6
INCREASING RETURNS
TO SCALE
AND IMPERFECT
COMPETITION
1
Basics of Imperfect
Competition
2
Trade under Monopolistic
Competition
3
Empirical Applications of
Monopolistic Competition
and Trade
4
Imperfect Competition with
Homogeneous Products
5
Conclusions
Introduction
• We will look at trade in golf clubs, a good that the
U.S. imports and exports in large quantities.
• Many countries that sell to the U.S. are also
buying from the U.S.
 The total value of imports is close to the total value of
exports.
• Why does the U.S. export and import golf clubs to
and from the same countries?
 We observe intra-industry trade.
 A new explanation for trade will be discussed here.
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Introduction
Table 6.1 U.S. Imports of Golf Clubs, 2005
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Introduction
Table 6.1 U.S. Exports of Golf Clubs, 2005
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Introduction
• We will look at a model of monopolistic
competition where goods are differentiated.
 Gives a degree of market power
• Firms tend to specialize because in monopolistic
competition we have increasing returns to scale
• The imperfect competition model also predicts
that larger countries will trade more with each
other.
 This is called the gravity equation.
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Trade Under Monopolistic Competition
• We begin this section with a few assumptions
 Assumption 1: each firm produces a good that is similar
to, but differentiated from, the goods that other firms in
the industry produce.
 Assumption 2: there are many firms in the industry.
 Assumption 3: firms produce using a technology with
increasing returns to scale (decreasing AC, fig. 6.3).
 Assumption 4: firms can enter and exit the industry
freely, so that monopoly profits are zero in the long run.
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Trade Under Monopolistic Competition
Figure 6.3
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Trade Under Monopolistic Competition
• Numerical Example
 Using the cost curve in figure 6.3, we get:
 Fixed costs = $100
 Marginal costs = $10/unit
Q
VC=Q*MC
TC=FC+VC
AC=TC/Q
10
$100
$200
$20
20
200
300
15
30
300
400
13.3
40
400
500
12.5
50
500
600
12
100
1000
1100
11
Large Q
10Q
10Q+100
Close to 10
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Trade Under Monopolistic Competition
• Equilibrium Without Trade
 Short-Run Equilibrium




Figure 6.4 shows our monopolistically competitive firm.
Each firm maximizes profits by producing Q0, where MR=MC.
Price is from the demand curve at P0.
Since price is greater than average cost, the firm is earning
positive monopoly profits.
 Long-Run Equilibrium
 Since firms are making positive profits, firms will enter the
industry.
 The demand for existing firms will fall until no firm is earning
positive profits; the demand curves also becomes flatter (more
elastic).
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Trade Under Monopolistic Competition
Figure 6.4
Price
Short run equilibrium here is the same as
for a monopolist. MR = MC with price from
demand. Since P > AC, firm is making a
profit.
P0
AC
MC
mr0
Demand curve
facing each firm, d0
Q0
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Quantity
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Trade Under Monopolistic Competition
Figure 6.5
Drawn by the profits in the industry, firms
enter. The demand for this firm drops to d1
Equilibrium is at A, producing Q1,
with corresponding mr1. d1 is more elastic,
where mr1 crosses MC. This gives
due to competition,
and therefore flatter
price, PA, from the demand, d1
than d0
Price
At Q1, the no-trade price PA = AC so the
firms are all earning zero monopoly profits
and there is no entry or exit
P0
PA
A
AC
MC
mr1
Q1
d1
D/NA
d0
Firm demand when all firms
charge the same price
Q0
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Quantity
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Trade Under Monopolistic Competition
• Equilibrium With Free 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 (NA)
 If there were no economies of scale, there would be no reason for
trade.
• Short-Run Equilibrium with Trade
 When trade opens, the number of customers available to each firm
doubles, but the number of product varieties available to each
consumer also doubles.
 With the greater number of varieties available, the demand for
each individual variety will be more elastic.
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Trade Under Monopolistic Competition
• Short-Run Equilibrium with Trade
 After trade, demand is no longer tangent to the AC.
 Each firm now produces at Q2 charging P2.
 Firms are making positive monopoly profits.
