NEW and (OLD NEW) TRADE THEORIES

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1 INTERNATIONAL ECONOMIC POLICY AND DEVELOPMENT AA NEW and (OLD NEW) TRADE THEORIES PROF. PIERLUIGI MONTALBANO

2 Why countries trade

3 Unit : US Dollar thousand USA's main exports to Germany P roduc t c ode P roduc t la be l Unite d S ta te s of Ame ric a 's e xports to Ge rma ny V a lue in V a lue in V a lue in TOTAL All products '87 Vehicles other than railway, tramway '90 Optical, photo, technical, medical, etc apparatus '84 Machinery, nuclear reactors, boilers, etc '88 Aircraft, spacecraft, and parts thereof '85 Electrical, electronic equipment '30 Pharmaceutical products '71 Pearls, precious stones, metals, coins, etc '38 Miscellaneous chemical products '99 Commodities not elsewhere specified '29 Organic chemicals '39 Plastics and articles thereof '27 Mineral fuels, oils, distillation products, etc '12 Oil seed, oleagic fruits, grain, seed, fruit, etc, nes '08 Edible fruit, nuts, peel of citrus fruit, melons '70 Glass and glassware '97 Works of art, collectors pieces and antiques '28 Inorganic chemicals, precious metal compound, isotopes '73 Articles of iron or steel '33 Essential oils, perfumes, cosmetics, toileteries '03 Fish, crustaceans, molluscs, aquatic invertebrates nes '74 Copper and articles thereof '47 Pulp of wood, fibrous cellulosic material, waste etc '40 Rubber and articles thereof '48 Paper and paperboard, articles of pulp, paper and board '22 Beverages, spirits and vinegar

4 USA's main imports from Germany V a lue in V a lue in V a lue in TOTAL All products '87 Vehicles other than railway, tramway '84 Machinery, nuclear reactors, boilers, etc '30 Pharmaceutical products '90 Optical, photo, technical, medical, etc apparatus '85 Electrical, electronic equipment '99 Commodities not elsewhere specified '29 Organic chemicals '88 Aircraft, spacecraft, and parts thereof '39 Plastics and articles thereof '73 Articles of iron or steel '38 Miscellaneous chemical products '71 Pearls, precious stones, metals, coins, etc '40 Rubber and articles thereof '28 Inorganic chemicals, precious metal compound, isotopes '72 Iron and steel '48 P roduc t c ode P roduc t la be l Unite d S ta te s of Ame ric a 's imports from Ge rma ny Paper and paperboard, articles of pulp, paper and board '97 Works of art, collectors pieces and antiques '82 Tools, implements, cutlery, etc of base metal '94 Furniture, lighting, signs, prefabricated buildings '74 Copper and articles thereof '76 Aluminium and articles thereof '32 Tanning, dyeing extracts, tannins, derivs,pigments etc '70 Glass and glassware '22 Beverages, spirits and vinegar '83 Miscellaneous articles of base metal

5 Why do countries export and import the same goods and/or services? The Ricardian model and the H-O model explain why countries trade but do not predict the simultaneous import and export of a product In those models, markets were perfectly competitive: many small producers of identical product not able to influence the market price To explain trade of the same product, we need to change those assumptions

6 The New Trade Theory New trade theory (NTT) is a collection of economic models in international trade - developed in the late 1970s and early 1980s -which focuses on the role of increasing returns to scale. Thirty years have passed since a small group of theorists began applying concepts and tools from industrial organization to the analysis of international trade. The new models of trade that emerged from that work didn t supplant traditional trade theory so much as supplement it, creating an integrated view that made sense of aspects of world trade that had previously posed major puzzles. The new trade theory an unfortunate phrase, now quite often referred to as the old new trade theory also helped build a bridge between the analysis of trade between countries and the location of production within countries. THE INCREASING RETURNS REVOLUTION IN TRADE AND GEOGRAPHY, Prize Lecture, December 8, 2008, Paul Krugman

7 2 key hypotheses: The New Trade Theory Imperfect competition: monopolistic competition, duopoly, oligopoly, where producers are able to exert some control over the market price. Differentiated goods: goods are differentiated, differently from perfectly competitive markets where the goods produced are homogeneous (identical).

