1.12 — New Trade Theory II

# 1.12 — New Trade Theory II

## ECON 324 • International Trade • Spring 2023

### Ryan Safner Associate Professor of Economics <a href="mailto:safner@hood.edu">safner@hood.edu</a> <a href="https://github.com/ryansafner/tradeS23">ryansafner/tradeS23</a> <a href="https://tradeS23.classes.ryansafner.com"> tradeS23.classes.ryansafner.com</a>

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# Outline

### [Increasing Returns](#3)

### [Trade and Variety](#14)

### [Monopolistic Competition](#14)

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# Increasing Returns

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# PPF: Decreasing Costs

- Increasing returns `\(\iff\)` decreasing costs

- PPF is *convex* to origin

- .hi[Marginal rate of transformation (MRT)] .hi-purple[*decreases*] as we produce more of a good
  - Again: .b[“slope”], .b[“relative price of x”], .b[“opportunity cost of x”]
  - Amount of y given up to get 1 more x

]

.pull-right[
<img src="1.12-slides_files/figure-html/unnamed-chunk-1-1.png" width="504" style="display: block; margin: auto;" />

]

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# PPF: Decreasing Costs

- To simplify our graph, assume .blue[Home] and .red[Foreign] have identical preferences (same indifference curve), and identical endowments (both start at A)

]

.pull-right[
<img src="1.12-slides_files/figure-html/unnamed-chunk-2-1.png" width="504" style="display: block; margin: auto;" />
]

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# PPF: Decreasing Costs

- Countries open up trade, face same relative prices

- Each country exploits economies of scale, producing only one good
  - .blue[Home] produces x, .red[Foreign] produces y
  - Points B and B'
]

<img src="1.12-slides_files/figure-html/unnamed-chunk-3-1.png" width="504" style="display: block; margin: auto;" />
]
---

# PPF: Decreasing Costs

- Countries open up trade, face same relative prices

- Each country exploits economies of scale, producing only one good
  - .blue[Home] produces x, .red[Foreign] produces y
  - Points B and B'

- Trade and reach a higher indifference curve at C
]

<img src="1.12-slides_files/figure-html/unnamed-chunk-4-1.png" width="504" style="display: block; margin: auto;" />
]

---

# PPF: Decreasing Costs

- Countries open up trade, face same relative prices

- Each country exploits economies of scale, producing only one good
  - .blue[Home] produces x, .red[Foreign] produces y
  - Points B and B'

- Trade and reach a higher indifference curve at C
]

<img src="1.12-slides_files/figure-html/unnamed-chunk-5-1.png" width="504" style="display: block; margin: auto;" />
]

---

# PPF: Decreasing Costs

- Countries open up trade, face same relative prices

- Each country exploits economies of scale, producing only one good
  - .blue[Home] produces x, .red[Foreign] produces y
  - Points B and B'

- Trade and reach a higher indifference curve at C
]

<img src="1.12-slides_files/figure-html/unnamed-chunk-6-1.png" width="504" style="display: block; margin: auto;" />
]

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# (Anti-)Competitive Implications of Economies of Scale

<img src="1.12-slides_files/figure-html/unnamed-chunk-7-1.png" width="504" style="display: block; margin: auto;" />
]

<img src="1.12-slides_files/figure-html/unnamed-chunk-8-1.png" width="504" style="display: block; margin: auto;" />
]

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# (Anti-)Competitive Implications of Economies of Scale

- Lowers `\(AC\)` and `\(p\)` even further, further outcompeting U.S.
]

<img src="1.12-slides_files/figure-html/unnamed-chunk-9-1.png" width="504" style="display: block; margin: auto;" />
]

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# (Anti-)Competitive Implications of Economies of Scale

.pull-left[
- Suppose .hi-orange[Vietnam] actually has lower `\(AC\)` than .hi-red[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 .hi-purple[inefficiently “locked in”] to Chinese production, .hi-purple[sub-optimal path dependence]
]

<img src="1.12-slides_files/figure-html/unnamed-chunk-10-1.png" width="504" style="display: block; margin: auto;" />
]

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# (Anti-)Competitive Implications of Economies of Scale

.pull-left[
- .b[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
]

<img src="1.12-slides_files/figure-html/unnamed-chunk-11-1.png" width="504" style="display: block; margin: auto;" />
]

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# Trade and Variety

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# Trade and Variety

- Consumers are better off with more variety

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

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# Trade & Variety: Tradeoff Between Variety & Cost

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

- Tradeoff between variety and (average) cost
]

