CHAPTER 6
SCALE ECONOMIES, IMPERFECT COMPETITION, AND
TRADE
Objectives of the Chapter
According to our standard trade theory, a country will export that good in which it has a comparative
advantage (such as wheat) and import that good in which it has a comparative disadvantage (such as
automobiles). But in “the real world” we observe that countries often both import and export the same
type of good! The explanation for this intra-industry trade between nations that have similar factor
endowments will focus on the ways in which our standard trade model, based upon comparative
advantage and perfect competition, may be oversimplified. In particular, economies of scale (both
internal and external), product differentiation, monopolistic competition, and global oligopoly all play a
role in explaining how a country can both import and export the same basic product, such as automobiles,
computers, apparel, or alcohol. Economies of scale can also help explain why industries locate in some
countries and not in others.
An interesting implication of these alternative theories is that more people may gain from trade than we
had previously thought using the standard models. In particular, under both monopolistic competition and
economies of scale, when production expands with the opening of trade, we may experience an added
benefit of reduction in the costs of production. As a result, not only will all buyers of goods enjoy a
greater variety, but all buyers (including those in the exporting country) will enjoy lower prices!
After studying Chapter 6, you should be able to identify
1. intra-industry trade (IIT).
2. the apparent contradiction between Heckscher-Ohlin theory and IIT.
3. the role of product differentiation in international trade
4. how economies of scale relate to monopolistic competition and oligopoly.
Important Concepts
Economies of scale:
The percent reduction in average costs achieved by expanding all
inputs by a given percentage.
External economies of scale:
Productivity gains and cost reductions that an individual firm reaps
from the expansion of other firms in the same geographic area.
Gravity model of trade:
The theory that trade between two countries increases as the size and
proximity of the countries increase.
Internal economies of scale:
Productivity gains and cost reductions that a firm reaps from
expanding its own scale of production.
Intra-industry trade:
Two-way trade in similar products between countries. IIT can be
measured as the difference between total trade [X+M] and net trade
│X-M│.
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Monopolistic competition:
A market structure with many firms selling differentiated products,
and low barriers to entry and exit in the industry. It is like monopoly in
that each firm has some control over the price it charges, because
products are differentiated. Yet, like perfect competition, free entry
and exit of other firms in the industry push each firm toward zero net
profit.
Oligopoly:
A market structure with a few firms supplying most of the output.
Firms know that their actions affect each other.
Warm-up Questions
True or False? Explain.
1.
T/F
Intra-industry trade in a product may be positive even if net trade in that product is zero.
2.
T/F
IIT is significantly more prevalent in perfectly competitive industries.
3.
T/F
Economies of scale are said to exist whenever a balanced growth of resources causes a
rise in average costs.
4.
T/F
In standard trade models, domestic consumers of the exported good always lose when
trade opens. In trade models that consider scale economics, domestic consumers of the
exported good may gain from the opening of trade.
5.
T/F
English riding boot manufacturers will lose if imports of Swiss hiking boots increase.
Multiple Choice
1.
Intra-industry trade is more likely to occur between
A. rich and poor countries.
B. countries with high and similar income levels.
C. developing countries.
D. developed and developing countries.
2.
Which of the following statements best describes the relationship between comparative
advantage and economies of scale?
A. Economies of scale determine each country’s comparative advantage.
B. Economies of scale do not determine each country’s comparative advantage, but rather
translate any given comparative advantage into lower prices and greater expansion of output
and trade.
C. Comparative advantage can be explained better through external economies of scale than
internal ones, since external economies of scale imply an expansion in output of other
competing firms.
D. Comparative advantage can best be explained by internal economies of scale because of the
resultant higher productivity and lower costs to the firm.
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3.
Economies of scale are more likely to occur in
A. a small-scale textile industry.
B. the aircraft industry.
C. the footwear industry.
D. small business.
4.
In the monopolistic competition model of trade,
A. if two countries have the same overall capital-labor ratio, there is no trade.
B. there are gains from trade from an increased variety of goods and possible scale economies.
C. firms earn positive economic profits in the long run.
D. factor endowments do not play any role.
5.
If production of a good is subject to external economies of scale, when trade in the good opens,
A. consumers of the good in both the export and import countries lose.
B. consumers of the good in both the export and import country win.
C. consumers in the export country lose; consumers in the import country win.
D. consumers in the export country win; consumers in the import country lose.
Problems
1.
Return, once again, to our hypothetical two-country world: labor-abundant Leinster and landabundant Saxony, as illustrated in Figure 2-1.
a. What is the share of IIT in Leinster? How would you interpret the number you calculated? Is
it consistent with Heckscher-Ohlin?
b. Under what conditions might you expect to see an increase in bread exports from Leinster to
Saxony?
2.
Could two countries with identical abilities to produce (i.e., the same production possibility
curves) and identical tastes (i.e., the same indifference curves) gain from trading with each other?
Explain, making your assumptions clear.
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3.
Suppose the liquor industries in the United States and in France are characterized by
monopolistic competition. What happens when trade is opened up between these countries? How
do countries gain from trade in this case?
4.
Consider a hypothetical example of trade between the United States, Japan (a developed country)
and Sudan (a developing country):
Primary
products
Manufactures
U.S. Exports
($b) to Japan
75
U.S. Exports
($b) to Sudan
50
U.S. Imports
($b) from Japan
60
U.S. Imports
($b) from Sudan
55
70
65
150
0
a. Compare the IIT trade share of the United States with Japan and Sudan.
b. Is IIT trade higher with Japan or with Sudan? Why should that be the case?
5.
The United States government sets limits on the export of computers and software to many
countries. If the government were to remove all restrictions on exports of computer products,
could this benefit U.S. buyers (consumers) of computer products? If not, explain why that is
impossible. If so, explain what conditions could make U.S. computer buyers better off.
Discussion Topics
1.
How does the theory of intra-industry trade explain why Canada is the largest trading partner of
the United States?
2.
How does the theory of intra-industry trade explain why Mexico is not the largest trading partner
of the United States?
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