CHAPTER S I X
6
International
Economics
Tenth Edition
Economies of Scale,
Imperfect Competition, and
International Trade
Dominick Salvatore
John Wiley & Sons, Inc.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
In this chapter:
 Introduction
 The Heckscher-Ohlin Model and New Trade




Theories
Economies of Scale and International Trade
Imperfect Competition and International Trade
Trade Based on Dynamic Technological
Differences
Costs of Transportation, Environmental
Standards, and International Trade
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
6.1 Introduction
 Two difficulties with the H-O theory:
(1) Some questions remain regarding the empirical
validity of the theory.
(2) This implies that a great deal of today's
international trade still left unexplained.
 This chapter fills this gap with some new trade
theories, which base international trade on economies
of scale, imperfect competition, and differences in the
development and spread of new technologies over
time among nations.
Introduction
 Heckscher-Ohlin theory based comparative
advantage on differences in factor
endowments among nations.
 Leaves significant portion of international
trade unexplained.
 Need complementary trade theories to fill in
the gaps.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
The Heckscher-Ohlin Model and New Trade
Theories
 Relaxing most assumptions of H-O theory
modifies but does not invalidate the theory.
 However, relaxing assumptions of perfect
competition and constant economies of scale
require complementary theories to explain
trade.
 Additional trade model required to explain
trade based on differences in technological
changes over time.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
Economies of Scale and International Trade
 Increasing returns to scale

Production situation where output grows
proportionately more than the increase in
inputs (doubling inputs more than doubles output).

With increasing returns to scale, mutually
beneficial trade can occur even if nations are
identical in every way.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
6.3 Economies of Scale and International
6.3A. Assumptions
(1) There are two nations (N1, N2) two commodities (X, Y)
(2) Both nations use the same technology in production.
(3) Both nations have the same amount of resources.
(4) Neither commodity is labor intensive or capital intensive.
(5) Both commodities are produced under increasing returns
to scale in both nations.
- i.e., Output grows proportionately more than the increase in inputs
of production. (eg., If all inputs are doubled, output is more than
doubled: Economies of scale.)
(6) Tastes are equal in both nations.
FIGURE 6-1 Trade Based on Economies of Scale.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
6.3 Economies of Scale and International
6.3B. Explanation
 Some aspects of the analysis:
(0) With trade, each nation becomes completely specialized in the
production of one commodity.
(1) Which of the two commodities each nation becomes specialized
may result from historical accident.
(2) In real world, the nations need not be identical in every respect.
(3) Eventually, one or a few firms in the nation will capture the entire
market for a given product, leading to monopoly or oligopoly.
(4) The nations may trade similar products in the same industry (i.e.,
intra-industry trade)
6.3 Economies of Scale and International
6.3C. Related Sources of International Trade
(1) International economies of scale (Case Study 6-1)
- Products manufactured by international corporations
have parts and components made in many different
nations.
- During the past decade or so, there has been a sharp
increase in international trade in parts and
components, as well as in setting up of production
facilities abroad, and these have been the source of
new and significant international economies of scale.
- E.g., The New International Economies of Scale
(Case Study 6-1)
Economies of Scale and International Trade
 Increasing returns to scale

Significant international economies of scale
from:

Outsourcing – purchase by firm of parts and
components abroad in order to keep costs
down.

Offshoring – firm producing in its own plants
abroad some of the parts and components used
in its products.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
6.4 Imperfect Competition and International
Trade
6.4A. Trade Based on Production Differentiation
(1) Product differentiation and monopolistic competition
- Differentiated products: "Neither identical products, nor
different products". E.g., Cars, TV sets, etc.
- Cf: Standardized (homogeneous) products: "Identical
products."E.g., Most of the agricultural products and
labor intensive products.
- Monopolistic competition: The market organization
where there are many firms selling a differentiated
product and entry into or exit from the industry is easy.
6.4 Imperfect Competition and International
Trade
6.4A. Trade Based on Production Differentiation
- Cf: Perfect competition vs. Monopoly
-
Thus differentiated products are usually produced under
monopolistic competition.
(2) Product differentiation and intra-industry trade
- Intra-industry trade: a phenomenon of international
exchanging of differentiated products of the same
industry. (As a result of economies of scale, product
differentiation under monopolistic competition.)
- Inter-industry trade: a phenomenon of exchanging
completely different products. (H-O model)
Imperfect Competition and International
Trade
 International trade can involve the exchange
of differentiated products of the same
industry or broad product group.
 Leads to intra-industry trade in
differentiated products, as opposed to interindustry trade in completely different
products.
 Allows economies of scale in production.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
Imperfect Competition and International
Trade
 Contrasts to H-O Model
1.
Trade in H-O model based on factor endowment
differentials, but intra-industry trade is based on
product differentiation and economies of scale,
and will likely be larger for nations of similar
size and factor proportions.
2.
With differentiated products produced under
economies of scale, pretrade-relative commodity
prices may not accurately predict patterns of
trade as they do under H-O model.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
Imperfect Competition and International
Trade
 Contrasts to H-O Model
3.
H-O model predicts trade will lower returns of
nation’s scarce factor. With intra-industry trade
based on economies of scale, it is possible for all
factors to gain.
4.
Intra-industry trade is related to sharp increases
in international trade in parts and components of
a product, or outsourcing.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
Imperfect Competition and International
Trade
 Comparative advantage seems to determine
patterns of inter-industry trade.