8 A model of monopolistic competition: introduction We now analyse a model of trade under monopolistic competition. Monopolistic competition has two key features: The goods produced by different firms are differentiated (hence firms are able to exert some control over the price). Firms enjoy increasing returns to scale, by which we mean that the average costs for a firm fall as more output is produced. By selling not only in the home market but also in the foreign market firms can increase their returns to scale So increasing returns to scale create a reason for trade to occur when the countries are similar in their technologies and factor endowments

nowadays): Intra-industry trade deals with imports and exports in

9 A model of monopolistic competition: introduction - 2 This model explains trade in the same type of product (very common nowadays): Intra-industry trade deals with imports and exports in different varieties of the same type of product (i.e. in the same industry)

10 K e y T e r m Model of monopolistic competition: KEY POINTS 1. The monopolistic competition model assumes differentiated products, many firms, and increasing returns to scale. Firms enter whenever there are profits to be earned, so profits are zero in the long-run equilibrium. 2. When trade opens between two countries, the demand curve becomes more elastic, as consumers have more choices and become more price-sensitive. Firms then lower their prices in an attempt to capture consumers from their competitors and obtain profits. When all firms do so, however, some firms incur losses and are forced to leave the market. 3. Introducing international trade leads to additional gains from trade for two reasons: (i) lower prices as firms expand their output and lower their average costs and (ii) additional imported product varieties available to consumers. There are also short-run adjustment costs, such as unemployment, as some firms exit the market. 4. Conclusion: The assumption of differentiated goods helps us to understand why countries often import and export varieties of the same type of good.

11 Trade under Monopolistic Competition Assumptions of the model of monopolistic competition: The first 2 assumptions are about the demand facing each firm: Assumption 1: Each firm produces a good that is similar to but slightly differentiated from the goods that other firms in the industry produce. Each firm faces a downward-sloping demand curve for its product and has some control over the price it charges.

12 Trade under Monopolistic Competition Assumption 2: There are many firms in the industry If the number of firms is N, then D/N is the share of demand that each firm faces when the firms are all charging the same price. When only one firm lowers its price, however, it will face a flatter demand curve d.

13 Trade under Monopolistic Competition The 3th assumption is about each firm s cost structure Assumption 3: Firms produce using a technology with increasing returns to scale. FIGURE 6-3 Increasing Returns to Scale This diagram shows the average cost, AC, and marginal cost, MC, of a firm. Increasing returns to scale cause average costs to fall as the quantity produced increases. Marginal cost is below average cost and is drawn as constant for simplicity.

14 Trade under Monopolistic Competition Numerical Example of Increasing Returns to Scale TABLE 6-2 Cost Information for the Firm This table illustrates increasing returns to scale, in which average costs fall as quantity rises. Whenever the price charged is above average costs, then a firm earns monopoly profits.

15 Trade under Monopolistic Competition The 4th assumption is about profit: Assumption 4: Because firms can enter and exit the industry freely, monopoly profits are zero in the long run. Firms will enter as long as it is possible to make monopoly profits, and the more firms that enter, the lower profits per firm become. Profits for each firm end up as zero in the long run, just as in perfect competition.

16 Trade under Monopolistic Competition Next, we will examine monopolistic competition: in the short run without trade in the long run in the short run in the long run with free trade

17 Trade under Monopolistic Competition FIGURE 6-4 Equilibrium without Trade Short-Run Equilibrium Short-Run Monopolistic Competition Equilibrium without Trade The shortrun equilibrium under monopolistic competition is the same as a monopoly equilibrium. The firm chooses to produce the quantity Q 0 at which the firm s marginal revenue, mr 0, equals its marginal cost, MC. The price charged is P 0. Because price exceeds average cost, the firm makes monopoly profits.

