates that the firm can sell more units of output only if the price of the output falls.

• A marginal revenue curve corresponds to the demand curve.

Marginal revenue is the extra or marginal revenue the firm gains from selling an additional unit.

Marginal revenue for a monopolist is always less than the price because to sell an additional unit the firm must lower the price of all units (not just the marginal one).

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Figure 1: Monopolistic Pricing and

Production Decisions

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• Marginal revenue is always less than the

price, but how much less?

• The relationship between marginal revenue

and price depends on two things:

1) On how much output the firm is already selling

2) On the slope of the demand curve, which tells us

how much the monopolist has to cut his price to

sell one more unit of output

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• To see this, we assume that the demand curve the

firm faces is a straight line. In this case, the

dependence of the monopolist’s total sales on the

price it charges can be represented by:

• Q = A – B P,

• where Q is the number of units the firm sells, P is the

price it charges per unit, and A and B are constants.

In this case, marginal revenue (MR) is:

• MR = P – Q/B,

• implying

• P – MR = Q/B.

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Figure 1: Monopolistic Pricing and

Production Decisions

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• Average cost is the cost of production (C)

divided by the total quantity of production (Q).

AC = C/Q

The downward slope reflects our

assumption that there are economies of

scale, so that the larger the firm’s output is

the lower are its cost per unit.

• Marginal cost (MC) is the cost of producing

an additional unit of output.

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• Suppose that costs are represented by

• C = F + cQ,

where F represents fixed costs, those independent of the level of output.

c represents a constant marginal cost: a constant cost of producing an additional quantity of production Q.

• The fixed cost in a linear cost function gives rise to economies of scale, because the larger the firm’s output, the less is the fixed cost per unit. Specifically, the firm’s average cost (total cost / output) is:

• AC = C/Q = F/Q + c

• This average cost declines as Q increases because the fixed cost is spread over a larger output.

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Figure 2: Average Versus Marginal Cost

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• The profit-maximizing output of a monopolist is

that at which marginal revenue equals marginal

cost.

• Intersection of the MC and MR curves (Figure 1).

• The price at which the profit-maximizing output

QM is demanded is PM, which is greater than the

average cost.

• When P > AC, the monopolist is earning some

monopoly profits.

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Monopolistic Competition

• The usual market structure in industries characterized by internal economies of scale is one of oligopoly: several firms, each of them large enough to affect prices, but none with an uncontested monopoly.

• Special case of oligopoly: monopolistic competition

• Monopolistic competition is a model of an imperfectly competitive industry which assumes that

1. Each firm can differentiate its product from the product of competitors.

2. Each firm ignores the impact that changes in its price will have on the prices that competitors set: even though each firm faces competition it behaves as if it were a monopolist.

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• A firm in a monopolistically competitive

industry is expected:

to sell more as total sales in the industry increase

and as prices charged by rivals increase.

to sell less the greater the number of firms in the

industry and the higher its own price.

• These concepts are represented by the

function:

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Q = S[1/n – b(P – P)]

Q is an individual firm’s sales

S is the total sales of the industry

n is the number of firms in the industry

b is a constant term representing the

responsiveness of a firm’s sales to its price

P is the price charged by the firm itself

P is the average price charged by its competitors

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• To model the behavior of this monopolistic competitive industry, we assume that all firms in this industry are symmetric. The demand function and cost function are identical for all

firms.

• When the firms are symmetric, the state of the industry can be described without enumerating the features of all firms in detail: All we need to know to describe the industry is how many firms

there are and what price the typical firm charges.

• To analyze the industry to assess the effects of international trade, we need to determine the number of firms and the average price they charge.

• Our method for determining n and the average price involves three steps:

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1) We derive a relationship between the number of

firms and the average cost of a typical firm. We show

that this relationship is upward sloping.

2) We show the relationship between the number of

firms and the price each firm charges, which must

equal in equilibrium. We show that this relationship is

downward sloping.

3) We show that in the long run the number of firms is

determined by the intersection of the curve that

relates average cost to n and the curve that relates

price to n.

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1. The number of firms and average cost • As a first step toward determining n and P, we ask how the

average cost of a typical firm depends on the number of firms in the industry.

• Since all firms are symmetric in this model, in equilibrium they all will charge the same price.

Thus in equilibrium, all firms charge the same price: P = P

• In equilibrium,

Q = S/n + 0

AC = C/Q = F/Q + c = F(n/S) + c

• The more firms there are in the industry, the higher is average cost.

