CHAPTER S I X
6
Economies of Scale,
Imperfect Competition, and
International Trade
Raj Kumar, Assistant Professor,
College of Vocational Studies, New Delhi.
Salvatore: International Economics,
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
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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.
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Relaxing the assumptions
 Relaxing the first assumption (2 nation, 2
factors, 2 commodities) leaves the HO model
basically valid, as long as number of
commodities is equal to or larger than the
number of factors. In general case, we will
require the construction of a factor intensity
index to predict the pattern of trade. This can
be complex but still be possible.
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Relaxing the assumptions
 Relaxing second assumption-both nation uses
same technology. However, technology can be
regarded as a factor of production, and trade
based on given technological difference among
nations could be viewed as falling within the
realm of the HO theory. But trade based on
change in technology over time among nations is
different matter, These are explained by the
technological gap and product cycle models.
Both models are dynamic extension of HO theory
Salvatore: International Economics,
Relaxing the assumptions
 Third assumption-absence of factor intensity
reversal. Factor intensity reversal would lead to
the rejection of the HO model. Empirical studies,
however, indicates that factor intensity reversal
is not very common in the real world. It seems
that the Leontief paradox could be eliminated by
the inclusion of human capital, the exclusion of
commodities intensive in natural resources, and
comparing the K/L ratio in production versus
consumption rather than in export versus
imports.
Salvatore: International Economics,
Relaxing the assumptions
 Forth assumption- CRS. International trade can
also be based on increasing returns to scale.
Increasing scale can be regarded as
complementary to the HO theory in that they try
to explain a portion of international trade not
covered by the basic HO theory.
 5th assumption-incomplete specialization in both
nations. If trade bring about complete
specialization in production in one of the nations,
relative commodity price will be equalized but
factor price will not.
Salvatore: International Economics,
Relaxing the assumptions
 6th assumption- equal tastes has been more or
less verified empirically. Tastes are certainly
not sufficiently different across nations to
overcome difference in the relative physical
availability of factors of production in
explaining different relative commodity
prices and trade among nations.
 7th assumption- Perfect competition in all
product and factor markets.
Salvatore: International Economics,
Relaxing the assumptions
It seems that about half of the trade in
manufacturing goods among industrialised
nations is based on product differentiation
and economices of scale, which are not easily
reconciled with the HO factor endowment
model. To explain Intra-Industry trade, we
need new trade theories.
 8th Assumption-No international factor
mobility but perfect mobility in a nation.
Salvatore: International Economics,
Relaxing the assumptions
The relaxation of 8th assumption will modifies
but does not invalidate the HO model. As we
will explain, international factor mobility can
be substitute for international trade in
bringing about equality of relative
commodity and factor prices among nations.
With some, but less than perfect international
factor mobility, the volume of trade required
to bring about relative commodity and factor
equalization would be less.
Salvatore: International Economics,
Relaxing the assumptions
 Similarly, transportation costs and other
nonprohibitive obstructions to the flow of
international trade (Assumption 9) reduce the
volume and the benefits of international trade,
but they only modify the HO theorem and the
factor equalization theorem.
 10th assumption-resources are fully utilised. If we
relax this assumption, then HO theorem
incorrectly predict the pattern of trade. But the
full employment assumption is for the most part
satisfied, at least in Industrial countries.
Salvatore: International Economics,
Relaxing the assumptions
 11th Assumption-international trade among
nation is balanced. Since most trade
imbalance are generally not very large in
relation to GNP, the charge that the HO
model might be unable to correctly predict
the pattern of trade is true only for those
commodities in which the nation has only a
very small comparative advantage.
Salvatore: International Economics,
Relaxing the assumptions
 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,
Economies of Scale and International Trade
 One of assumption of the HO model was that
both commodities were produced under
constant returns to scale in the two nations
(assumption 4). In this section, we relax this
assumption
 With Increasing returns to scale, mutually
beneficial trade can take place when the two
nations are identical in every respect. This is
type of trade that the HO model does not
explain.
Salvatore: International Economics,
Economies of Scale and International Trade
Type of economic scale
 Economies of scale could mean either that
larger firms or a larger industry is more
efficient.
 External economies of scale occur when cost
per unit of output depends on the size of the
industry.
 Internal economies of scale occur when the
cost per unit of output depends on the size of a
firm.