19 Trade under Monopolistic Competition FIGURE 6-5 (1 of 2) Equilibrium without Trade Long-Run Equilibrium Long-Run Monopolistic Competition Equilibrium without Trade Drawn by the possibility of making profits in the short-run equilibrium, new firms enter the industry (drawing demand away from existing firms and producing more product varieties) and the firm s demand curve, d 0, shifts to the left and becomes more elastic (i.e., flatter), shown by d 1. The long-run equilibrium under monopolistic competition occurs at the quantity Q 1 where the marginal revenue curve, mr 1 (associated with demand curve d 1 ), equals marginal cost. At that quantity, the no-trade price, P A, equals average costs at point A.

20 Trade under Monopolistic Competition FIGURE 6-5 (2 of 2) Firm s demand curve in the long-run (flatter than d 0 ) (quantity demanded depending on the price charged by that firm) Equilibrium without Trade Long-Run Equilibrium Long-Run Monopolistic Competition Equilibrium without Trade In the long-run equilibrium, firms earn zero monopoly profits and there is no entry or exit. The quantity produced by each firm is less than in short-run equilibrium. Q 1 is less than Q 0 because new firms have entered the industry. With a greater number of firms and hence more varieties available to consumers, the demand for each variety d 1 is less then d 0. The demand curve D/N A shows the notrade demand when all firms charge the same price.

21 Trade under Monopolistic Competition Equilibrium with Free Trade Short-Run Equilibrium with Trade Assume Home and Foreign are exactly the same. Same number of consumers Same technology and cost curves Same factor endowments Same number of firms in the no-trade equilibrium Given the above conditions, if there are economies of scale, there is reason for trade. Even two identical countries will engage in trade because increasing returns to scale exist.

22 Trade under Monopolistic Competition Equilibrium with Free Trade Short-Run Equilibrium with Trade The number of firms in the no-trade equilibrium in each country is N A. When trade opens, the number of customers available to each firm doubles as does the number of firms Since there are twice as many consumers, but also twice as many firms, the demand curve is the same (2D/2N A =D/N A )). The product varieties also double. With the greater number of varieties available, the demand for each individual variety will be more elastic. If one firm drops its price below P A, it can attract a greater number of (Home and Foreign) customers away from other firms

23 Trade under Monopolistic Competition FIGURE 6-6 (1 of 2) Equilibrium with Free Trade Short-Run Equilibrium with Trade Short-Run Monopolistic Competition Equilibrium with Trade When trade is opened, the larger market makes the firm s demand curve more elastic, as shown by d 2 (with corresponding marginal revenue curve, mr 2 ). The firm chooses to produce the quantity Q 2 at which marginal revenue equals marginal costs; this quantity corresponds to a price of P 2 (point B). With sales of Q 2 at price P 2, the firm will make monopoly profits because price is greater than AC.

Trade under Monopolistic Competition FIGURE 6-6 (2 of 2) Equilibrium with Free Trade Short-Run Equilibrium with Trade Short-Run Monopolistic Competition Equilibrium with Trade When all firms lower

24 Trade under Monopolistic Competition FIGURE 6-6 (2 of 2) Equilibrium with Free Trade Short-Run Equilibrium with Trade Short-Run Monopolistic Competition Equilibrium with Trade When all firms lower their prices to P 2, however, the relevant demand curve is D/N A, which indicates that they can sell only Q 2 at price P 2. At this short-run equilibrium (point B ), price is less than average cost and all firms incur losses. As a result, some firms are forced to exit the industry.

25 Trade under Monopolistic Competition Equilibrium with Free Trade Long-Run Equilibrium with Trade Since firms are making losses, some of them will exit the industry. Firm exit will increase demand for the remaining firms products and decrease the available product varieties to consumers. We now have N T firms which is fewer than the N A firms we had before. The new demand D/N T >D/N A (because the reduction of firms increases the share of demand facing each one)

26 Trade under Monopolistic Competition FIGURE 6-7 (1 of 2) Equilibrium with Free Trade Long-Run Equilibrium with Trade Long-Run Monopolistic Competition Equilibrium with Trade The long-run equilibrium with trade occurs at point C. At this point, profits are maximized for each firm producing Q 3 (which satisfies mr 3 = MC) and charging price P W (which equals AC). Since monopoly profits are zero when price equals average cost, no firms enter or exit the industry.