 This shows the firm’s incentive to lower its price
 Every firm in the industry has the same incentive.
 If all firms lower prices, though, the quantity demanded
from each firm increases along D/NA, instead of d2.
 Remember D/NA is the demand if all firms had the same price.
 In the short run, firms lower their prices expecting to
make profits at B, but end up with losses at B′.
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Trade Under Monopolistic Competition
Figure 6.6
As
all firms
lower
their the
price
to Pdemand
demand
Opening
trade
makes
firm’s
even more
2, the relevant
A
is
D/N at
B’ selling
Q’firm
this point
are at Q2,
elastic,
shown
by d2only
. The
to firms
produce
2. Atchooses
incurring
losses and
some
forced
exit
the
where MR=MC,
selling
at Pfirms
thisbe
price
the to
firm
makes
2. At will
industry
monopoly profits as P2>AC
Price
PA
P2
Long-run equilibrium
without trade
Short-run equilibrium
with trade
A
B
B’
d2
AC
MC
mr2
D/NA
Q1 Q’2
Q2
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Quantity
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Trade Under Monopolistic Competition
• Long-Run Equilibrium with Trade
 Since firms will exit the industry, increasing demand for
the remaining firms’ products and decrease the
available product varieties to consumers.
 We now only have NT firms which is fewer than the NA
firms we had before.
 The new demand D/NT lies to the right of D/NA.
 Long-run equilibrium with trade is at point C.
 The demand for each firm d3 is tangent to AC.
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Trade Under Monopolistic Competition
Figure 6.7
Price
Since
some
firms
have
exited
the is
Since
PW = AC,
firms
making
zero
The demand
faced
byare
each
firm
d3
industry,
are=MC
leftnowith
T firms
which
monopoly
firms
exit
enter the
with mr3we
. profits,
mr
shows
that or
each
3
gives
each
firm
aisshare
of the
demand
industry,
and
CQ
the long
runW
equilibrium
firm produces
3 at a price P
T
shown
by D/N
with trade
Long-run equilibrium
without trade
D/NT
PA
Long-run equilibrium
with trade
A
C
PW
d3
AC
MC
mr3
Q1
Q3
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Quantity
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Trade Under Monopolistic Competition
• Long-Run Equilibrium with Trade
 The world number of products is greater than the
number available in each country before trade.
 Fewer firms remain in each country, but each is bigger.
 As quantity increases, average costs fall due to
increasing returns to scale, therefore so do prices.
• Gains From Trade
 There are two sources of gains for consumers:
 Price is lower after trade.
 Consumers obtain higher surplus when there are more product
varieties from which to choose.
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Trade Under Monopolistic Competition
• Adjustment Costs from Trade
 There are adjustment costs as some firms shut down and
exit the industry.
 Workers in those firms experience a spell of unemployment.
 Over the long run however, we expect those workers to find
new positions.
 Temporary costs
 Compare short-run and long-run adjustment costs.
 We will look at evidence form Mexico, Canada, and the U.S.
under the North American Free Trade Agreement (NAFTA).
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Empirical Applications of Monopolistic
Competition and Trade
• Gains and Adjustment Costs for Canada
 The potential for Canadian firms to expand output was a key
factor in Canada’s free-trade agreement with the U.S. in
1989 and entry into NAFTA (along with Mexico) in 1994.
 Studies in Canada as early as the 1960s predicted
substantial gains from free trade with the U.S.
 Firms would expand their scale of operations to service
the larger market and lower their costs.
 Studies by Harris in the mid-80s influenced Canadian policy
makers to proceed with the free trade agreement with the
U.S.
 The article described next looks at what happened in
Canada after the implementation of NAFTA.
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What Happened When Two countries Liberalized Trade?
HEADLINES
• Data from 1988–1996 was used by Daniel Trefler
of University of Toronto to estimate effects of the
Canada-U.S. Free Trade Agreement.
• Some findings:
 Short-run adjustment costs of 100,000 jobs, or 5% of
manufacturing employment.
 Some industries that had very large tariff cuts saw
employment fall by as much as 12%
 Over time, however, these job losses were more than
made up for by creation of new jobs elsewhere in
manufacturing.
 There were no long run job losses due to NAFTA.
