Monopolistic Competition and Trade

Dr. PRATAP C. MOHANTY

DEPT. OF HUMANITIES & SOCIAL SCIENCES, IIT ROORKEE

1
 The “Krugman Model”: Assumptions
1. Internal economies of scale
2. Monopolistic competition (non‐homogeneous goods)
3. One factor of production (labour)
4. Identical preferences
5. Large number of goods produced with the same
technology
6. Full employment Paul R. Krugman (1979): Increasing returns, monopolistic competition, and
international trade. Journal of International Economics, Vol. 9(4): 469‐479

2
 Key assumption: Economies of Scale

• External: cost per unit depends on the size of the industry, not the firm
(Silicon Valley, Hollywood...)
• Internal: cost per unit depends on the size of the firm, not industry
(Nokia, Phillips, GE...)
– Krugman models technology as
L = a + b*Q  Q = 1/b*L – a/b
– the amount of labour required (L) to produce amount of input (Q)
depends on b and constant a (fixed cost)
→ Doubling the inputs more than doubles the output (increasing internal
economies of scale)

3
 Long‐Run Market Equilibrium of
Monopolistically Competitive Market
The more firms there are:
1. the less each firm Price
AC
produces → higher
average cost (due to
increasing returns to
scale) → upward sloping
cost curve
p*
2. the harder the
compe on →
decreasing price → P
downward sloping price
curve
n*
Number of firms
4
Introducing Trade to the Monopolistic Competition Model

• Trade increases market size Price

→ firms exploit more of the ACA
returns to scale → average ACFT
cost decreases → price
decreases → number of firms
increases
• i.e. a larger variety of pA
products is available for pFT
smaller price P
• everybody are better off even
if the countries are identical
nA nFT
Number of firms
5
 Monopolistic Competition
• Monopolistic competition is a model of an imperfectly
competitive industry which assumes that
1. Each firm can differentiate its product from the product of
competitors.
2. Each firm ignores the impact that changes in its own price will
have on the prices of competitors set: even though each firm
faces competition it behaves as if it were a monopolist.

6
• A firm in a monopolistically competitive industry is
expected:
– to sell more the larger the total sales of the industry and the
higher the prices charged by
its rivals.
– to sell less the larger the number of firms in the industry and
the higher its own price.
• These concepts are represented by the mathematical
relationship:

7
 Q = S[1/n – b(P – P*)]
– Q is an individual firm’s sales
– S is the total sales of the industry
– n is the number of firms in the industry
– b is a constant term representing the responsiveness of a
firm’s sales to its price
– P is the price charged by the firm itself
– P* is the average price charged by its competitors
8
• To make the model easier to understand, we assume
that all firms have identical demand functions and
cost functions.
– Thus in equilibrium, all firms charge the same price: P = P

• In equilibrium,
– Q = S/n + 0
– AC = C/Q = F/Q + c = F(n/S) + c

9
1. The Number of Firms and Average Cost
AC = F(n/S) + c
• The larger the number of firms n in the industry,
the higher the average cost for each firm because
the less each firm produces.
• The larger the total sales S of the industry, the
lower the average cost for each firm because the
more that each firm produces.
10
 2. The Number of Firms and the Price

Q = S[1/n – b(P – P*)]

Q = S/n – Sb(P – P*)
Q = S/n + SbP – SbP*
Q = A – BP
• Let A  S/n + SbP and B ≡ Sb
11
 MR = P – Q/B = c
MR = P – Q/Sb = c
P = c + Q/Sb
P = c + (S/n)/Sb
P = c + 1/(nxb)
• The larger the number of firms n in the industry, the
lower the price each firm charges because of increased
competition.
12
• At some number of firms, the price that
firms charge (which decreases in n) matches the
average cost that firms pay (which increases in n).
• This number of firms is the number at which each
firm has zero profits: price matches average cost.
• This number is the equilibrium number
of firms.

13
• If the number of firms is greater than or less than n2,
then in industry is not in equilibrium in the sense
that firms have an incentive to exit or enter the
industry.
– Firms have an incentive to enter the industry when profits
are greater than zero (price > average cost).
– Firms have an incentive to exit the industry when profits
are less than zero (price < average cost).
14
• Because trade increases market size, trade is predicted to
decrease average cost in an industry described by
monopolistic competition.
– Industry sales increase with trade leading to decreased average costs:
AC = F(n/S) + c

• Because trade increases the variety of goods that consumers

can buy under monopolistic competition, it increases the
welfare of consumers.
– Because average costs decrease, consumers can also benefit from a
decreased price.

15
16
17
 Intra‐ and Inter‐industry Trade
• Inter‐industry trade: countries export goods of one product
category and imports goods of other product category as in
the Ricardian and the Heckscher‐Ohlin models
– Basis for trade: Comparative Advantage due to differences
in productivity (Ricardian model) or in factor endowments
(HO‐model)
• Intra‐industry trade: countries export and import products of
the same products category as in the Krugman model
– Basis for trade: Internal economies of scale
18
Inter‐industry Trade

19
Intra‐industry Trade

20
 Characteristics of IIT
• Intra‐industry trade between industrial countries is common
• Fundamental problem is defining an industry.
• For example, if computers are defined as office machinery, then computers and
pencil sharpeners are in the same industry,
• More broadly an industry is defined, the more trade appears to be intra‐industry
• Evidence suggests that intra‐industry trade is greater –in high technology
industries –where there is more scope for product differentiation –in countries
more open to trade –in nations that have received larger amounts of foreign direct
investment

21
 Gains from IIT
• Lower prices : An increase in the size of the market
allows for scale economies, which lowers production
costs and eventually prices to consumers
• Increase in the number of firms : There is a high
likelihood that intra industry trade expands the number
of domestic firms and the quantity of domestic output
• Increase in consumer choices : Intra‐ industry trade
tends to give access to a much greater variety of goods
than produced domestically
22
 Models with Heterogeneous Firms
Melitz (2003, Econometrica) model
• Extension of the “Krugman model”
• firms can enter an industry by paying a fixed entry cost, they then learn their
productivity (profitability) and leave if this is too low
• There are fixed and variable costs also for expor ng → only the most
productive firms export
• reduc ons in barriers to trade → increase profits of exporters and reduce
the export produc vity cutoff → labor demand within the industry rises →
increase in wages → profits of nonexporter decrease → less produc ve
firms bankrupt
A new source of gains from trade: Increase in productivity

23
24