# Lesson22: Trade under Monopolistic Competition

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1 International trade in the global economy 60 hours II Semester Luca Salvatici Lesson22: Trade under Monopolistic Competition 1

2 Trade under Monopolistic Competition Assumptions of the model of monopolistic competition: 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. 2

3 Trade under Monopolistic Competition Assumptions of the model of 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. 3

4 Trade under Monopolistic Competition Assumptions of the model of monopolistic competition: 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. 4

5 Trade under Monopolistic Competition Assumptions of the model of 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. 5

6 Trade under Monopolistic Competition Assumptions of the model of monopolistic competition: 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. 6

7 Trade under Monopolistic Competition Next, we will examine monopolistic competition: in the short run, without trade. in the long run, without trade. in the short run, with free trade. in the long run with free trade. 7

8 Trade under Monopolistic Equilibrium without Trade Short-Run Equilibrium FIGURE 6-4 Competition Short-Run Monopolistic Competition Equilibrium without Trade The short-run 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. 8

9 Trade under Monopolistic Competition Equilibrium without Trade Long-Run Equilibrium FIGURE 6-5 (1 of 2) Long-Run Monopolistic Competition Equilibrium without Trade Drawn by the possibility of making profits in the short-run equilibrium, new firms enter the industry 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. 9

10 Trade under Monopolistic Competition Equilibrium without Trade Long-Run Equilibrium FIGURE 6-5 (2 of 2) 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 (Figure 6-4). 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. 10

11 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 number of firms in the no-trade equilibrium Given the above conditions, if there were no economies of scale, there would be no reason for trade. Similarly, Under the Ricardian model, countries with identical technologies would not trade. Under the Heckscher-Ohlin model, countries with identical factor endowments would not trade. However, under monopolistic competition, two identical countries will still engage in trade. 11

12 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. First, we will consider each country in long-run equilibrium without trade When trade opens, the number of customers available to each firm doubles. Since there are twice as many consumers, but also twice as many firms, the ratio stays the same. The product varieties also double. With the greater number of varieties available, the demand for each individual variety will be more elastic. 12

13 Trade under Monopolistic Competition Equilibrium with Free Trade Short-Run Equilibrium with Trade FIGURE 6-6 (1 of 2) 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. With sales of Q 2 at price P 2, the firm will make monopoly profits because price is greater than AC. 13

14 Trade under Monopolistic Equilibrium with Free Trade Short-Run Equilibrium with Trade FIGURE 6-6 (2 of 2) Competition 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. 14

15 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 lies to the right of D/N A. 15

16 Trade under Monopolistic Competition Equilibrium with Free Trade Long-Run Equilibrium with Trade FIGURE 6-7 (1 of 2) 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. 16

17 Trade under Monopolistic Competition Equilibrium with Free Trade Long-Run Equilibrium with Trade FIGURE 6-7 (2 of 2) Long-Run Monopolistic Competition Equilibrium with Trade (continued) Compared with the long-run equilibrium without trade (Figure 6-5), d 3 (along with mr 3 ) has shifted out as domestic firms exited the industry and has become more elastic due to the greater total number of varieties with trade, 2N T > N A. 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. 17

18 Trade under Monopolistic Equilibrium with Free Trade Gains from Trade The long-run equilibrium at point C has two sources of gains from trade for consumers: A drop in price. The lower price is a result of increased productivity of the surviving firms coming from increasing returns to scale. Gains from trade to consumers. Competition 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. 18

19 Trade under Monopolistic Competition Equilibrium with Free Trade Adjustment Costs from 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. 19

20 Gains from trade Gains from trade will occur because the world economy will produce a greater diversity of goods than would either country alone, offering each individual a wider range of choice (i.e., even if wages do not change). To get an increase in scale, we must assume that the demand facing each individual firm becomes more elastic as the number of firms increases. Increasing elasticity of demand when the variety of products grows seems plausible, since the more finely differentiated are the products, the better substitutes they are likely to be for one another. 20

21 Who produces what? While the volume of trade is determinate, the direction of trade- which country produces which goods-is not. This indeterminacy seems to be a general characteristic of models in which trade is a consequence of economies of scale. Nothing important hinges on who produces what within a group of differentiated products. There is an indeterminacy, but it doesn't matter. 21

22 Home market effect The larger country, other things equal, will have the higher wage. If production costs were the same in both countries, it would always be more profitable to produce near the larger market, thus minimizing transportation costs. To keep labor employed in both countries, this advantage must be offset by a wage differential 22

23 K e y T e r m 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.

24 K e y T e r m KEY POINTS 2. When trade opens between two countries, the demand curve faced by each firm 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.

25 K e y T e r m KEY POINTS 3. Introducing international trade under monopolistic competition 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.

26 K e y T e r m KEY POINTS 4. The assumption of differentiated goods helps us to understand why countries often import and export varieties of the same type of good. That outcome occurs with the model of monopolistic competition.

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