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What Happened When Two countries Liberalized Trade?
HEADLINES
• In the long run, large positive effects on
productivity were found.
 15% over eight years in industries most affected by tariff cuts—
compound growth of 1.9%/year.
 6% for manufacturing overall—compound growth of 0.7%/year.
 The difference of 1.2%/year is an estimate of how free trade with
the U.S. affected the Canadian industries over and above the
impact on other industries.
 There was also a rise of 3% in real earnings over this period.
• These findings support the monopolistic
competition model.
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Empirical Applications of Monopolistic
Competition and Trade
• Gains and Adjustment Costs for Mexico
 Joining NAFTA was a way to ensure the permanence of
economic reforms already underway.
 Under NAFTA, Mexican tariffs on U.S. goods declined
from an average of 14% in 1990 to 1% in 2001.
 In addition, U.S. tariffs on Mexican imports fell as well.
• Productivity in Mexico (figure 6.8)
 Panel A shows productivity over time.
 Panel B shows what happened to real wages and real
income over time.
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Empirical Applications of Monopolistic
Competition and Trade
Figure 6.8
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Empirical Applications of Monopolistic
Competition and Trade
• Productivity in Mexico
 For the maquiladora plants, productivity rose 45% from
1994 to 2003—compound growth rate of 4.1%/year.
 For non-maquiladora plants, productivity rose overall by
25%—compound growth rate of 2.5%/year.
 The difference, 1.6%/year, is an estimate of the impact
of NAFTA on the productivity of maquiladora plants
over and above the increase in productivity that
occurred in the rest of Mexico.
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Empirical Applications of Monopolistic
Competition and Trade
• Real Wages and Income
 From 1994 to 1997, there was a fall of over 20% in real wages
in both sectors, even with increase in productivity. Why did it
happen?
 Shortly after joining NAFTA, Mexico suffered a financial crisis
that led to a large devaluation of the peso.
 Mexican CPI went up leading to a fall in real wages.
 The decline was, however, short lived.
 Real wages in both sectors began to rise again in 1998.
 By 2003, real wages were almost back to their 1994 value.
 Since real wages were not higher than in 1994, any
productivity gains from NAFTA were not shared with workers.
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Empirical Applications of Monopolistic
Competition and Trade
• Real Wages and Income
 If we look at real monthly income, the picture is a little
better.
 This includes other sources of income beside wages, especially
for higher-income persons.
 In the maquiladora sector, real incomes were higher in
2003 than in 1994.
 Some gains for workers in plants most affected by NAFTA.
 Higher-income workers fared better than unskilled
workers in Mexico.
 Higher-income workers in the maquiladora sector are principal
gainers due to NAFTA in the long run.
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Empirical Applications of Monopolistic
Competition and Trade
Figure 6.8
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Empirical Applications of Monopolistic
Competition and Trade
• Adjustment Costs in Mexico
 When Mexico joined NAFTA, it was expected that the
agricultural sector would fare the worst due to
competition from the U.S.
 Tariff reductions in agriculture were phased in over 15 years.
 The evidence to date shows the corn farmers did not
suffer as much as was feared. Why?
 The poorest farmers consume the corn they grow.
 Mexican government was able to use subsidies to offset the
reduction in income for other corn farmers.
 Total production of corn in Mexico rose following NAFTA.
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Empirical Applications of Monopolistic
Competition and Trade
• Adjustment Costs in Mexico
 Increasing volatility due to trade can be counted as
adjustment costs.
 For maquiladora plants, employment grew rapidly
following NAFTA to a peak of 1.29 million in 2000.
 After that, this sector entered a downturn.
 The U.S. entered a recession decreasing demand for Mexican
exports.
 China was competing for U.S. sales by exporting goods similar
to those sold by Mexico.
 The Mexican peso became over-valued, making it difficult to
export abroad.
 Employment in the maquiladora sector fell after 2000 to
1.1 million in 2003.
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Empirical Applications of Monopolistic
Competition and Trade
• Gains and Adjustment Costs for the U.S.
 Studies on the effects of NAFTA on the U.S. have not
estimated its effects on the productivity of U.S. firms.
