ECON7530

Lecture 8
The New Trade Theory (part 2)
Nhan Phan
UQ School of Economics
Last Week – Summary
• Trade need not be the result of comparative advantage. Instead, it
can result from increasing returns or economies of scale.
• Economies of scale give countries an incentive to specialize and trade
even in the absence of differences in resources or technology
between countries.
• Economies of scale can be internal (depending on the size of the firm)
or external (depending on the size of the industry).
• External economies give an important role to history and accident in
determining the pattern of international trade.
• When external economies are important, countries can conceivably
lose from trade.
Refresh – Summary of International Trade
Country Main Target Reasons of Trade

Difference in
Inter-industry
Ricardian model different technology
trade
(labour productivity) Comparative
Advantage
Inter-industry Difference in factor
Hecksher-Ohlin model different
trade endowment

can be Intra-industry Economies of Scale

(Old) New trade theory
identical trade (Internal & External)
can be Heterogeneous productivity across
(New) New trade theory Firm-level exports
identical firms
Learning Objectives
• Understand how internal economies of scale and product
differentiation lead to international trade and intra-industry trade.
• Recognize the new types of welfare gains from intra-industry trade.
• Describe how economic integration can lead to both winners and
losers among firms in the same industry.
Introduction
• Internal economies of scale result when large firms have a cost
advantage over small firms
• The industry becomes uncompetitive.
• Internal economies of scale imply that a firm’s average cost of
production decreases the more output it produces.
• In most sectors, goods are differentiated from each other and there
are other differences across firms.
• International trade causes the better-performing firms to thrive and
expand, while the worse-performing firms contract.
• Gain from trade: overall efficiency of the industry improves.
UQ Extend
The Theory of Imperfect Competition
• In imperfect competition, Each firm views itself as a price setter,
choosing the price of its product.
• Sell more only by reducing their price.
• A few major producers of a particular good or when each firm
produces a good that is differentiated from that of rival firms.
• Monopoly: industry with only one firm.
• Oligopoly: industry with only a few firms.
• Internal economies of scale: A larger is more efficient because
average cost decreases as output 𝑄 increases.
UQ Extend
Monopoly – A Brief Review

Demand curve: 𝑄 = 𝐴 − 𝐵 × 𝑃 𝐶 𝐹
𝑄 𝐴𝐶 = = + 𝑐 𝑀𝐶 = 𝑐
Marginal revenue: 𝑀𝑅 = 𝑃 − 𝑄 𝑄
𝐵
 UQ Extend – Monopolistic Competition
Each firm
1. can differentiate its product from the
product of competitors,
2. takes the prices charged by its rivals as
given.
• A firm in a monopolistically competitive
industry is expected to sell
• more as total sales in the industry increase
and as prices charged by rivals increase.
• less as the number of firms in the industry
increases and as the firm’s price increases. Source: Wikimedia Commons
UQ Extend
Monopolistic Competition and Trade

Two effects of trade as the market

size increases ➔ The number of
firms increases
1. Greater variety of goods for
consumers.
• Each firm’s product is differentiated
2. The price decreases
• Average cost decreases

