• Increasing returns $⟺$ decreasing costs

• PPF is convex to origin

• Marginal rate of transformation (MRT) decreases as we produce more of a good

  • Again: “slope”, “relative price of x”, “opportunity cost of x”
  • Amount of y given up to get 1 more x

• To simplify our graph, assume Home and Foreign have identical preferences (same indifference curve), and identical endowments (both start at A)

• Countries open up trade, face same relative prices

• Each country exploits economies of scale, producing only one good

  • Home produces x, Foreign produces y
  • Points B and B'

• Countries open up trade, face same relative prices

• Each country exploits economies of scale, producing only one good

  • Home produces x, Foreign produces y
  • Points B and B'

• Trade and reach a higher indifference curve at C

• Countries open up trade, face same relative prices

• Each country exploits economies of scale, producing only one good

  • Home produces x, Foreign produces y
  • Points B and B'

• Trade and reach a higher indifference curve at C

• Countries open up trade, face same relative prices

• Each country exploits economies of scale, producing only one good

  • Home produces x, Foreign produces y
  • Points B and B'

• Trade and reach a higher indifference curve at C

U.S.

• Trade increases demand for China’s output

• Lowers $AC$ and $p$ even further, further outcompeting U.S.

• Suppose Vietnam actually has lower $AC$ than China, once it gets up to scale (V1)

• Chinese economies of scale have world market price at C

• Current market price provides no profit to Vietnamese producers starting production at V0

• World is inefficiently “locked in” to Chinese production, sub-optimal path dependence

• Policy implication for Vietnam: shut out imports from China with tariffs, and subsidize this industry to get it up to scale

• In the long run, Vietnam can become the least-cost producer, increasing welfare

• Consumers are better off with more variety

• Two interpretations of why:

  1. Love of variety: consumers value variety for its own sake (directly enters utility function)
  2. Ideal variety: consumers have an ideal variety in mind, and having more varieties available increases probability that each consumer matches with their ideal variety

• Why can’t consumers each always have their favorite variety?

• Tradeoff between variety and (average) cost

• Why can’t consumers each always have their favorite variety?

• Tradeoff between variety and (average) cost

• If every consumer had their favorite variety: many varieties, each firm produces very few units at a very high price $(Q_M,P_M)$

• Why can’t consumers each always have their favorite variety?

• Tradeoff between variety and (average) cost

• If every consumer had their favorite variety: many varieties, each firm produces very few units at a very high price $(Q_M,P_M)$

• If there are only a few varieties, few firms produce many units at very low price $(Q_F,P_F)$

• Suppose they trade 4 Harleys for 4 Kawasakis

• Globalization reduces geographic variation (more places look the same, have same amenities)

• But increases varieties available to individuals in each area

• Monopolistic competition: each firm has some market power, but, the industry has free entry and exit (no barriers to entry)

  • Each firm faces its own downward-sloping demand
  • Firms are price-searchers

• Model as a hybrid of monopoly and perfect competition models

• Product differentiation: firms’ products are imperfect substitutes

• Consumers recognize non-price differences between sellers’ goods

  • Brand name & reputation
  • Customer service
  • Product features, shape, color, etc.
  • Marketing
  • Location, convenience

^† Note it is not at the minimum of AC(q)!

• Keep it simply, assume $MC\left(q\right)=0$

• In autarky, long-run equilibrium for firm is $p=AC$, $\pi =0$ at $q_1,p_1$

• Firm opens up to international trade, has two effects on demand for firm:
  • greater demand for firm’s products
  • more competition from other countries’ firms
  • overall, demand becomes more elastic

• Firm opens up to international trade, has two effects on demand for firm:

  • greater demand for firm’s products
  • more competition from other countries’ firms
  • overall, demand becomes more elastic

• Allows firm to lower price, produce more at $q_2,p_2$ and earn some profit

• Firm opens up to international trade, has two effects on demand for firm:

  • greater demand for firm’s products
  • more competition from other countries’ firms
  • overall, demand becomes more elastic

• Allows firm to lower price, produce more at $q_2,p_2$ and earn some profit

• In reality, the size of the world market (Home+Foreign) has not changed

• Thus, not all firms can expand and survive in global market

• As all firms try to expand and compete, this lowers demand for each individual firm

• In reality, the size of the world market (Home+Foreign) has not changed

• Thus, not all firms can expand and survive in global market

• As all firms try to expand and compete, this lowers demand for each individual firm

• This continues until new equilibrium, where $p=AC$, $\pi =0$ again, at $q_3,p_3$

• In reality, the size of the world market (Home+Foreign) has not changed

• Thus, not all firms can expand and survive in global market

• As all firms try to expand and compete, this lowers demand for each individual firm

• This continues until new equilibrium, where $p=AC$, $\pi =0$ again, at $q_3,p_3$

• In autarky (before trade), suppose there were $2n$ firms $(n$ in each country)

• When trade opens, each firm tries to gain larger share (but not all can)

• Some firms exit; firms that remain will produce more than before $(q_1\to q_3)$

• With trade, and after the shakeout, there are $n^{\star }$ firms, $n<n^{\star }<2n$

• Price & AC fall, and product variety in each country rises from $n\to n^{\ast }$

• With fewer firms, the remaining (low cost) firms can further increase their output

• Exploit economies of scale, moving down their average cost curves

• Implies lower costs, lower prices, and greater productivity for the incumbent firms remaining

• H-O theory vs. increasing returns

• Ex ante vs. ex post comparative advantage

• Emphasize different causes of trade

• Imply very different policies

  • free trade vs. industrial policy?

• Cultural/aesthetic views of the world? Difference vs. sameness?