Salvatore: International Economics,
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).
We can explain mutually beneficial trade
based on increasing returns to scale by fig 6.1
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FIGURE 6-1 Trade Based on Economies of Scale.
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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,
Economies of Scale and International Trade
 Important points
 It is matter of complete indifference which of
the two nations specialises in the production
of commodity X or commodity Y. In the real
world, this may result from historical
accident.
 It should be clear (at-least intuitively) that the
two nations need not be identical in every
respect for mutually beneficial trade to result
from increasing returns to scale
Salvatore: International Economics,
Economies of Scale and International Trade
 If economice of scale persist over a
sufficiently long range of outputs one or a
few firms in the nation will capture the entire
market for a given product, leading to
monopoly or oligopoly.
 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 economic of scale
Salvatore: International Economics,
Economies of Scale and International Trade
 Economic of Scale vs External economics
Economic of scale or increasing return to scale
refers to the reduction in the average costs of
production as firms output expands. Thus,
economic of scale or increasing returns to
scale are internal to the firm.
External economics refer to the reduction in
each firm’s average costs of production as the
entire industry output expands (for reason
external to the firm)
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Imperfect competition and international Trade
Trade based on Product Differentiation
 As large portion of the output of modern
economic today involves differentiated rather
than homogenous products. As a result, a
great deal of international trade can does
involve the exchange of differentiated
products of the same industry or broad
product group.
 Intra-industry trade refers to the exchange of
similar products belonging to the same
industry.
Salvatore: International Economics,
Imperfect competition and international Trade
Trade based on Product Differentiation
 Intra industry trade arises in order to take
advantage of important economic scale in
production. That is, international competition
forces each firm or plant in industrial
countries to produce only one, or at most a
few, varieties and styles of the same product
rather than many different varieties and
styles. This is crucial in keeping unit costs
low.
Salvatore: International Economics,
Imperfect competition and international Trade
Trade based on Product Differentiation
Important features
 intra-industry
trade is based on
differentiation and economic of scale.
 With
product
differentiated products produced under
economics of scale, pre-trade relative commodity
prices may no longer accurately predict the pattern of
trade,
 with intra industry trade based on economies of scale
it is possible for all factors to gain.
 Intra industry trade is related to the sharp increase in
international trade in parts and components of a
product
Salvatore: International Economics,
Imperfect competition and international Trade
Trade based on Product Differentiation
Application
This may explain why the formation of the
EU and the great postwar trade liberlisation
in manufactured goods met little resistance
by interest groups. This is to be contrasted to
the strong objections raised by labor in
industrial countries against liberalising trade
with some of the most advanced of the
developing countries because this trade,
being of the inter-rather than of the intra
industry trade type.
Salvatore: International Economics,
Imperfect competition and international Trade
Trade based on Product Differentiation
Conclusion
 Comparative advantage seems to determine
the pattern of inter-industry trade, while
economies of scale in differentiated products
give rise to intra industry trade. Both type of
international trade occur in today’s world.
Salvatore: International Economics,
Imperfect competition and international Trade
Trade based on Product Differentiation
 The more dissimilar are factor endowments, the
more important are comparative advantage and
inter industry trade (as between developed and
developing countries). On the other hand, intra
industry trade is likely to be dominant the more
similar are factor endowments (as among
developed countries)
 So one could say that inter industry trade reflect
natural comparative advantage while intra
industry trade reflect acquired comparative
advantage.
Salvatore: International Economics,
Imperfect competition and international Trade
Trade based on Product Differentiation
 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,
Imperfect competition and international Trade
Trade based on Product Differentiation
 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,
Imperfect Competition and International Trade
The Grubel-Lloyd Index (1975)
 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.
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FIGURE 6-2 Production and Pricing Under Monopolistic
Competition.
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FIGURE 6-3 Monopolistic Competition and Intra-Industry Trade.
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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,
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.
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FIGURE 6-4 The Product Cycle Model.
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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,
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,
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.
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FIGURE 6-5 Partial Equilibrium Analysis of Transport Costs.
Salvatore: International Economics,
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.
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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.
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Appendix to Chapter 6
 External Economies and Specialization
 The Learning Curve and Specialization
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FIGURE 6-6 External Economies and Specialization.
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FIGURE 6-7 The Learning Curve and Specialization.
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