More likely with dissimilar factor endowments.
 Economies of scale in differentiated products
gives rise to intra-industry trade.

More likely with similar factor endowments.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
Imperfect Competition and International
Trade
 Intra-industry Trade Index (T):
|X - M|
T=1- X+M
 X = exports
 M = imports
 Numerator is absolute value
 T ranges from 0 to 1
 T=0 when nation only imports or exports the good
 T=1 when exports = imports.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
6.4 Imperfect Competition and International
Trade
 Key characteristics of Intra-industry trade:
(1) While inter-industry trade (eg., trade in the H-O
model) is based on comparative advantage among
nations, intra-industry trade is based on product
differentiation and economies of scale.
(2) With intra-industry trade, pretrade-relative
commodity prices may no longer accurately predict
the pattern of trade.
(3) While the H-O model predicts that trade will lower
the return of the nation's scarce factor, with intraindustry trade it is possible for all factors to gain.
6.4 Imperfect Competition and International
Trade
 Key characteristics of Intra-industry trade:
(4) Intra-industry trade is related to the sharp increase in
international trade in parts and components of a
product.
(5) Intra-industry trade arises more between nations with
similar tastes and income levels.
(6) While most of the trade between developed and
developing countries is inter-industry trade, an
increasing proportion of the trade among industrial
countries is intra-industry trade.
6.4 Imperfect Competition and International
Trade
6.4B. Measuring Intra-Industry Trade
 Intra-industry trade index (Grubel-Lloyd index):
T = 1 - | X M | / (X + M)
 If T = 1, perfect intra-industry trade.
 If T = 0, perfect inter-industry trade.
Case Study 6-2. U.S. Intra-Industry in Automotive Products
Case Study 6-3 Variety Gains with International Trade
6.4C. Formal Model of Intra-Industry Trade (Skip)
6.4D. Another Version of the Intra-Industry Trade Model
(Skip)
FIGURE 6-2 Production and Pricing Under Monopolistic
Competition.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
FIGURE 6-3 Monopolistic Competition and Intra-Industry Trade.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
Trade Based on Dynamic Technological
Differences
 Product Cycle Model (Vernon, 1966)
 Advanced industrialized countries develop and
introduce new products, with temporary
monopoly power as the sole exporter of the
product.
 As the technology producing the product becomes
more widespread, production will spread to other
nations.
 This moves international trade to a standard
comparative advantage framework
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
Trade Based on Dynamic Technological
Differences
 Product Cycle Model (Vernon, 1966)
 As production becomes standardized, the original
introducer of the product loses its technologically
based comparative advantage in the production of
the product and becomes an importer of the
product.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
FIGURE 6-4 The Product Cycle Model.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
Costs of Transportation, Environmental
Standards and International Trade
 Transportation costs
 Transport, or logistics, costs are the freight
charges, warehousing costs, costs of loading and
unloading, insurance premiums, and interest
charges incurred while goods are in transit
between nations.
 Homogeneous goods will be trade internationally
only if the pretrade price difference exceeds
transport costs.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
Costs of Transportation, Environmental
Standards and International Trade
 Transportation costs
 Nontraded goods and services are goods for
which transport costs exceed price differences
across nations.
 Examples:


Cement is not traded internationally because of its
high weight-to-value ratio.
Average people do not travel from New York to
London for a haircut.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
Costs of Transportation, Environmental
Standards and International Trade
 Two ways to analyze transport costs

General equilibrium analysis


Uses production frontiers or offer curves, and
expresses transport costs in terms of relative
commodity prices.
Partial equilibrium analysis


Analyze absolute cost by holding constant exchange
rates, income, and all else in the two nations except
amount of good produced, consumed and traded.
More straightforward method than general
equilibrium analysis.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
FIGURE 6-5 Partial Equilibrium Analysis of Transport Costs.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
Costs of Transportation, Environmental
Standards and International Trade
 Transport costs influence location of production
and industry:



Resource-oriented industries locate near the source of
raw materials used by the industry.
Market-oriented industries produce goods that
become heavier or more difficult to transport during
production, so they locate near the markets for their
products.
Footloose industries face neither substantial weight
gains nor losses during production, and can locate
where availability of other inputs leads to lower
manufacturing costs.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
Costs of Transportation, Environmental
Standards and International Trade
 Environmental standards


Refers to levels of air, water and thermal
pollution resulting from garbage disposal that
a nation allows.
A nation with lower environmental standards
can use the environment as a resource
endowment, achieving comparative
advantage in polluting goods and services.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
Appendix to Chapter 6
 External Economies and Specialization
 The Learning Curve and Specialization
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
FIGURE 6-6 External Economies and Specialization.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
FIGURE 6-7 The Learning Curve and Specialization.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.