27 Trade under Monopolistic Competition FIGURE 6-7 (2 of 2) Equilibrium with Free Trade Long-Run Equilibrium with Trade Long-Run Monopolistic Competition Equilibrium with Trade (continued) Compared with the long-run equilibrium without trade, d3 has shifted out as domestic firms exited the industry and has become more elastic due to the greater total number of varieties with trade.. Compared with the long-run equilibrium without trade at point A, the trade equilibrium at point C has a lower price and higher sales by all surviving firms.

28 Trade under Monopolistic Competition Gains from Trade Equilibrium with Free Trade The long-run equilibrium at point C has two sources of gains from trade for consumers: 1. A drop in price: The lower price is a result of increased productivity of the surviving firms coming from increasing returns to scale. 2. Gains from trade to consumers: Although there are fewer product varieties made within each country (by fewer firms), consumers have more product variety because they can choose products of the firms from both countries after trade.

29 Trade under Monopolistic Competition Adjustment Costs from Trade Equilibrium with Free Trade There are adjustment costs associated with monopolistic competition, as some firms shut down or exit the industry. Workers in those firms experience a spell of unemployment. Over the long run, however, we could expect those workers to find new jobs, so these costs are temporary.

30 Conclusions of the model When firms have differentiated products and increasing returns to scale, there is a potential for gains from trade that did not exist in earlier models. The model of monopolistic competition shows that trade will occur between countries even if these countries are identical. There is trade within the same industries across countries because there is a potential to sell in a larger market. This will induce firms to lower their prices below those charged in the absence of trade. As firms exit, remaining firms increase their output and average cost falls. Lower costs results in lower prices for consumers in the importing country.

31 Conclusions-2 Lower prices and higher product variety are the gains from trade under monopolistic competition. However, since some firms exit the market, there are short-run adjustment costs due to worker displacement.

32 Why countries trade

33 A brief introduction to the New New trade theory: firms in international trade (or heterogeneous firms)

34 Firms in international trade Under Ricardian Model and H-O Model firms are black boxes Under New trade theories: firms' dimension counts with increasing return to scale, but all domestic firms will export after opening up to trade; there is a firm-exit effect, but it is indeterminate which firms exit the market Micro-level empirical evidence (see the many papers by Bernard, et al. starting in the mid-90s) show stylized facts unexplained under these theories

35 Firms in international trade -2 Firms are very different in terms of productivity Only a minority of firms are exporters Usually exporters are more productive Exporting is characterized by fixed costs What effects on gains from trade? Opening up to trade kicks out the least productive firms and enhances average productivity. Hence, need a framework that could account for firms heterogeneity

36 The New new trade theory This framework is called the New new trade theory (or the theory of heterogeneous firms) Melitz (2003) constructed a model in which only a few highly productive firms are engaged in export: these firms are able to make sufficient profits to cover the large fixed costs required for export operations. Helpman et al. (2004) expanded the Melitz (2003) model into one in which the productivity of exporting firms is lower than that of firms engaged in local production overseas (FDI). only productive firms can cover the enormous fixed costs (local factory construction, etc.) entailed in local production overseas. These "Melitz-type models" constituted the theoretical foundations for empirical research based in particular on firm-level data.

37 The New new trade theory -2 New source of trade gains: When lowered trade barriers stimulate competition on a global scale, low-productivity firms that had been protected are forced to withdraw from the market, replaced by the increased production volume of high-productivity firms. As a consequence, the average productivity of a country on the whole rises. This rise in average productivity means a rise in people's real income; people become wealthier through the natural selection of firms on a global scale.

Lesson22: Trade under Monopolistic Competition

International trade in the global economy 60 hours II Semester Luca Salvatici luca.salvatici@uniroma3.it Lesson22: Trade under Monopolistic Competition 1 Trade under Monopolistic Competition Assumptions