Source: Adobe Stock

Numerical Example
Gains from Integrated Market
• Consider the monopolistically competitive automotive (car) industry.
• Product differentiation: Every firm’s cars are considered slightly different by consumers in
terms of branding, functionality etc.
• Suppose there are 2 countries: Home and Foreign
• Home and Foreign are identical in every way.
• E.g. cost of production for firms, consumer preferences, resource abundance etc.
• Only differ in market size (not critical consideration)
Home Market Size: 𝑺𝑯 = 𝟗𝟎𝟎, 𝟎𝟎𝟎 cars sold annually.
Foreign Market Size: 𝑺𝑭 = 𝟏, 𝟔𝟎𝟎, 𝟎𝟎𝟎 cars sold annually.
• 3 possible markets: (1) Home (𝐻); (2) Foreign (𝐹) if there is no trade; and (3) the
integrated World market (𝑊) if there is trade between the countries.
Numerical Example
Gains from Integrated Market
• Each firm faces the demand curve:
1
𝑄 = 𝑆 − 𝑏 𝑃 − 𝑃ത
𝑛
• For market 𝑘: every firm 𝑖 faces the demand function
1 1 𝑘
𝑄𝑖 = 𝑆 𝑘
− 𝑃𝑖 − ത𝑘
𝑃
𝑛𝑘 30000
• 𝑆 𝑘 : size of market 𝑘
• 𝑛𝑘 : number of firms in the market 𝑘
• 𝑃𝑖𝑘 : price firm 𝑖 charges
• 𝑃ത 𝑘 : average price in market 𝑘.
1
• 𝑏= : responsiveness of a firm’s sales to its price
30000
Numerical Example
Gains from Integrated Market
• Firms are symmetric (regardless of where it is in Home or Foreign)
• Fixed Costs: 𝐹 = $750 𝑀𝑖𝑙𝑙𝑖𝑜𝑛
• Marginal Cost: 𝑐 = $5000
• Same demand function
𝑆𝑘
• ➔ 𝑄𝑖 =
𝑛𝑘

• Then, each firm faces the average cost

𝐹 𝑘
𝐹
𝐴𝐶 = + 𝑐 = 𝑛 × 𝑘 + 𝑐
𝑄𝑖 𝑆
Price Setter
Each firm treats 𝑃ത 𝑘 as given
1 𝑆𝑘
• 𝑄𝑖 = 𝑆𝑘 −𝑏 𝑃𝑖𝑘
− =𝑃ത 𝑘 + 𝑆 𝑘 × 𝑏 × 𝑃ത 𝑘 − 𝑆 𝑘 × 𝑏 × 𝑃𝑖𝑘
𝑛 𝑛
𝑄
• Linear demand ➔ 𝑀𝑅 = 𝑃𝑖𝑘 − 𝑘 𝑖
𝑆 ×𝑏
𝑘 𝑄𝑖
Profit maximising: 𝑀𝑅 = 𝑀𝐶, or 𝑃𝑖 − 𝑘 = 𝑐
𝑆 ×𝑏
𝑘 𝑄𝑖
⇒ 𝑃𝑖 = 𝑐 + 𝑘
𝑆 ×𝑏
𝑆𝑘
Firms are symmetric ➔ 𝑄𝑖 = :
𝑛𝑘
1 30000
𝑃𝑖𝑘 =𝑐+ 𝑘 = 5000 +
𝑛 ×𝑏 𝑛
Example: Home Market
In the Home Market: Every firm 𝑖 in Home
• charges the same price 𝑃𝑖𝐻 = 𝑃ത 𝐻
𝑆𝐻
• obtains equal market share 𝑄𝑖𝐻 =
𝑛𝐻

𝐹 2500 𝐻
• 𝐶𝐶: 𝐴𝐶 𝐻 =𝑐 𝐻
+𝑛 𝐻 = 5000 + 𝑛
𝑆 3
1 30000
• 𝑃𝑃: 𝑃𝐻 =𝑐+ = 5000 +
𝑛𝐻 ×𝑏 𝑛𝐻
Example: Home Market (Autarky)
• At market equilibrium in Home:
𝐴𝐶 𝐻 = 𝑃𝐻
𝐹 1
⇒𝑐+ 𝑛𝐻 𝐻
=𝑐+ 𝐻
𝑆 𝑛 ×𝑏

𝑆𝐻 0.9𝑀 × 30000
⇒ 𝑛𝐻 = = = 36 = 6
𝑏×𝐹 750𝑀
1 30000
⇒ 𝑃𝐻
=𝑐+ 𝐻 = 5000 + = 10000
𝑛 ×𝑏 6
𝐹
⇒ 𝐴𝐶 = 𝑐 + 𝑛 𝐻 = 10000 (= 𝑃𝐻 )
𝐻 𝐻
𝑆
Example: Foreign Market
In the Foreign Market: Every firm 𝑖
• charges the same price 𝑃𝑖𝐹 = 𝑃ത 𝐹
𝑆𝐹
• obtains equal market share 𝑄𝑖𝐹 =
𝑛𝐹

