Ch. 6: Economies of Scale, Imperfect Competition, and International Trade

1. Ch. 6: Economies of Scale, Imperfect Competition, and International Trade

2. Constant Returns To Scale • The models we have looked at previously all assumed constant returns to scale. • Constant returns to scale means if all of the resources are doubled, output will be doubled as well. • aQ = Q(aK,aL) • This assumption allows firms to have increasing costs so that there could be many firms in a market.

3. Increasing Returns to Scale • It is possible that firms might experience increasing returns to scale. • Doubling inputs more than doubles output. • This is called economies of scale. • Internal economies of scale: per unit cost of production will decline as the firm expands. • External economies of scale: per unit cost of production will decline as the industry expands.

4. Monopolistic Competition • Internal economies of scale favor large firms. • The number of firms in the industry becomes small. • Oligopoly or monopoly results. • Declining average cost means that if the firm can operate in a larger market it can lower its costs hence its price.

5. An Example of Economies of Scale If wage rate were $1, the last column would show average (per unit) cost.

7. Firm in Imperfect Competition • Decision rule: compare MR with MC. • If MR>MC increase production. • If MR<MC decrease production. • MR (marginal revenue) is the contribution of the last unit of output to revenue. • MC (marginal cost) is the contribution of the last unit of output to cost. • Imperfect competition means when the firm increases its output, the price of the product falls: firm’s D is downward.

8. Firm in Imperfect Competition • Demand curve facing a firm is downward sloping. • More output results in lower price because of the behavior of the consumers. • Demand curve will determine the price charged at each and every level of output. • Marginal revenue will be below the price because in order to sell an extra unit the price for all units has to be lowered.

9. Demand and Marginal Revenue P P D MR D MR Q Q Marginal revenue curve has a slope twice as steep as the demand curve.

10. Demand and Marginal Revenue Demand: P = a – bQ -b is the slope Total Revenue: TR = PQ PQ = aQ –bQ2 Marginal Revenue: MR = Δ(PQ)/ΔQ MR = a – 2bQ -2b is the slope

11. How Close Is P to MR? • MR = P – bQ • P – MR = bQ • The steeper is the demand curve, the larger is b, and the farther is P from MR. • The flatter is the demand curve, the smaller is b, and the closer is P to MR. • Why is the relationship in the book different than here? • Book: P-MR=Q/b; here: P-MR=bQ

12. Firm Making Excess Profits $ P1 AC MC D MR Q Q1

13. Long Run Equilibrium of a Monopolistically CompetitiveFirm Existence of excess profits attracts new firms into the industry. Increased competition reduces the market share for each firm. We show this by shifting the demand leftward. Excess profits remain until P=AC. In the long run a monopolistically competitive firm gets only normal profits. More firms forces firms to produce less at a higher AC. P1 AC MC D1 MR2 Q1

14. LR Eqm and # of Firms In the long-run, the higher the industry output (S), the higher will be the output of the firm (Q), given the number of firms (n). In the long-run, the higher the competitive firms’ price (P), the higher will be the price charged by the monopolistically competitive firm (P). Let the Demand curve for the firm be: Q = S [1/n – b (P – P)]

16. Let P = P Q = S [1/n – b (P – P)] Q = S/n AC = F/Q + c AC = F (n/S) + c Therefore, more firms there are, higher the AC. This will be our CC curve later. Larger the industry output, lower the AC.

17. Marginal Revenue Demand: Q = S [1/n – b (P – P)] Q = S/n – SbP + SbP SbP = S/n + SbP – Q P = 1/bn + P – Q/Sb Total Revenue: PQ = Q/bn + QP – Q2/Sb MR = d(PQ)/dQ = 1/bn + P – Q/Sb – Q/Sb MR = P – Q/Sb

18. Firm Equilibrium MR = MC P – Q/Sb = c At equilibrium, P = c + Q/Sb If all the firms charge the same price, then P = P Q = S/n Plug in: P = c + 1/bn The more firms there are in the industry, the lower the price each firm will charge. This is our PP curve.

28. Trade and Monopolistic Competition • Typically, firms in one country will produce a range of differentiated products different than the firms in another country. • Trade will increase the market for all firms and allow a larger output by firms. • Each firm and each country will specialize in a different set of brands. • Exchange will allow consumers to have a larger choice at lower prices.

29. Pattern of Trade • Interindustry trade reflects comparative advantage. • Capital abundant country exports capital-intensive goods. • Intraindustry trade reflects economies of scale that keep a country from producing a full range of products. • The pattern of intraindustry trade is dependent on history and accident. • Similar countries (K/L ratios) will engage in intraindustry trade; different K/L ratios support interindustry trade.

30. The Significance of Intraindustry Trade • About 1/4 of world trade is intraindustry. • It is the main trade pattern between industrialized nations. • The index of intraindustry trade is calculated by the following formula. • I = 1 - (|exports-imports|)/(exports+imports)

31. Significance of Intraindustry TradeIndexes of Intra-industry Trade for US, 1993 The measure shown above is intra-industry trade/total trade. The measure would be zero for an industry in which the US was only an exporter or importer. It would be one in an industry where exports equaled imports. Sophisticated manufactured goods are exported by advanced nations and are probably subject to important economies of scale. Footwear and apparel are typically labor-intensive goods.

32. Significance of Intraindustry Trade Source: S. Vona, “Intra-Industry Trade: A Statistical Artifact of a Real Phenomenon?” Banca Nazionale Lavoro Quart. Rev., December 1990, p. 400. Quoted in D. Salvatore, International Economics, 5th ed., Prentice-Hall, New Jersey, 1995, p. 164.