CC in Figure 3

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Figure 3: Equilibrium in a Monopolistically

Competitive Market

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Monopolistic Competition 2. The number of firms and the price

• If monopolistic firms have linear demand functions,

then the relationship between price and quantity may be represented as:

Q = A – BxP

where A and B are constants

and marginal revenue may be represented as

MR = P – Q/B

• When firms maximize profits, they should produce until marginal revenue is no greater than or no less than marginal cost:

MR = P – Q/B = c

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2. The number of firms and the price

Q = S[1/n – b(P – P)]

Q = S/n – Sb(P – P)

Q = S/n + SbP – SbP

Q = A – BxP

• Let A ≡ S/n + SbP and B ≡ Sb

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Monopolistic Competition 2. The number of firms and the price

MR = P – Q/B = c

MR = P – Q/Sb = c

P = c + Q/Sb

P = c + (S/n)/Sb

P = c + 1/(nxb)

The more firms there are in the industry, the lower the

price each firm will charge.

PP in Figure 3

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Figure 3: Equilibrium in a Monopolistically

Competitive Market

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• At some number of firms, the price that firms charge (which decreases in n) matches the average cost that firms pay (which increases in n).

• When the industry has this number of firms, each firm will earn revenue that exactly offsets all costs (including opportunity costs): price will match average cost.

This number is the equilibrium number of firms in the industry because firms have no incentive or tendency to enter or exit the industry.

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• If the number of firms is greater than or less

than the equilibrium number, then firms have

an incentive to exit or enter the industry.

Firms have an incentive to enter the industry when

revenues exceed all costs (price > average cost).

Firms have an incentive to exit the industry when

revenues are less all costs (price < average cost).

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Monopolistic Competition and Trade

• Because trade increases market size, trade is

predicted to decrease average cost in an industry

described by monopolistic competition.

Industry sales increase with trade leading to decreased

average costs: AC = F(n/S) + c

• Because trade increases the variety of goods that

consumers can buy under monopolistic competition, it

increases the welfare of consumers.

And because average costs decrease, consumers can also

benefit from a decreased price.

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Figure 4: Effects of a Larger Market

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Inter-industry Trade

• According to the Heckscher-Ohlin model or Ricardian

model, countries specialize in production.

Trade occurs only between industries: inter-industry trade

• In a Heckscher-Ohlin model suppose that:

The capital abundant domestic economy specializes in the

production of capital intensive cloth, which is imported by the

foreign economy.

The labor abundant foreign economy specializes in the

production of labor intensive food, which is imported by the

domestic economy.

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Figure 5: Trade in a World Without

Increasing Returns

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Intra-industry Trade

• Suppose now that the global cloth industry is

described by the monopolistic competition model.

• Because of product differentiation, suppose that each

country produces different types of cloth.

• Because of economies of scale, large markets are

desirable: the foreign country exports some cloth and

the domestic country exports some cloth.

Trade occurs within the cloth industry: intra-industry trade

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• If domestic country is capital abundant, it still

has a comparative advantage in cloth.

It should therefore export more cloth than it

imports.

• Suppose that the trade in the food industry

continues to be determined by comparative

advantage.

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Figure 6: Trade with Increasing Returns

and Monopolistic Competition

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Inter-industry and Intra-industry Trade

• Notice these four points about the pattern of trade:

1) Interindustry (cloth for food) reflects comparative

advantage.

2) Intraindustry trade (cloth for cloth) does not reflect

comparative advantage.

3) The pattern of intraindustry trade itself is

unpredictable.

4) The relative importance of intraindustry and

interindustry trade depends on how similar

countries are.

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Inter-industry and


• About 25% of world trade is intra-industry trade according to standard industrial classifications.

But some industries have more intra-industry trade than others: those industries requiring relatively large amounts of skilled labor, technology, and physical capital exhibit intra-industry trade for the U.S.

Countries with similar relative amounts of skilled labor, technology, and physical capital engage in a large amount of intra-industry trade with the U.S.

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Table 2: Indexes of Intraindustry

Trade for U.S. Industries, 1993

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Dumping

• Dumping is the practice of charging a lower price for

exported goods than for goods sold domestically.

• Dumping is an example of price discrimination:

the practice of charging different customers different

prices.

• Price discrimination and dumping may occur only if

imperfect competition exists: firms are able to influence

market prices.

markets are segmented so that goods are not easily bought

in one market and resold in another.