𝐹
• 𝐶𝐶: 𝐴𝐶 𝐹 =𝑐+ 𝐹
𝑛 𝐹
𝑆

𝐹 1
• 𝑃𝑃: 𝑃 = 𝑐 +
𝑛𝐹 ×𝑏
Example: Home Market (Autarky)
• At market equilibrium in Foreign:
𝐴𝐶 𝐹 = 𝑃𝐹
𝐹 1
⇒𝑐+ 𝑛𝐹 𝐹
=𝑐+ 𝐹
𝑆 𝑛 ⋅𝑏

𝑆𝐹 1.6𝑀 × 30000
⇒ 𝑛𝐹 = = = 64 = 8
𝑏⋅𝐹 750𝑀
1 30000
⇒ 𝑃𝐹
=𝑐+ 𝐹 = 5000 + = 8750
𝑛 ⋅𝑏 8
𝐹
⇒ 𝐴𝐶 = 𝑐 + 𝑛 𝐻 = 8750 (= 𝑃𝐹 )
𝐻 𝐻
𝑆
Example: Integrated Market
Suppose on the other hand that the 2 countries trade – forming an
integrated world market.
• Size of integrated market
𝑆 𝑊 = 𝑆 𝐻 + 𝑆 𝐹 = 2.5 𝑀𝑖𝑙𝑙𝑖𝑜𝑛
• Firms operating in the integrated market can sell to any country
(Home or Foreign)
• Hence each firm faces demand
𝑊 1 𝑊
𝑄𝑖 = 𝑆 𝑊 − 𝑏 𝑃𝑖 − ത
𝑃 𝑊
𝑛𝑊
Example: Integrated Market
Every firm:
• charges the same price 𝑃𝑖𝑊 = 𝑃ത 𝑊
𝑆𝑊
• obtains equal market share 𝑄𝑖𝑊 =
𝑛𝑊

𝑊 𝐹
• 𝐶𝐶: 𝐴𝐶 𝑊
=𝑐+ 𝑛 𝑊 = 5000 + 300 × 𝑛𝑊
𝑆
1 30000
• 𝑃𝑃: 𝑃𝐻 =𝑐+ = 5000 + 𝑊
𝑛𝑊 ×𝑏 𝑛
Example: Integrated Market
• At market equilibrium:
𝐴𝐶 𝑊 = 𝑃𝑊
𝐹 1
⇒𝑐+ 𝑛𝑊 𝑊
=𝑐+ 𝑊
𝑆 𝑛 ⋅𝑏