.pull-right[
<img src="1.12-slides_files/figure-html/unnamed-chunk-12-1.png" width="504" style="display: block; margin: auto;" />
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# Trade & Variety: Tradeoff Between Variety & 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 `\((Q_M, P_M)\)`
]

.pull-right[
<img src="1.12-slides_files/figure-html/unnamed-chunk-13-1.png" width="504" style="display: block; margin: auto;" />
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# Trade & Variety: Tradeoff Between Variety & 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 `\((Q_M, P_M)\)`

- If there are only a few varieties, few firms produce many units at very low price `\((Q_F, P_F)\)`
]

.pull-right[
<img src="1.12-slides_files/figure-html/unnamed-chunk-14-1.png" width="504" style="display: block; margin: auto;" />
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# International Trade and Variety

- Suppose it takes 2 workers to design a motorcyle

- Once designed, it takes 1 worker to produce a motorcycle

- There are 2 countries, each with 10 workers
]

]

![](../images/tradevariety1.png)

8 units of 1 variety
]
]

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# International Trade and Variety

- Suppose it takes 2 workers to design a motorcyle

- Once designed, it takes 1 worker to produce a motorcycle

- There are 2 countries, each with 10 workers
]

]

![](../images/tradevariety2.png)

3 units each of 2 varieties
]
]

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# International Trade and Variety

- Suppose it takes 2 workers to design a motorcyle

- Once designed, it takes 1 worker to produce a motorcycle

- There are 2 countries, each with 10 workers
]

]

![:scale 45%](../images/tradevariety1.png) ![:scale 45%](../images/tradevariety3.png)

Each country specializes in one variety
]
]

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# International Trade and Variety

- Suppose it takes 2 workers to design a motorcyle

- Once designed, it takes 1 worker to produce a motorcycle

- There are 2 countries, each with 10 workers
]

]

![](../images/tradevariety4.png)

Each country specializes in one variety
]
]

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# International Trade and Variety

- Suppose it takes 2 workers to design a motorcyle

- Once designed, it takes 1 worker to produce a motorcycle

- There are 2 countries, each with 10 workers
]

- Suppose they trade 4 Harleys for 4 Kawasakis
]

![](../images/tradevariety5.png)

Each country ends up with 4 units of 2 varieties
]
]

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# International Trade and Variety

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

- But increases varieties available to individuals in each area
]

![:scale 70%](../images/nycchinese.jpg)

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# Monopolistic Competition

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# The Role of the Firm in Trade

.pull-left[
.smaller[
- Classical trade theory (Ricardo, Hecksher-Ohlin, etc) has no role for the firm!
  - might as well be people directly selling wheat or computers, etc.

- Once we jettison the unrealistic assumption of perfect competition `\((p=MC)\)`, we can say a lot more about firms and trade

- We move to a theory of .hi[imperfect competition]: where firms have market power (but not full market power, as in a monopoly)

]
]

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# Imperfect Competition

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# Imperfect Competition

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# Imperfect Competition

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# Imperfect Competition

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# Monopolistic Competition

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# Monopolistic Competition

- .hi[Monopolistic competition]: **each firm has _some_ market power**, but, the industry has .hi-purple[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

]

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# Monopolistic Competition: Product Differentiation

- .hi[Product differentiation]: firms’ products are .hi-purple[imperfect substitutes]

- Consumers recognize **non-price differences** between sellers’ goods
  - Brand name & reputation
  - Customer service
  - Product features, shape, color, etc.
  - Marketing
  - Location, convenience
]

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# Monopolistic Competition: Residual Demand

.pull-left[
.smallest[
- Each firm faces own downward-sloping .hi-blue[“residual” demand] for each firm’s products
  - Firm faces market demand (for broad product) *leftover* from all other firms’ sales

- .hi-green[Example]: demand for *Lenovo* laptops `\(\approx\)` demand for *laptops* minus laptops supplied by Acer, Asus, Apple, Dell, etc.
]
]

.pull-right[
<img src="1.12-slides_files/figure-html/unnamed-chunk-15-1.png" width="504" style="display: block; margin: auto;" />
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# Monopolistic Competition Model: Short Run

.pull-left[
<img src="1.12-slides_files/figure-html/unnamed-chunk-16-1.png" width="504" style="display: block; margin: auto;" />
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- **Short Run**: model firm as a price-searching monopolist:
]

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# Monopolistic Competition Model: Short Run

.pull-left[
<img src="1.12-slides_files/figure-html/unnamed-chunk-17-1.png" width="504" style="display: block; margin: auto;" />
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- **Short Run**: model firm as a price-searching monopolist:

- `\(q^*\)`: where `\(\color{purple}{MR(q)}=\color{red}{MC(q)}\)`
]

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# Monopolistic Competition Model: Short Run

.pull-left[
<img src="1.12-slides_files/figure-html/unnamed-chunk-18-1.png" width="504" style="display: block; margin: auto;" />
]

- **Short Run**: model firm as a price-searching monopolist:

- `\(q^*\)`: where `\(\color{purple}{MR(q)}=\color{red}{MC(q)}\)`
- `\(p^*\)`: at .blue[market demand] for `\(q^*\)`
]

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# Monopolistic Competition Model: Short Run

.pull-left[
<img src="1.12-slides_files/figure-html/unnamed-chunk-19-1.png" width="504" style="display: block; margin: auto;" />
]

- **Short Run**: model firm as a price-searching monopolist:

- `\(q^*\)`: where `\(\color{purple}{MR(q)}=\color{red}{MC(q)}\)`
- `\(p^*\)`: at .blue[market demand] for `\(q^*\)`
- Earns `\(\color{green}{\pi} = [\color{blue}{p^*}-\color{orange}{AC(q^*)}]q^*\)`
]

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# Monopolistic Competition Model: Long Run

.pull-left[
<img src="1.12-slides_files/figure-html/unnamed-chunk-20-1.png" width="504" style="display: block; margin: auto;" />
]

- **Long Run**: market becomes competitive (**no barriers to entry!**)

- `\(\color{green}{\pi > 0}\)` attracts **entry** into industry

]

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# Monopolistic Competition Model: Long Run

.pull-left[
<img src="1.12-slides_files/figure-html/unnamed-chunk-21-1.png" width="504" style="display: block; margin: auto;" />
]

- **Long Run**: market becomes competitive (**no barriers to entry!**)

- `\(\color{green}{\pi > 0}\)` attracts **entry** into industry

- .blue[Residual demand] for each firm’s product:
  - **decreases** (more output by other firms)
  - become more **elastic** (more substitutes from new competitors)
  - until...

]

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# Monopolistic Competition Model: Long Run

.pull-left[
<img src="1.12-slides_files/figure-html/unnamed-chunk-22-1.png" width="504" style="display: block; margin: auto;" />

]

- **Long Run**: market becomes competitive (**no barriers to entry!**)

- `\(\color{green}{\pi > 0}\)` attracts **entry** into industry

- .blue[Residual demand] for each firm’s product:
  - **decreases** (more output by other firms)
  - become more **elastic** (more substitutes from new competitors)

- .hi-purple[Long run equilibrium]: firms earn `\(\color{green}{\pi=0}\)` where `\(\color{blue}{p}=\color{orange}{AC(q)}\)`

]

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# Monopolistic Competition vs. Perfect Competition

.pull-left[
<img src="1.12-slides_files/figure-html/unnamed-chunk-23-1.png" width="504" style="display: block; margin: auto;" />
]

- `\(q_c\)` where `\(\color{blue}{P}=\color{red}{MC(q)}\)`

- `\(\color{blue}{p_c} = \color{orange}{AC(q)_{min}}\)`, .hi-orange[productively efficient]
  - Production at lowest average cost

- `\(\color{blue}{p_c} = \color{red}{MC(q)}\)`, .hi-purple[allocatively efficient]
  - Production until .blue[MB] = .red[MC]
  - Maximum .blue[consumer surplus] (and .red[producer surplus])
  - No **DWL**

]]

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# Monopolistic Competition vs. Perfect Competition

.pull-left[
<img src="1.12-slides_files/figure-html/unnamed-chunk-24-1.png" width="504" style="display: block; margin: auto;" />

]

- `\(q_c > q_m\)`, where `\(\color{purple}{MR(q)}=\color{red}{MC(q)}\)`

- `\(\color{blue}{p_m} = \color{orange}{AC(q)}\)`
  - but not `\(\color{orange}{AC_{min}}\)`, so some .hi-orange[productive .ul[inefficiency]]

- `\(\color{blue}{p_m} > \color{red}{MC(q)}\)`, .hi-purple[allocative .ul[inefficiency]]
  - Less .blue[Consumer Surplus]
  - Some **Deadweight loss**
  
]
]
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# Monopolistic Competition vs. Perfect Competition

.pull-left[
<img src="1.12-slides_files/figure-html/unnamed-chunk-25-1.png" width="504" style="display: block; margin: auto;" />

]

- Like a monopoly, produces less `\(q\)` at a higher `\(p\)` than competition, some **DWL**

- But like perfect competition, still **no `\(\pi\)` in the long run**!

