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Chapter 8

Firms in the Global Economy

ECON 40710 –University of Notre Dame 5-2

Summary

1. Introduction– International trade is an important economic activity

2. General equilibrium model– There are welfare gains from trade whenever relative prices

are different across countries

3. Classic Models– Comparative advantages lead to differences in relative prices– Ricardo: technological differences– Specific Factors and HO: differences in relative factor

endowments


Overview

4. New Trade Theories– Trade is mostly between similar countries– Firms trade, not countries– New motives for trade: returns to scale and product

differentiation

5. Trade Policies– The impact of trade policy depends on the size of the country

and the structure of the industry


INTRODUCTION


Two waves of globalization


First wave: composition


Second wave: composition


First vs. Second wave: destinations


First wave of globalization

Trade in dissimilar products between dissimilar countries

• Britain traded mostly with distant countries able to produce what it could not:– Britain is densely populated and capital-abundant but scarce

in land– It exports manufactured goods and imports raw materials

• Comparative advantage theories explain those patterns


Second wave of globalization

Trade in similar product between similar countries

• Britain trades mostly with similar nearby European countries• Trade is mostly manufactured goods

• Comparative advantage theories cannot explains this pattern

• We need to develop additional explanations for trade• “New” Trade Theories• Returns to scale and Product differentiation


• Intra-industry Trade – Concept and measurement

• Monopolistic competition model (Krugman, 1980)– New source of gains from trade: increases in varieties

• Heterogeneous firms model (Melitz, 2003)– New source of gains from trade: increases in aggregate

productivity

• Empirical Applications – NAFTA

Road Map


INTRA-INDUSTRY TRADE


Intra-Industry Trade

• In classic models of international trade:

– Countries are different (technology or resources)

– Trade leads to specialization according to comparative advantage

– Inter-industry trade: exchange of one product for another



• Intra-industry trade: Two-way exchanges within narrowly defined product categories – exchange of one variety for another

• Suppose that the global cloth industry produces differentiatedvarieties or types of cloth.

– Each country produces and exports different types of cloth

– Firms exploit economies of scale through the lengthening of production runs – specialize in a subset of varieties

– If different consumers like different varieties, trade occurs within the cloth industry


• Home produces and exports only cloth

• Foreign exports cloth and food, but is a net importer of cloth




• How important is intra-industry trade relative to inter-industry trade?

• We can use the Grubel-Lloyd index:

• See notes

Share of Intra ≡ IntraTotal

=1−EXP − IMPEXP + IMP



• Using that measure as much as 60% of world trade is classified as intra-industry trade.

• Lots of variation in intra-industry trade

– across countries

– across industries

• Classification issues:

– The amount of intra-industry trade depends on the level of aggregation

– The more aggregated the classification the more intra-industry trade



Source: OECD

Country CountryIceland 20.1 USA 68.5Australia 29.8 Netherlands 68.9Greece 36.9 Spain 71.2Norway 37.1 Belgium 71.4Turkey 40 Germany 72NewZealand 40.6 Switzerland 72Japan 47.6 Hungary 72.1Finland 53.9 Mexico 73.4Ireland 54.6 U.K. 73.7Korea 57.5 Austria 74.2Portugal 61.3 SlovakRep. 76Poland 62.6 Canada 76.2Italy 64.7 CzechRep. 77.4Denmark 64.8 France 77.5

ShareofIntra-IndustryTradeinmanufacturing(1996-2000)



Intra-industry Trade in the US


MONOPOLISTIC COMPETITION


Monopolistic Competition

• We need models of trade consistent with intra-industry trade between similar countries.

• This requires changing some of the assumptions we used in the classical theories:

1. Differentiated Products – instead of homogeneous• Consumers can distinguish between varieties: Domestic

and foreign varieties are not the same.• If consumers love variety, they will import foreign

products even if domestic firms produce varieties of the same product.



2. Increasing returns to scale– Fixed production costs: An increase in quantity leads to a

decrease in average cost.– Profits are increasing in total sales (conditional on price) –

Firms have an incentive to enter foreign markets to benefit from economies of scale.