𝑆𝑊 2.5𝑀 × 30000
⇒ 𝑛𝑊 = = = 100 = 10
𝑏⋅𝐹 750𝑀
1 30000
⇒ 𝑃𝑊
=𝑐+ 𝑊 = 5000 + = 8000
𝑛 ⋅𝑏 10
𝑊 𝑊
𝐹𝐶 𝑊)
⇒ 𝐴𝐶 = 𝑐 + 𝑛 = 8000 (= 𝑃
𝑆𝑊
Example: Integrated Market
Home Market Foreign Market, Integrated Market,
Blank
before Trade before Trade after Trade
Industry output 900,000 1,600,000 2,500,000
(# of autos)
Number of firms 6 8 10
Output per firm 150,000 200,000 250,000
(# of autos)
Average cost $10,000 $8,750 $8,000
Price $10,000 $8,750 $8,000
UQ Extend
Integrated Market and Gains from Trade
• The integrated market supports more firms
• Each producing at a larger scale and selling at a lower price than either national
market does on its own.
• Consumers are better off as a result of the larger market with integration:
1. Wider range of products available for purchase
2. Lower prices
• Each Firm is no worse than before
• Economic profits for each surviving firm remains at 0
• Firms exiting the market are no worse than before – still earns economic profits of 0
• Trade has benefited both countries – with the gains largely enjoyed by
consumers.
UQ Extend
Monopolistic Competition and Trade
• Product differentiation and internal economies of scale lead to trade
between similar countries with no comparative advantage
differences between them.
• Very different kind of trade than the one based on comparative
advantage
• Each country exports its comparative advantage good.
• How different? We have a new concept: Intra-industry trade
UQ Extend – Intra-Industry Trade
• Intra-Industry Trade: two-way exchanges of similar goods.
• In our example, both Home and Foreign export and import cars.
• Two new channels for welfare benefits from trade:
1. Benefit from a greater variety at a lower price.
2. Firms consolidate their production and take advantage of economies of
scale.
• A smaller country stands to gain more from integration than a larger
country.
• About 25–50% of world trade is intra-industry.
• Most prominent is the trade of manufactured goods among advanced
industrial nations.
Indexes of Intra-Industry Trade for U.S.
Industries, 2009
• Measure of importance of Intra- Metalworking Machinery 0.97
Inorganic Chemicals 0.97
Industry Trade
Power-Generating Machines 0.86
min 𝑀, 𝑋
𝐼= Medical and Pharmaceutical Products 0.85
𝑀+𝑋 Scientific Equipment 0.84
2 Organic Chemicals 0.79
• One-way trade: If a country Iron and Steel 0.76
Road Vehicles 0.70
imports 𝑀 = $100 of cars, and Office Machines 0.58
exports no cars 𝑋 = 0 , then Telecommunication Equipment 0.46
𝐼=0 Furniture 0.30
Clothing and Apparel 0.11
Footwear 0.10
Determinants of Intra-Industry Trade
• Significant in sophisticated, capital-intensive
manufactured goods
Metalworking Machinery 0.97
• Most likely subject to internal economies of scale. Inorganic Chemicals 0.97
• High fixed costs (e.g. related to capital investment) Power-Generating Machines 0.86
relative to variable costs of labor and materials. Medical and Pharmaceutical Products 0.85
Scientific Equipment 0.84
• Insignificant in typically labour-intensive products Organic Chemicals 0.79
Iron and Steel 0.76
• Low internal economies of scale. Road Vehicles 0.70
• Variable costs of labour more significant compared to Office Machines 0.58
fixed cost of capital/initial investment. Telecommunication Equipment 0.46
Furniture 0.30
• Factor costs probably more important in determining Clothing and Apparel 0.11
location of production. Footwear 0.10
• Probably better explained by comparative advantage.
 Case Study: The North American Auto Pact of
1964 and NAFTA

Source: Adobe Stock

Source: Wikimedia
Commons
Case Study: The North American Auto Pact of
1964 and NAFTA
• Before 1965, tariff protection by Canada and the United States
produced a Canadian auto industry that was largely self-sufficient.
• The Canadian auto industry was about one-tenth the size of the
United States and had a labour productivity about 30% lower than
that of the United States.
• Most Canadian plants produced several different things, requiring the plants
to shut down periodically to change over from producing one item to
producing another, to hold larger inventories, to use less specialized
machinery.
Case Study: The North American Auto Pact of
1964 and NAFTA
• The United States and Canada agreed in 1964 to establish free trade
in automobiles.
• This allowed the auto companies to reorganize their production.
• The overall level of Canadian production and employment was
maintained.
• Canadian subsidiaries cut many products that were made in Canada.
• Production levels for the models produced in Canada rose dramatically
• The Canadian plants became one of the main (or only) supplier of that model
for the whole North American market.
• Canada imported the models from the United States that it was no longer
producing.
• Both exports and imports increased sharply.
Case Study: The North American Auto Pact of
1964 and NAFTA
Models produced solely in Canada
(for NA market):
• Toyota RAV4
• Honda Civic Sedan
• Ford GT
Models produced solely in U.S.:
• Honda Civic Hatchback