 It would be hard to identify the impact since Mexico and
Canada are only two of many trading partners.
 Instead, researchers have estimated the second source
of gains from trade: the expansion of import varieties
available to consumers.
 For U.S. we will compare the long-run gains to
consumers due to expanded product varieties with the
short-run adjustment costs from exiting firms and
unemployment.
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Empirical Applications of Monopolistic
Competition and Trade
• Expansion of Variety to the U.S.
 To understand how NAFTA affected the range of products
available to U.S. customers, we will look at imports from
Mexico in 1990 and 2001.
 Focus on the number of different types of products Mexico
sells to the U.S. compared to the total the U.S. imports from
all countries.
Table 6.3 Mexico’s Export Variety to the United States
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Empirical Applications of Monopolistic
Competition and Trade
• Expansion of Variety to the U.S.
 According to one estimate, the total number of product
varieties imported into the U.S. from 1972–2001 has
increased four times.
 That expansion in import variety has had the same
effect as a reduction in import prices of 1.2% per year.
 Using an average $90 billion in U.S. imports per year
and the 1.2% reduction in prices to U.S. consumers,
$90(1.2%) = $1.1 billion per year in savings to
consumers.
 These consumer savings are permanent and increase
over time as export varieties grow.
 In 2003, the 10th year of NAFTA, consumers would gain
$11 billion as compared to 1994.
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Empirical Applications of Monopolistic
Competition and Trade
• Adjustment Costs in the U.S.
 These come as firms exit the market due to import competition and
the workers employed there are temporarily unemployed.
 One way to measure this loss is to look at claims under the U.S.
Trade Adjustment Assistance (TAA) provisions.
 From 1994–2002, about 525,000 workers, or about 58,000 per
year, lost their jobs and were certified as adversely affected by
trade under the NAFTA-TAA program.
 Compare to the annual number of workers displaced in
manufacturing or 444,000 workers per year.
 The NAFTA layoffs of 58,000 workers were about 13% of total
displacement—this is a substantial amount.
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Empirical Applications of Monopolistic
Competition and Trade
• Adjustment Costs in the U.S.
 Another way to measure effects is to compare the loss in
wages from the displaced workers to the consumer gains.
 Suppose the average length of unemployment for laid off
workers is 3 years.
 Average yearly earnings for manufacturing workers was
$31,000 in 2000 so each displaced worker lost $93,000 in
wages. total losses were $5.4 billion.
 These private costs of $5.4 billion are nearly equal to the
average welfare gains of $5.5 billion.
 However, gains continue to grow over time and job loss was
only temporary.
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Empirical Applications of Monopolistic
Competition and Trade
• Summary of NAFTA
 We have been able to measure in part the long-run
gains and short-run costs from NAFTA for Canada,
Mexico, and the U.S.
 It is clear that for Canada and the U.S., the long-run
gains considerably exceed the short-run costs.
 In Mexico the gains have not been reflected in the
growth of real wages for production workers.
 The real earnings for higher-income workers in the
maquiladora sector have risen and have been the
principal beneficiaries of NAFTA so far.
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Empirical Applications of Monopolistic
Competition and Trade
• Intra-Industry Trade
 Countries will specialize in producing different varieties
of a differentiated good and will trade those varieties
back and forth.
 The index of intra-industry trade tells us what
proportion of trade in each product involves both
imports and exports.
 100 = equal quantities of exports and imports
 0 = only exports or imports
Min of Imports & Exports
Index of IIT 
1 Exports  Imports
2
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Empirical Applications of Monopolistic
Competition and Trade
• Index of Intra-Industry Trade
 For the golf clubs, we can use data from Table 6.1.
 The minimum of imports and exports is $305.8.
 Using the other data, we have
Index of IIT = 305.8/[.5(305.8+318.7)] = 98%.
 In Table 6.4 there are other examples of intra-industry
trade in other products for the U.S.
 To obtain a high index of intra-industry trade, it is
necessary for the good to be differentiated and for
costs to be similar in the Home and Foreign countries,
leading to both imports and exports.
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Empirical Applications of Monopolistic
Competition and Trade
Table 6.4 Index of Intra-Industry Trade for the U.S.