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Dumping

• Dumping may be a profit maximizing strategy because of differences in foreign and domestic markets.

• One difference is that domestic firms usually have a larger share of the domestic market than they do of foreign markets.

Because of less market dominance and more competition in foreign markets, foreign sales are usually more responsive to price changes than domestic sales.

Domestic firms may be able to charge a high price in the domestic market but must charge a low price on exports if foreign consumers are more responsive to price changes.

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Dumping

• We draw a diagram of how dumping occurs when a firm is a monopolist in the domestic market but must compete in foreign markets.

Because the firm is a monopolist in the domestic market, the demand function that it faces in the domestic market is downward sloping, and marginal revenue from additional output is always less than a uniform price for all units of output.

Because the firm competes in foreign markets, the demand function that it faces in foreign markets is horizontal, representing the fact that exports are very responsive to small price changes.

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Figure 7: Dumping

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Dumping

• To maximize profits, the firm should sell a limited

amount in the domestic market at a high price PDOM ,

but sell in foreign markets at a low price PFOR.

Since more can always be sold at PFOR , the firm should sell

its products at a high price in the domestic market until

marginal revenue there falls to PFOR.

Thereafter, it should sell exports at PFOR until marginal costs

exceed this price.

• In this case, dumping is a profit-maximizing strategy.

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Reciprocal Dumping

• Price discrimination can actually give rise to

international trade:

Two monopolies, each producing the same good, one in

Home and one in Foreign.

The situation in which dumping leads to two way-trade in the

same product is known as reciprocal dumping

• Is such a peculiar trade socially desirable?

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External Economies of Scale

• If external economies exist, a country that has

a large industry will have low costs of

producing that industry’s good or service.

• External economies may exist for a few

reasons:

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1. Specialized equipment or services may be needed for the industry, but are only supplied by other firms if the industry is large and concentrated.

For example, Silicon Valley in California has a large concentration silicon chip companies, which are serviced by companies that make special machines for manufacturing silicon chips.

These machines are cheaper and more easily available for Silicon Valley firms than for firms elsewhere.

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2. Labor pooling: a large and concentrated

industry may attract a pool of workers,

reducing employee search and hiring costs

for each firm.

3. Knowledge spillovers: workers from

different firms may more easily share ideas

that benefit each firm when a large and

concentrated industry exists.

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External Economies and Increasing

Returns

• A country cannot have a large concentration of firms in an

industry unless it possesses a large industry.

• When external economies are important, a country with a

large industry will be more efficient in that industry than a

country with small industry.

Increasing returns to scale at the level of the national

industry

• External economies can be represented by assuming that an

industry’s costs are lower, the larger the industry.

This means that the industry will have a forward-falling

supply curve

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External Economies of Scale and Trade

• External economies play an important role in international trade,

but they may be quite different in their effects.

• External economies can cause countries to get “locked in” to

undesirable patterns of specialization and can even lead to

losses from international trade.

• If external economies exist, the pattern of trade may be due to

historical accidents:

When there external economies of scale, a country that has

large scale production in some industries will tend to have

low costs of producing that good.

Countries that start as large producers in certain industries

tend to remain large producers even if another country could

potentially produce more cheaply.

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Figure 8: External Economics and

Specialization

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• Trade based on external economies has an ambiguous effect on national welfare.

There may be gains to the world economy by concentrating production of industries with external economies.

But there is no guarantee that the right country will produce a good subject to external economies.

It is even possible that a country is worse off with trade than it would have been without trade: a country may be better off if it produces everything for its domestic market rather than pay for imports.

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Figure 9: External Economics and Losses

from Trade

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• We have considered cases where external economies depend on the amount of current output at a point in time.

• But external economies may also depend on the amount of cumulative output over time.

• Dynamic increasing returns to scale exist if average costs fall as cumulative output over time rises.

Dynamic increasing returns to scale imply dynamic external economies of scale.

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• Dynamic increasing returns to scale could arise if the cost of production depends on the accumulation of knowledge and experience, which depend on the production process over time.

• A graphical representation of dynamic increasing returns to scale is called a learning curve.

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Figure 10: The Learning Curve

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• Like external economies of scale at a point in time,

dynamic increasing returns to scale can lock in an

initial advantage or a head start in an industry.

• Like external economies of scale at a point in time,

dynamic increasing returns to scale can be used to

justify protectionism.

Temporary protection of industries enables them to gain

experience: infant industry argument.

But temporary is often for a long time, and it is hard to identify

when external economies of scale really exist.

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