Source: Nuvo Magazine

Case Study: The North American Auto Pact of
1964 and NAFTA
• By the early 1970s, the Canadian industry was comparable to the U.S.
industry in productivity.
• Later on, this transformation of the automotive industry was
extended to include Mexico.
• This process continued with the implementation of NAFTA.
• For each model of car, there is typically a plant in one of these three countries
that sells to the whole North American market.
• The manufacture of auto parts was also consolidated throughout the
North American market.
Case Study: The North American Auto Pact of
1964 and NAFTA
• In the first decade following NAFTA, trade in automotive parts
between the United States and Mexico more than doubled in both
directions.
• Trade doubled again in the ensuing decade, highlighting the
increasing importance of intra-industry trade.
Case Study: The North American Auto Pact of
1964 and NAFTA
• Concerns raised over a few final assembly plants relocating from the
United States to Mexico rarely mentions the large growth of U.S.
autos and parts exports to Mexico
• Over two-thirds of Mexican automotive imports originated in the United
States in 2002.
• Ending NAFTA likely would not result in higher car production in the
United States.
• Lower demand for U.S. imports in Mexico and Canada would lead to lower car
production in the United States.
• Only car production outside North America would increase.
Firm Responses to Trade
• Before, we assume firms are identical, but this is not true in reality.
• Different productivity ➔ Different marginal costs.
• Increased competition tends to hurt the worst-performing firms.
• They are forced to exit.
• However, economics profit of 0 means that they are not completely worse off
if they leave – they might just have a better opportunity elsewhere.
• The best-performing firms take the greatest advantage of new sales
opportunities and expand the most.
 Firm Responses to Trade
• Overall industry performance improves.
• The better-performing firms expand;
• The worse-performing ones contract or exit.
• Trade and economic integration improve
industry performance as much as the
discovery of a better technology does.
• Economics 101: Competition is good!

Source: Adobe Stock

 Performance Differences across Firms
• Two firms with two
different marginal costs:
• 𝑐1 vs 𝑐2
• Firm’s demand curve:
1
𝑄 = 𝑆 − 𝑏 𝑃 − 𝑃ത
𝑛
1 𝑄
⇒ 𝑃 = 𝑃ത + −
𝑏×𝑛 𝑆×𝑏
• Each marginal cost level
corresponds to an
operating profit level
• Figure (b)
Winners and Losers from Economic
Integration
• With economic integration, the
market size 𝑆 increases.
1 𝑄
• 𝑃 = 𝑃ത + −
𝑏×𝑛 𝑆×𝑏
• ➔ The slope becomes flatter
• 𝑛 also increases ➔ Intercept
decreases
• The operating profit curve on
(b) also pivots & becomes
steeper.
Intuition: Trade Costs and Export Decisions
Proportion of U.S. Firms Reporting
• A majority of domestic firms do not Export Sales by Industry, 2007
exports. Printing 15%
• What are firms subject to if they Furniture 16%
export? ➔ Trade costs Wood Products 21%

• We can model this trade cost as an Apparel 22%

Fabricated Metal 30%
increase in operating (marginal)
Petroleum and Coal 34%
cost.
Transportation Equipment 57%
• Intuitively, it is easy to see that only Machinery 61%
some firms will be able to export, Chemicals 65%
due to their lower costs. Electrical Equipment and Appliances 70%
Computer and Electronics 75%
Trade Costs and Export Decisions

• Firms 1 and 2 both operate in their domestic (Home) market.

• However, only firm 1 chooses to export to the Foreign market.
• It is not profitable for firm 2 to export given the trade cost t.
Summary
1. Internal economies of scale imply that more production at the firm level
causes average costs to fall.
2. With monopolistic competition, each firm can set its price due to
product differentiation but must compete with other firms whose prices
are believed to be unaffected by each firm’s actions.
3. Monopolistic competition allows for gains from trade through lower
costs and prices, as well as through wider consumer choice.
4. Monopolistic competition predicts intra-industry trade, and does not
predict changes in income distribution within a country.
5. Location of firms under monopolistic competition is unpredictable, but
countries with similar relative factors are predicted to engage in intra-
industry trade.