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Empirical Applications of Monopolistic
Competition and Trade
• The Gravity Equation
 To explain the value of trade, we need a different equation
called the gravity equation.
 Dutch economist and Nobel laureate, Jan Tinbergen was
trained in physics and thought the trade between countries
was similar to the force of gravity between objects.
 Objects with larger mass or those that are close together have
greater gravitational pull between them.
 The force of gravity between these two masses is:
Fg = G[M1M2/d2]
 G is the constant that tells the magnitude of the relationship.
 M1 and M2 are the two objects’ masses.
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Empirical Applications of Monopolistic
Competition and Trade
• The Gravity Equation in Trade
 We use a similar equation to measure the trade
between two countries.
 Instead of mass, we use the GDP of each country.
 The distance still matters, but we are not sure of the
precise relationship between distance and trade.
 There is also a constant term that indicates the
relationship between the gravity term and trade.
GDP1 GDP2
Trade  B
dist n
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Empirical Applications of Monopolistic
Competition and Trade
• The Gravity Equation in Trade
 The constant term can also be interpreted as
summarizing the effects of all factors, other than
distance and size, that influence the amount of trade
between two countries.
 The effect of size is an implication of the monopolistic
competition model we studied in this chapter.
 Larger countries export more because they produce more
product varieties, and import more because their demand is
higher.
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Empirical Applications of Monopolistic
Competition and Trade
• Deriving the Gravity Equation
 Start with Country 1, which produces a differentiated
product.
 Other countries’ demand for Country 1’s goods depends on:
 The relative size of the importing country
 The distance between the two countries
 Relative size, is a country’s share of world GDP.
 Share2 = GDP2/GDPw
 Exports from Country 1 to Country 2 will equal the goods
available in Country 1 times the relative size of country 2,
divided by the transportation costs:
GDPShare
1
Trade =
=
dist
GDP
1
2
n
W
GDPGDP
dist
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1
2
n
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The Gravity Equation for Canada and the United States
APPLICATION
• Figure 6.9 shows data collected on the value of trade
between Canadian provinces and the U.S. states in 1993.
• An exponent of 1.25 is used on the distance variable
based on other research studies.
• The horizontal axis is the log of the gravity equation The
higher the value means either a large GDP for the trading
province and state or a smaller distance between them
• The vertical axis shows the 1993 value of exports
between a Canadian province and U.S. state or vice
versa, again in logarithms.
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The Gravity Equation for Canada and the United States
APPLICATION
• Each of the points in panel A represents the trade flow and
gravity term between one state and one province.
• We can see that a pair with a high gravity term also has
more trade.
 This supports the gravity equation theory.
• We can also estimate a best fit line through the data points
which gives a constant term of 93.
 When the gravity term equals 1, then the predicted amount of trade
between that state and province is $93 million.
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The Gravity Equation for Canada and the United States
APPLICATION
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Figure 6.9
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Trade with Canada
APPLICATION
• The gravity equation should also work well at predicting
trade within a country, or intra-national trade.
• Panel B of figure 6.9 graphs the value of exports and the
gravity term between any two Canadian provinces.
• There is a strong positive relationship between the gravity
term between two provinces and their trade.
• The best fit line gives a constant term of 1300.
 When gravity term is 1, the predicted amount of trade is $1.3
billion.
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Trade with Canada
APPLICATION
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Figure 6.9
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Trade with Canada
APPLICATION
• Taking the ratio of the constant terms (1300/93 = 14),
means on average there is 14 times more trade within
Canada than occurs across the border.
• The number is even higher if we consider an earlier year
before the free trade agreement.
 In 1988, intra-national trade within Canada was 22 times higher.
• The fact that there is so much trade within Canada reflects
all the barriers to trade that occur between countries.
 Tariffs and Quotas
 Other administrative rules and regulations
 Geographic an cultural factors
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Imperfect Competition with Homogeneous
Products: The Case of Dumping
• While product differentiation is a good assumption for
many goods, it does not hold for unprocessed goods
traded between firms.
 Chemicals, lumber, minerals, steel, can all be treated as
homogeneous.
• However, in many of these goods, the markets are not
perfectly competitive.
 We want to assume imperfect competition here even though the
goods are homogeneous.