- Outcome is *between* perfect competition & monopoly in terms of efficiency & social welfare
]

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# Monopolistic Competition in Autarky

- Keep it simply, assume `\(MC(q)=0\)`

- In autarky, long-run equilibrium for firm is `\(p=AC\)`, `\(\pi=0\)` at `\(q_1, p_1\)`
]

.pull-right[
<img src="1.12-slides_files/figure-html/unnamed-chunk-26-1.png" width="504" style="display: block; margin: auto;" />
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# Monopolistic Competition with Trade: Short-Run

- 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 .b[more elastic]

]

.pull-right[
<img src="1.12-slides_files/figure-html/unnamed-chunk-27-1.png" width="504" style="display: block; margin: auto;" />
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# Monopolistic Competition with Trade: Short-Run

- Allows firm to lower price, produce more at `\(q_2, p_2\)` and earn some .hi-green[profit]
]

.pull-right[
<img src="1.12-slides_files/figure-html/unnamed-chunk-28-1.png" width="504" style="display: block; margin: auto;" />
]

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# Monopolistic Competition with Trade: Short-Run

- Allows firm to lower price, produce more at `\(q_2, p_2\)` and earn some .hi-green[profit]
]

.pull-right[
<img src="1.12-slides_files/figure-html/unnamed-chunk-29-1.png" width="504" style="display: block; margin: auto;" />
]

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# Monopolistic Competition with Trade: Long-Run

- In reality, the size of the world market (.blue[Home]+.red[Foreign]) has not changed

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

- As all firms try to expand and compete, this .b[lowers demand] for each individual firm
]

.pull-right[
<img src="1.12-slides_files/figure-html/unnamed-chunk-30-1.png" width="504" style="display: block; margin: auto;" />
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# Monopolistic Competition with Trade: Long-Run

- In reality, the size of the world market (.blue[Home]+.red[Foreign]) has not changed

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

- As all firms try to expand and compete, this .b[lowers demand] for each individual firm

- This continues until new equilibrium, where `\(p=AC\)`, `\(\pi=0\)` again, at `\(q_3, p_3\)`
]

.pull-right[
<img src="1.12-slides_files/figure-html/unnamed-chunk-31-1.png" width="504" style="display: block; margin: auto;" />
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# Monopolistic Competition with Trade: Long-Run

- In reality, the size of the world market (.blue[Home]+.red[Foreign]) has not changed

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

- As all firms try to expand and compete, this .b[lowers demand] for each individual firm

- This continues until new equilibrium, where `\(p=AC\)`, `\(\pi=0\)` again, at `\(q_3, p_3\)`
]

.pull-right[
<img src="1.12-slides_files/figure-html/unnamed-chunk-32-1.png" width="504" style="display: block; margin: auto;" />
]

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# Monopolistic Competition with Trade: Long-Run

- 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 `\((q_1 \rightarrow q_3)\)`

- 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 `\(n \rightarrow n^*\)`
]

.pull-right[
<img src="1.12-slides_files/figure-html/unnamed-chunk-33-1.png" width="504" style="display: block; margin: auto;" />
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# Monopolistic Competition with Trade: Long-Run

- Compare two firms, one with .red[high costs], `\(\color{red}{MC_H}\)` and one with .orange[low costs] `\(\color{orange}{MC_L}\)`
  - .orange[Low cost firm] earns more .hi-green[profits] than .red[high cost firm]

- Opening up trade increases competition, lowering profits

- .orange[Low cost firms] better equipped to survive falling profits
  - .red[High cost firms] leave the market; allowing .orange[low cost firms] to expand output!
]
]

.pull-right[
<img src="1.12-slides_files/figure-html/unnamed-chunk-34-1.png" width="504" style="display: block; margin: auto;" />
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# Monopolistic Competition with Trade: Productivity

.pull-left[
- With fewer firms, the remaining .orange[(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
]

<img src="1.12-slides_files/figure-html/unnamed-chunk-35-1.png" width="504" style="display: block; margin: auto;" />
]

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# Trade Agreements and Firm Productivity

.smallest[After Canadian free trade agreement with U.S., Canadian productivity increased rapidly by 8.4%, a huge increase over a short time period. Note this is a logarithmic scale!]
]

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# What is at Stake in Competing Trade Theories?

- 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?

]

![:scale 60%](../images/knowledgetransfer.png)
]
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