New Trade Theory: Krugman

New Trade Theory: Krugman

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  PAUL KRUGMAN’S NEWTRADE THEORY St. Xavier’s College, Kolkata Economics Department Arunima Paul Phone: 8013794924, Email: [email protected] Avipsha Sengupta Phone: 9830291564 , Email: [email protected] INTRODUCTION: Pure theory of trade explains inter-industry trade on the basis of the principle of comparative advantage – technology driven in Classical, and relative factor abundance driven in Neo-Classical theories. The central assumptions of both the theories are : 1. Perfect competition with constant returns to scale 2. Factor mobility between sectors within the country, and immobility between countries. Developments of 1950s, 60s and 70s brought about major empirical findings. The Asian Tigers, China etc started capturing global markets. Major empirical findings suggest that a large part of such trade is intra- industry. Intra-industry trade led to the development of new trade theories. Consumers love variety and therefore products are quality differentiated. It led to the development of trade under a monopolistic competition. THE SIGNIFICANCE OF INTRA-INDUSTRY TRADE About one-fourth of world trade consists if intra-industry trade, that is, two-way exchanges of goods within standard industrial classifications. Intra-industry trade plays a particularly large role in the trade in manufactured goods among advanced industrial nations, which accounts for most of world trade. Over time, the industrial countries have become increasingly similar in their levels of technology and in the availability of capital and skilled labor. Since the major trading nations have similar in technology and resources, there is often no clear comparative advantage within an industry, and much of international trade therefore takes the form of two way exchanges within industries-probably driven in large part by economies of scale-rather than inter-industry specialization driven by comparative advantage. ECONOMIES OF SCALE AND MARKET STRUCTURE
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  External economies ofscale occur when the cost per unit depends on the size of the industry but not necessarily on the size of any one firm. Internal economies of scale occur when the cost per unit depends on the size of an individual firm but not necessarily on that of the industry. External and internal economies of scale have different implications for the structure of industries. An industry where economies of scale are purely external will typically consist of many small firms and be perfectly competitive. On the other hand, internal economies of scale give large firms a cost advantage over small and lead to an imperfectly competitive market structure. We begin with a model based on internal economies of scale. THE THEORY OF IMPERFECT COMPETITION In imperfect competition, firms are aware that they can influence the prices of their products and that they can sell more only by reducing their price. Imperfect competition is characteristic both of industries in which there are only a few major producers and of industries in which each producer’s product is seen by consumers as strongly differentiated from those of rival firms. Under these circumstances, the firm sees itself as a price setter, choosing the price of its product rather than a price taker. When firms are not price takers it is essential to develop additional tools to explain how prices and outputs are determined. A pure monopoly is the simplest imperfectly competitive market structure-it describes the market in which a firm faces no competition and the tools that are developed can then be used to examine more complex market structures. Underlying the application of the monopolistic competition model to trade is the idea that trade increases market size. In industries where there are economies of scale both the variety of goods that a country can produce and the scale of its production are constrained by the size of the market. By trading with each other and therefore forming an integrated world market that is bigger than any individual national market, nations are able to loosen their constraints. Each country can specialize in using a narrower range of products than it would in the absence of trade; on the same hand by buying goods that it does not make from other countries, each nation can simultaneously increase the variety of goods available to its consumers. As a result trade offers an opportunity for mutual gain even when countries do not differ in their resources or technologies. The monopolistic competition model can be used to show how trade improves the trade-off between scale and variety faced by individual nations. We will show how in this model a larger market leads to a lower average price as well as availability of a greater variety of goods. Applying this result to international trade it is observed that a world market larger than any of the national markets that comprise it is created by trade. Therefore, integrating market through international trade has the same effects as growth of a market within a single country.
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  cost and priceCC1 CC2 1 P1 2 P2 PP n1 n2 number of firms, n The figure shows the effect of an increase in the size of the market on long-run equilibrium. Initially, equilibrium is at point 1, with a price p1 and number of firms n1. An increase in the size of the market, measured by industry sales S, shifts the CC curve down from CC1 to CC2, while it has no effect on the PP curve. The new equilibrium is at point 2: The number of firms increases from n1 to n2, while the price falls from p1 to p2. Clearly, consumers would prefer to be part of a large market rather than a small one. At point 2, a greater variety of products is available at a lower price than at point 1. International trade can create a larger market. We can illustrate the effects of trade on prices, scale, and the variety of goods available with a specific example. Imagine a commodity is produced by a monopolistically competitive industry. More the number of firms, more intense is their competition, hence lower is the industry price. This relationship is plotted on a graph and labeled PP. On the other hand, the more firms there are, the less each firm sells and so, higher is the average cost. This relationship is plotted on the graph and represented by CC. Let us take a hypothetical example. Let the total cost function be, TC= 750 + 5q. Let Home under autarky sell 900 units at p= 10. Let the foreign sell 1600 units at p= 8.75. The market being monopolistically competitive, autarky number of firms in Home = autarky varieties would be given by zero profit solution. Similarly for the Foreign. For the Home, p= AC implies 10=750/q + 5 or 5q= 750 or q= 150. Therefore, number of firms= 900/150= 6. For the Foreign, 8.75= 750/q + 5 or 3.75q= 750 or q= 200. So number of firms= 1600/200= 8. Total number of varieties in the two countries are limited to the respective number of firms. Let trade occur. 2500 units are now sold at p= 8 (say). Therefore, 8= 750/q + 5 or 3q= 750 or q= 250. Therefore, number of firms= 2500/250= 10. It follows that trade under monopolistic competition implies more production by each firm (scale economy), lower price and larger varieties.