• With imperfect competition, firms can charge different
prices across countries and will do so whenever it is
profitable.
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Imperfect Competition with Homogeneous
Products: The Case of Dumping
• A Model of Product Dumping
 Dumping occurs when a firm sells a product abroad at
a price that is either less than the price it charges in its
local market, or less than its average cost to produce
the product.
 Under the rules of the WTO, am importing country is
entitled to apply a tariff, called an antidumping duty
any time a foreign firm dumps its product on a local
market.
 Why do firms dump at all?
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Imperfect Competition with Homogeneous
Products: The Case of Dumping
• Discriminating Monopoly
 Assume a foreign monopolist sells both to its local
market and exports to Home.
 The monopolist is able to charge different prices in the
two markets.
 Discriminating monopoly
 Firm has a monopoly at home but faces a competitive
export market
 Downward sloping demand curve in home market.
 Horizontal demand curve in export market.
 Consider the following example:
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Imperfect Competition with Homogeneous
Products: The Case of Dumping
Figure 6.10
Price
The monopolist sells Q2 to its
local market and (Q1-Q2) to
its export market
Local
Price, P*
AC*
AC1
Export
Price, P
C
B
Local Marginal
Revenue, MR*
Q2
Local Sales
Q1
The
sold in the
Thequantity
export monopoly
local
market profits
is at point
maximizes
at
C
where
local
marginal
MC*
point B where local
costs,
MC*,costs,
equalMC*,
local
marginal
marginal
revenues,
equal export
marginal
MR*.
They
can
revenues, MR then
charge a local price, P*,
from the local demand
curve
Notice the local price, P*, is greater
than AC*; but, the export price, P, is
less than AC*. This means the firm
is dumping into the export market
Export Demand, D, and export
marginal revenue, MR
Local
Demand, D*
Foreign Quantity
Exports
© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
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Imperfect Competition with Homogeneous
Products: The Case of Dumping
• The Profitability of Dumping
 The Foreign firm charges P* selling Q2 in the local
market.
 The local price is higher than the export price.
 It is dumping its product into the export market.
 The average costs are lower than the local price but
higher than the export price.
 Since AC is above the export price, the firm is also
dumping according to this cost comparison.
© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
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Imperfect Competition with Homogeneous
Products: The Case of Dumping
• Numerical Example of Dumping
 Suppose the following data:
 Fixed costs = $100; Marginal costs = $10/unit
 Local price = $25; Local quantity = 10
 Export price = $15; Export quantity = 10
 Profits from the local market are:
 $25(10) - $10(10) - $100 = $50
 Average costs for the firms are $20.
 Profits in the export market are:
 [$25(10) + $15(10)] - $10(20) - $100 = $100
 The export price is below AC but above MC.
© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
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Imperfect Competition with Homogeneous
Products: The Case of Dumping
• Reciprocal Dumping
 It can happen that firms in both countries are accused
of dumping in the other—this is reciprocal dumping.
 For example, shortly after the U.S. ruled that Canadian
greenhouse tomatoes were being dumped into the
U.S., the Canadian government investigated dumping
against American fresh tomatoes.
 The final ruling was that there was no harm or injury to
the firms in either country, so no antidumping duties
were applied.
© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
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Imperfect Competition with Homogeneous
Products: The Case of Dumping
• Reciprocal Dumping
 How can it be profitable for both firms to charge prices
for their exports that are below their local prices?
 We show that, in fact, it is a common feature of
imperfectly competitive markets.
 Rather than selling additional units in the local market
and depressing its own price, a firm can enter the
export market.
 It then depresses the price of firms abroad by
increasing quantity.
 Since both firms have this incentive, equilibrium will
have both firms selling abroad.
© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
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Imperfect Competition with Homogeneous
Products: The Case of Dumping
• Numerical Example of Reciprocal Dumping
 Assume Home and Foreign have identical demand
curves: P = 100 – Q
 Remember, marginal revenue, MR = P – ΔP*Q
 The price drops $1 for even extra unit sold, so ΔP=1
and MR = P-Q, this gives:
 MR = P – Q = (100 – Q) – Q = 100 – 2Q
 Home and Foreign have identical MC = $20/unit.