3. Imperfect competition – instead of perfect competition– Small number firms– Firms have some control over the price they charge– Profits can be positive



• Different types of imperfect competition:

1. Monopoly• Single firm • USPS is the only “firm” (ind. agency of the US gov.)

allowed to deliver non-urgent letters in the US.

2. Duopoly• Two firms • Boeing and Airbus share the market for large aircrafts



3. Oligopoly– Small number of firms– Soft drinks (World market share 2011: Coca-Cola 26%, Pepsi

12%, Nestle 3%, other 59%)– Difficult to analyze because in general firms’ pricing decision

are interdependent

4. Monopolistic Competition – Assume away interdependence– The number of firms is large enough that they ignore their

impact on the market but small enough that they still have market power.



• Is monopolistic competition realistic?– Not entirely– Firms are generally aware of their impact on the market– Still useful because it captures important aspect of reality

(e.g., price setting) and is simple to analyze

• Summary of key assumptions– Each firm sells a different variety of the product– Consumers like variety– Firms take the prices of their rival as given– The size (total expenditure) of the industry is fixed



P



• A specific form for the demand function that satisfies those conditions is:

– When for all firms, Q = S/n

– When , the firm’s sales are above average

– “a” is a constant that governs the elasticity of demand – how sensitive to prices consumers are.

Q = S 1n− a(P −P)

"

#$%

&'

P = P

P < P



• Firms use a technology that includes both fixed and marginal production costs:

– F is a one time costs (e.g. building a plant)– C is the (constant) marginal cost for each unit produced

– The average production cost (AC) is decreasing in output (increasing returns to scale)

TC = F +CQ

AC = F +CQQ

=FQ+C



Q VC = C x Q TC = F + C AC = TC/Q10 $100 $200 $2020 200 300 1530 300 400 13.340 400 500 12.550 500 600 12

100 1,000 1100 111,000 10,000 10,100 10.1

Numerical Example

– Fixed costs F = $100– Marginal costs C = $10/unit



§ The MC is constant§ As Q increases the AC decreases § When Q is very large, AC ≈ MC



• In this model, firms are symmetric– Same cost structure– Same demand– Therefore, in equilibrium all firms behave in the same way,

i.e., there is a representative firm

• To describe the equilibrium, we only need to solve for:– The behavior (price/quantity) of the representative firm– The number of representative firms such that profits are zero

(free entry equilibrium)



P n

P



What is the impact of free trade?

• From the point of view of firms, free trade is equivalent to an increase in market size (↑S).

• A higher demand allows firms to produce more output and better exploit economies of scale

– Trade allows countries to specialize in a narrower range of products

– Consumer can buy more varieties, which increase in welfare



A

C

B

• An increase in S shifts AC down

• If the number of firms remains the same (n1), profit are positive à Entry.

• Therefore n goes up and P goes down.

• Note:– n1 is the number of domestic

firms in closed econ. equil. – n2 is the sum of domestic

and foreign firms in open econ. equil.



• The total number of firms in the world under free trade is greater than the number of firms in one country under autarky.

• However, the number of firms in each country is lower under free trade than under autarky.

• Example: Suppose that both country are identical– Find the total number of firms under free trade as a function

of the number of firms in one country under autarky– Find the number of firms in each country as a function of the

number of firms in one country under autarky



Summary

• The model of monopolistic competition shows trade will occur between identical countries because of returns to scale and taste for variety.

• International trade:– Forces some firms to exit the industry– Increases the output of surviving firms

• P is lower so demand is higher• S (in each country) is the same and n goes down



• In equilibrium, consumers are better off for two reasons:

– They pay lower prices

– They can purchase more varieties (new source of GFT)


CONCLUSIONS


Conclusions

Intra-industry Trade– A large fraction of trade is between similar countries– A large fraction of trade is in differentiated goods

(manufactures)

Monopolistic Competition Model– Returns to scale and love of variety provides a new motive

for trade– Trade liberalization increases the number of varieties

available for consumption– New sources of GFT: An increase in the number of varieties

available raises welfare

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