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  Thus it isclear that everyone is better off as a result of integration. A little intervention from us at this juncture does not seem to be too adventurous. Assuming total cost, C= F + c.q, demand function of a firm q= S[1/n-b(P-P0)] where F= fixed cost, S= total market, n= number of firms, b= price responsiveness of demand, P= price charged by the firm and P0= average price of all the firms. We can establish that n= (S/b.F)^0.5. It follows that if the number of varieties increases because of trade higher demand elasticity implies bigger b such that when S rises (F remaining the same), n need not rise. This possibility seems to have been overlooked by Krugman’s model. THE THEORY OF EXTERNAL ECONOMIES For a variety of reasons, it is often the case that concentrating production of an industry in one or a few locations reduces the industry’s costs, even if the individual firms in the industry remain small. When economies of scale apply at the level of the industry rather than at the level of the individual firm, they are called external economies. External economies, like economies of scale that are internal to firms, play an important role in international trade, but they may be quite different in their effects. In particular, external economies can cause countries to get “locked in” to undesirable patterns of specialization and can even lead losses from international trade. When there are external economies of scale a country that has large production in some industry will tend, other things equal, to have low cost of producing that good. This gives rise to an obvious circularity since a country that can produce a good cheaply will also therefore tend to produce a lot of that good. Strong external economies tend to confirm existing patterns of inter industry trade, whatever their original sources: countries that start out as large producers in certain industries, for whatever reason tend to remain large producers, they may do so even if some other country could potentially produce the goods more cheaply. Price, cost (per watch) CO 1 P1 2 AC1 D AC2 Qty of watches produced & demanded Q1
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  The average costcurve for Country 2, AC2 lies below the average cost curve of Country 1. Thus Country 2 could potentially supply the world market more cheaply than Country 1. If the industry of Country 1 gets established first, however it may be able to sell watches at price P1 which is below the cost C0 that an individual firm of Country 2 would face if it began production on its own. So a pattern of specialization established by historical accident may persist even new producers could potentially have lower costs. DUMPING In imperfectly competitive markets firms sometimes charge one price for a good when that good is exported and a different price for the same good when it is sold domestically. In general the practice of charging different customers different prices is called price discrimination. The most common form of price discrimination in international trade is ‘dumping’, a pricing practice in which a firm charges a lower price for exported goods than it does for the same goods sold domestically. Dumping can occur only if two conditions are met. First, the industry must be imperfectly competitive, so that firms prices rather than taking market prices as given. Second, markets must be segmented so that domestic residence cannot easily purchase goods intended for export. Given these conditions, a monopolistic firm may find that it is profitable to engage in dumping. The diagram below shows a monopolist that faces a demand curve DDOM for domestic sales but which can also sell as much as it likes at the export price PFOR. Since an additional unit can always be sold at PFOR, the firm increases output until the marginal cost equals PFOR. This profit maximizing output is shown as QMONOPOLY. Since the firm’s marginal cost at QMONOPOLY is PFOR, it sells out on the domestic market up to the point where marginal revenue equals PFOR. This profit maximizing level of domestic sales is shown as QDOM. The rest of its output QMONOPOLY – QDOM is exported. The price at which domestic consumers demand QDOM is PDOM. Since PDOM > PFOR, the firm sells exports at a lower price than it charges domestic consumers. PRICE PDOM MC PFOR DFOR=MRFOR DDOM MRDOM QDOM QMONOPOLY QUANTITY Domestic sales Exports Total Output
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  The analysis ofexternal economy as the basis of trade seems to be too simplistic in terms of the cost functions. The results will differ if the cost functions are any of the following: AC2 AC1 AC1 AC2 RECIPROCAL DUMPING The analysis of dumping suggests that price discrimination can actually give rise to international trade. Suppose there are two monopolies, each producing the same good, one in Home and one in Foreign. To simplify the analysis let us assume that both firms have the same marginal cost. If we introduce the possibility of dumping, however trade may emerge. Each firm will limit the quantity it sells in its home market recognizing that if it tries to sell more it will drive down the price on its existing domestic sales. If a firm can sell a little bit in the other market, however, it will add to its profit even if the price is lower than in the domestic market. If both firms do this, however, the result will be the emergence of trade even though there was no initial difference in the price of the goods in the two markets. Even more peculiarly, there will be two-way trade in the same product. The situation in which dumping leads to two-way trade is known as reciprocal dumping. CONCLUSION: OLD AND NEW, SOME RECONCILATION This designation derives from the fact that in these theories, the departure from the orthodox theory is kept minimum (in particular the assumption of perfect competition is maintained) and the conclusion is obtained that the intra-industry trade conforms to the traditional statement of Heckscher-Ohlin theorem. We shall introduce a model given by Falvey (1981) which initially says that each industry does no longer produce a single homogenous output but instead can engage in production of a range of products differentiated by quality. The second point of departure from the orthodox theory is the nature of capital: the capital stock is no longer homogenous but consists of capital equipments specific to each industry. Because of its specificity, the capital stock is immobile among industries but of course freely mobile in the production of the various qualities within each industry.