 Without trade, we get the monopoly equilibrium
 Q = 40 and P = $60
© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
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Imperfect Competition with Homogeneous
Products: The Case of Dumping
Figure 6.11
As with any monopoly, each firm will choose their profit maximizing output where
MR=MC and get their price from the demand curve: Q=40 and P=$60. For the
firm to increase production would require lowering price, which is not profitable.
(a) Home
Price
(b) Foreign
Price
No-trade
monopoly
equilibrium
No-trade
monopoly
equilibrium
$60
A
A*
$20
MC
MR
40
D
D*
MR*
Quantity
40
© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Quantity
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Imperfect Competition with Homogeneous
Products: The Case of Dumping
• Trade Equilibrium in the Home Market
 Foreign has an incentive to export to Home (since price is
still above marginal cost and doing so depresses price for
the other firm).
 The Foreign firm will export more than one unit since the
MR>MC.
 We can use the equilibrium condition (MR=MC) from before
to determine how much will be exported.
 In this case we will assume there are transportation costs for
the exports of $10 per unit, so the equilibrium condition is:
 $20 + $10 = P – QF
 QF = P - $30
© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
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Imperfect Competition with Homogeneous
Products: The Case of Dumping
• Trade Equilibrium in the Home Market
 In response to the price decline, the Home firm will reduce the
quantity it produces in Home.
 Home firm will choose the Home quantity by comparing MR to MC
in the Home market:
 QH = P - 20
 The price in the Home market is related to the total quantity sold:
 P = 100 – Q = 100 – QF – QH
 Using the profit maximizing conditions and the demand equation,
we get:
 P = 100 – (P - $30) – (P - $20) = $50
 The equilibrium price with trade is $50. Home produces 30 for
domestic market and 20 for Foreign.
© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
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Imperfect Competition with Homogeneous
Products: The Case of Dumping
• Two-way Trade
 Since the Foreign firm has an incentive to enter the
Home market and both firms are the same, the Home
firm has the same incentive in the Foreign market.
 Foreign price with trade will also be $50 with Foreign
producing 30 units for its own market and importing 20
units from Home.
 B and B* in figure 6.11
 Notice that as each firm sells in the other market, prices
fall in both market. Firms are engaged in “reciprocal
dumping”
© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
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Imperfect Competition with Homogeneous
Products: The Case of Dumping
Figure 6.11
From theequal
previous
derivation,
sawand
thatForeign
equilibrium
reciprocal
Exports
imports
for bothwe
Home
fromwith
each
dumping
will occur Dumping
at points B and B*, at a price of $50 selling 50.
other
– Reciprocal
Each country will have 30 in local sales and export 20.
Price
(a) Home
(b) Foreign
Price
No-trade
monopoly
equilibrium
No-trade
monopoly
equilibrium
$60
A
A*
B
$50
B*
$20
MC
D
D*
MR
30 40
50
Local Exports=
Sales Imports
MR*
Quantity
Reciprocal Dumping
30 40 50
Local
Sales
Quantity
Exports=
Imports
© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
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Imperfect Competition with Homogeneous
Products: The Case of Dumping
• Measurement of Dumping
 In trade disputes over dumping, the government in
each country compares the price that a Foreign firm
earns in the country’s market, net of transportation
costs, to the price the Foreign firm earns in its local
market.
 In our example, Foreign exports at $50 with $10 in
transportation costs: net $40.
 Since the price in local market is $50, Foreign is
dumping in the Home market.
 Similarly, Home is dumping into the Foreign market.
 Reciprocal dumping is occurring.
© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
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Imperfect Competition with Homogeneous
Products: The Case of Dumping
• Measurement of Dumping
 This example has allowed us to illustrate the incentives
for firms to enter markets abroad.
 For the first units sold to the export market, the MR for
the exporting firm will always be higher than the MR of
the local firm abroad.
 The exporting firm does not lose as much revenue from existing
sales by selling additional units in the export market.
 The Foreign firm has an incentive to enter the Home
market and the Home firm has an incentive to enter the
Foreign market.
 We should not be surprised to see two-way trade even
with homogeneous products.
© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
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