33. Welfare and Distribution Effects of Intraindustry Trade • Intraindustry trade allows countries to benefit from larger markets. They produce fewer varieties of goods at a larger scale with higher productivity and lower costs. Consumers benefit from the increased range of choice. (Example: The North American Auto Pact of 1964.)

34. Welfare and Distribution Effects of Intraindustry Trade • Comparative advantage punishes the domestic industries competing with imports even though the overall well-being is raised. In intraindustry trade income distribution effects are small and there are substantial gains from trade. (Example: European Union).

35. The North American Auto Pact of 1964 • Before 1965, tariff protection by Canada and the United States produced a Canadian auto industry that was largely self-sufficient. • The Canadian industry was one-tenth the size of US industry with labor productivity 30 percent lower.

36. The North American Auto Pact of 1964 • Canadian plants were smaller and had to produce more varied products than US plants. They had to hold larger inventories, use less specialized machinery, shut down more often to change over from one model to another.

37. The North American Auto Pact of 1964 • The Auto Pact of 1964 allowed auto companies to reorganize their production. Number of products made in Canada was drastically reduced; GM cut half of its models made in Canada. • The overall level of Canadian employment and production was maintained through specialization.

38. The North American Auto Pact of 1964 • In 1962, Canada exported $16 million worth of automotive products to the US while importing $519 million worth. • By 1968, Canada exported $2.4 billion worth and imported $2.9 billion worth. • The gains were substantial: by early 1970s the Canadian industry was comparable to the US industry in productivity.

39. European Union • In 1957, the major countries of continental Europe established a free trade area in manufactured goods. • Trade within the EEC grew twice as fast as world trade during the 1960s.

40. European Union • There were no dislocations and political problems from the rapid growth of trade because it was entirely intraindustry. • Instead of French electrical machinery workers being hurt while those in Germany gained, workers in both sectors gained from the increased efficiency of the integrated European industry. • There were far fewer social and political problems from the rapid growth of trade than anyone anticipated.

41. Dumping

42. Dumping

43. Dumping • If the more elastic demand curve is abroad, the firm will charge higher prices domestically and lower prices abroad. • It is conceivable that a firm might have more monopoly power (higher market share) at home than abroad. • Import competitors cry foul in this case.

44. Dumping P MC Pdom Pfor=MRfor Ddom MRdom Q Qdom Qtotal

45. Politics of Steel Trade restrictions in the U.S. in 1999

46. The Vote • The House voted decisively on Wednesday (March 17, 1999) to limit steel imports, ignoring opposition from the Republican leadership and a White House warning that the measure would violate world trade agreements. • The 289-to-141 vote -- one short of the two-thirds margin needed to override a Presidential veto -- displayed the division in the Democratic Party over Clinton's free trade policies as well as the appeal of protectionism to Republicans from the Rust Belt states. All but 13 House Democrats deserted the Administration. And 91 Republicans, a surprisingly large number, broke from their party's traditional free-trade position. Alison Mitchell, "By a Wide Margin, House Votes Steel Import Curbs," The New York Times, March 18, 1999, http://partners.nytimes.com/ 3/18/99

47. The Bill • The bill, the first major trade measure of this session of Congress, directs the United States to limit steel imports from other nations to their average monthly volume for the three-year period ending in July 1997. It would be up to the Administration to decide whether to use quotas, tariffs or voluntary agreements to achieve such a reduction, which would approach 30 percent. • The limits in the House bill would reduce steel imports by 12 million tons a year from 1998 levels, while still allowing about 29 million tons of steel into the country. At the height of the import surge in 1998, 41 million tons of steel was being imported annually. Alison Mitchell, "By a Wide Margin, House Votes Steel Import Curbs," The New York Times, March 18, 1999, http://partners.nytimes.com/ 3/18/99

48. The Upsurge in Imports • With world demand hurt by the Asian financial crisis, foreign steelmakers have sold their products at low prices. The American industry has seen a drop in business while imports rose 33 percent in 1998 before starting to subside in December. • In February 1999, the Clinton Administration said it would impose tariffs to punish Japan and Brazil for dumping steel in this country at prices below cost and negotiated an agreement with Russia to limit imports. Alison Mitchell, "By a Wide Margin, House Votes Steel Import Curbs," The New York Times, March 18, 1999, http://partners.nytimes.com/ 3/18/99

49. Anti-Dumping Duties • On Feb. 12, 1999, U.S. Commerce Department announced import duties on Japanese and Brazilian steel. • Japan, Brazil and Russia have been in a recession and their cheap steel exports to US soared partly because of a strong US economy. US steelmakers saw profits decline, forcing them to lay off workers and idle plants. • In September 1998, Bethlehem Steel, LTV Corp. and 10 others filed a complaint. http://www.bloomberg.com/news2.cgi?T=news2_ft_topww.ht&s=380485412 2/13/99

50. Anti-Dumping Duties • Hot-rolled steel, used in pipe and machinery, makes up 20% of US steel imports. • Dumping penalties range from 57% to 80% on Brazilian companies and 25% to 68% on Japanese. • Japan Steel Information Center in New York claimed that since September 1998 no hot-rolled steel was being shipped to the US. • Japan is the largest steel exporter to the US: 1998 total $4.1 billion. • Bethlehem stock rose 9%, CSN, Brazil stock fell 4.5%. Http://www.bloomberg.com/news2.cgi?T=news2_ft_topww.ht&s=380485412 2/13/99