Chapter 6

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INCREASING RETURNS

TO SCALE

AND IMPERFECT

COMPETITION

6

1

Basics of Imperfect Competition

2

Trade under Monopolistic Competition

3

Empirical Applications of Monopolistic Competition

and Trade

4

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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.

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Introduction

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Introduction

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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.

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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

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Trade Under Monopolistic Competition

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•

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

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•

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.

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Trade Under Monopolistic Competition

Price

Quantity MC AC

Demand curve facing each firm, d₀ mr₀

P₀

Q₀

Figure 6.4

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Trade Under Monopolistic Competition

Price MC AC d₀ D/NA P₀ Figure 6.5 d₁ mr₁

Equilibrium is at A, producing Q1, where mr₁ crosses MC. This gives price, PA_{, from the demand, d}

1

PA A

Firm demand when all firms charge the same 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

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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.

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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 P_2.

 _{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 d

2.

 _{Remember D/N}A_{is the demand if all firms had the same price.}

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Trade Under Monopolistic Competition

Price Quantity MC AC D/NA Figure 6.6 d₂ mr₂

PA A

Q₁

B’

Q’₂ Q₂

B P₂ Long-run equilibrium without trade Short-run equilibrium with trade

Opening trade makes the firm’s demand even more

elastic, shown by d₂. The firm chooses to produce at Q₂, where MR=MC, selling at P₂. At this price the firm makes monopoly profits as P₂>AC

As all firms lower their price to P₂, the relevant demand is D/NA_{at B’ selling only Q’}

2. At this point firms are

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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.

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Trade Under Monopolistic Competition

Price Quantity MC AC D/NT Figure 6.7 d₃ mr₃

PA A

Q₁ Q₃

C

PW

Long-run equilibrium without trade

Since some firms have exited the

industry, we are left with T firms which gives each firm a share of the demand shown by D/NT

The demand faced by each firm is d₃ with mr₃. mr₃=MC shows that each firm produces Q₃ at a price PW

Since PW_{= AC, firms are making zero}

monopoly profits, no firms exit or enter the industry, and C is the long run equilibrium with trade

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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.}

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• 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.

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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.

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HEADLINES

What Happened When Two countries Liberalized Trade?

•

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.

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HEADLINES

What Happened When Two countries Liberalized Trade?

•

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.

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Empirical Applications of Monopolistic

•

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.

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Empirical Applications of Monopolistic

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•

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

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Empirical Applications of Monopolistic

• 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

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Empirical Applications of Monopolistic

•

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.

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Empirical Applications of Monopolistic

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•

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.

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Empirical Applications of Monopolistic

•

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.

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Empirical Applications of Monopolistic

•

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

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Empirical Applications of Monopolistic

• 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.

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Empirical Applications of Monopolistic

•

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

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Empirical Applications of Monopolistic

• 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.

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Empirical Applications of Monopolistic

• 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.

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Empirical Applications of Monopolistic

•

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.

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Empirical Applications of Monopolistic

• 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



Imports



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•

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

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Empirical Applications of Monopolistic

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• 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: F_g = G[M₁M₂/d2_]

 G is the constant that tells the magnitude of the relationship.

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Empirical Applications of Monopolistic

•

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.

n

dist

GDP

B

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Empirical Applications of Monopolistic

•

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.

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Empirical Applications of Monopolistic

• 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/GDP_w

 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:

n W n

dist

GDP

dist

Share

GDP

Trade

1 2

1

1 2

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APPLICATION

The Gravity Equation for Canada and the United States

• 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

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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

.

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APPLICATION

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APPLICATION

Trade with Canada

• 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}

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APPLICATION

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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

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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.

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Imperfect Competition with Homogeneous

•

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.

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Imperfect Competition with Homogeneous

•

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.

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Imperfect Competition with Homogeneous

Price Foreign Quantity MC* Local Demand, D* Local Marginal Revenue, MR* AC* Export Price, P

Export Demand, D, and export marginal revenue, MR

C Local Price, P* Q₂ B Q₁ Local Sales Exports

The export monopoly maximizes profits at point B where local marginal costs, MC*, equal export marginal revenues, MR

AC₁

The monopolist sells Q₂ to its local market and (Q₁-Q₂) to its export market

The quantity sold in the local market is at point C where local marginal costs, MC*, equal local marginal revenues, MR*. They can 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

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Imperfect Competition with Homogeneous

•

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.

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Imperfect Competition with Homogeneous

•

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

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Imperfect Competition with Homogeneous

•

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.

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Imperfect Competition with Homogeneous

•

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.

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Imperfect Competition with Homogeneous

•

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

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Imperfect Competition with Homogeneous

(a) Home (b) Foreign

Figure 6.11

Quantity Quantity

Price Price

D

MR _MR* D*

$20

$60 A A*

40 40 MC No-trade monopoly equilibrium No-trade monopoly equilibrium

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Imperfect Competition with Homogeneous

• 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 – Q_F

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Imperfect Competition with Homogeneous

• 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:

 Q_H = P - 20

 The price in the Home market is related to the total quantity sold:

 P = 100 – Q = 100 – Q_F – Q_H

 Using the profit maximizing conditions and the demand equation, we get:

 P = 100 – (P - $30) – (P - $20) = $50

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Imperfect Competition with Homogeneous

•

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

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Imperfect Competition with Homogeneous

(a) Home (b) Foreign

Quantity Quantity

Price Price

D

MR _MR* D*

$20

$60 A A*

40 40 MC No-trade monopoly equilibrium No-trade monopoly equilibrium

30 30 50

B*

50 B $50

Local Exports= Reciprocal Dumping _Local _Exports=

Exports equal imports for both Home and Foreign from each other – Reciprocal Dumping

From the previous derivation, we saw that equilibrium with reciprocal dumping will occur at points B and B*, at a price of $50 selling 50. Each country will have 30 in local sales and export 20.

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Imperfect Competition with Homogeneous

•

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.

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Imperfect Competition with Homogeneous

•

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.