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  For simplicity, letus limit the analysis to a single industry ❖ This industry owns a certain amount of specific capital (whose rate of return R adjusts in order to maintain the full employment of the capital stock) and can employ a desirable amount of labor at current wage rate W. ❖ The industry under consideration produces a continuum of different qualities of product with CRS technology. ❖ In order to define quality Falvey introduced a numerical index α, such that greater values of α implied greater qualities, and assumes that the production of higher-quality goods requires a correspondingly higher quantity of capital per unit of labor. It is now possible to define the measurement units in such a way that the production of a good quality α requires one units of labor and α units of capital. Given the assumption of perfect competition, for any quality, the price equals the unit cost of production, namely P1(α) = W1 + αR1 P2(α) = W2 + αR2 Where the subscripts 1 and 2 refer as usual to the two countries, whose technology is assumes identical. Without loss of generality we can assume that W1>W2. It follows that international trade requires R1<R2: in the opposite case in fact we see from the above equations that country 2 can produce any quality of the commodity at a cost which is lower than in country 1, so that there would be no scope for international trade. Assuming then R1<R2 it follows that a certain subset of qualities will be produced in country 1 at a lower cost than in country 2 and vice versa for the other subsets. To identify these two subsets let us use a diagram where there are two linear price-cost relationships given in the two previous equations. P(α) R2(α) P2(α) W1 W2 ά Let us note that Ri is the slope of line pi, p2 line is steeper than p1 sine R2>R1. We see from the diagram that prices are equal in the two countries. In correspondence to the ‘marginal quality’ ά where country 2 has a comparative cost advantage over country 1 for lower quality products (α<ά); conversely, country 1 has a comparative cost advantage for a higher quality products (α>ά). If we now make the plausible assumption that in both countries there is a demand for both lower quality and higher quality products, it follows that, in the typical situation of free trade with no transport costs,
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  there will beinternational trade in the products of the industry considered: country 1 will export higher quality products to country 2. Since we are dealing with products of the same industry, what has taken place is indeed intra-industrial trade. So we see such a trade follows the lines of Heckscher-Ohlin theorem as can be easily shown given the assumptions made on the returns to the factors of production, we have R1/W1 < R2/W2 which means that country 1 is capital abundant relative to country 2 according to the price definition of relative factor abundance. Now since higher values of α means higher qualities and values of the capital/labor ratio. We observe that country 1, the capital abundant country exports capital intensive products. It is worthwhile emphasizing the fact that a plausible model of intra-industry trade has been produced with a minimum of departure from the orthodox theory: apart from product differentiation, it has not been necessary to introduce economies of scale or monopolistic competition and other models too. After everything is said and done two precautions are in order. We do not live in the world of perfect information. Firms under monopolistic competition do advertise to inform the buyers. But misleading advertisements are hardly rare. In such cases two problems appear, namely : the problem of Moral Hazard and the problem of Adverse Selection. When the firms are taking the benefit of scale economy, total number of firms in the globe is going down. It is possible that firms producing cleaner goods (at higher cost) exit the market. The society wants to avoid dirty goods. However, firms producing dirty goods at lower cost survive. Trade may not be welfare augmenting under such a situation and yet the old order changeth yielding place to the new and we look forward to the best hoping that scale economy would not reduce the global economy to a sink for pollution. REFERENCES: • International economics theory and policy by Krugman Obstfeld • Gandolfo : International Economic Theory • Caves, Jones and Frankel : World, Trade and Payments • Peter Kenen : International Economy • Soddersteen and Reed : International Economics