Review of International Economics 3(2),235-243, 1995

On Nations’ Size and Transportation Costs*

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Abstract zyxwvuts
Yochanan Shachmurove and Uriel Spiegel

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This paper develops a noncooperative Nash model in which a closed border is opened to trade between
countries that differ in size and transportation costs The paper suggests an explanation as to why
economists have not convinced policymakers to lift all barriers to free trade The question\ we pose drc
Who will gain as a result of opening the borders? Is free trade beneficial to the two parties involved? D o
they both share equally in the fruits of free trade? Which country. large or small, henefirc most7 11 I S
shown that free trade is not beneficial to both countries

1. Introduction
Economists have been nearly unanimous in their condemnation of protectionism; for
example, see Bovard (1991) for the latest condemnation of protectionism. Yet the
case for protectionism seems more powerful than ever; for example see the recent
exposition of “The Fallacy of Free Trade,” by Batra (1992). This paper tries to
suggest an explanation as to why economists’have not convinced others, most
notably policymakers and politicians, to lift all barriers to free trade. It is believed
that the model presented provides a potentially important explanation for the per-
sistence of tariffs and the difficulty of attaining free trade. The conclusions of the
model presented contradict the existing industrial organization -oriented literature
on international trade, which maintains that the larger country gains from trade
(Kennan and Riezman, 1988, 1990; Cordella, 1991).’ The model we present dovetails
with the classical literature, at least since Ricardo’s work in 1817, which
maintains that the smaller country has the potential to gain from free trade, whereas
the larger country may not gain.
This paper studies the implications of opening borders between two neighboring
countries that differ in size. For a recent treatment of sizes in international trade see,
for example, Krugman and Elizondo (1992) and Kanbur and Keen (1993). The
dissimilarity in the two countries’ sizes will be one of the main sources for deriving
our results. It is shown that free trade is not beneficial to both countries. The
questions we pose are: Who is going to gain as a result of opening the borders? Is
free trade beneficial to both parties? Do they share equally in the fruits of free
trade? Is it the small or the large country which benefits most? Is the large country
going to gain? Are all consumers better off?

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Another important characteristic of our model is the explicit consideration of
transportation costs; location and distance are important factors which are not
ignored. All sales of the product take place in the central business district (CBD)
and the consumer has to consider the location of his dwelling relative to the CBD.
Once free trade is allowed, the location of the CBD in each country cannot change.
This is assumed to reflect high fixed costs in creating a new CBD.’
-
Shachmurove, University of Pennsylvania. Philadelphia, P A 19104. Tel: 215-898-1090. Fax: 573-2057.
Spicgel: Bar-Ilan University. 52900 Ramat-Gan. Israel. and University of Pennsylvania. We would like to
thank our colleague, Bill Ethier. for his thoughtful comments and advice. We dedicate this paper in honor
of David Pines, Emeritus Professor of Economics. Tel-Aviv University.
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236 Yochanan Shachmuruve and Uriel Spiegel

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In our model, the large country’s producer loses whereas the producer in the small
country reaps the fruits of free trade. The argument driving this conclusion is that, as

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a consequence of free trade, profits shift from the large to the small country, thereby
benefiting the small and hurting the large c0unt1-y.~ Moreover, conditions are
developed which show that if the small country is small enough, the home consumers
are better off.

2. TheModel
Assume two closed economies with a border between them. Each economy is
populated with a given number of consumers, h in the Home economy and H in the
Foreign economy. Consumers in both countries have identical preferences and equal

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incomes, but they differ in their locations. Each consumer demands one unit of a
single product and he is willing to pay a reservation price. Under autarky, it is
assumed that in each country there exists a monopoly which sells to all its customers:
h units to h customers in the Home economy, charging each one of them the same
price, and H units to H customers in the Foreign entity for a common, yet potentially
different price from the price at h. Although there is no need to assume that
customers will purchase the unit, unless the price chosen by the monopoly is lower
than the reservation price of the consumer, it is assumed that in the no-trade case all
consumers buy the product. The sale to the consumer takes place in the CBD. Thus,
the consumer in h who buys in the CBDh has to take into account the location of his
dwelling relative to the location of the CBD, and similarly for a Foreign consumer in

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H, who is restricted to buying from his corresponding CBDH. In this model the
emphasis is on the transportation costs. Thus, it is assumed that there are trans-
portation costs equal to 6 per unit of distance (which is also a dwelling unit). These
costs are for going to and from the CBD. Thus, when the consumer is farther from
the central store, he is willing to pay only a lower reservation price, RP, which is
RP(X) =A - 6X, (1)
where X denotes the distance from the CBD, and A denotes the reservation price
that the consumer is willing to pay if he faces zero transportation costs, i.e., when he
lives in or right next to the central business d i ~ t r i c t . ~
Furthermore, it is assumed that the consumers are distributed uniformly around
the central district in such a way that the last consumer is located at a distance of h/2
in the Home country and HI2 in the Foreign country. Thus, the monopoly price in
the closed-economy regime is equal to RP, given that X = h12, or by using equation
(l), the pretrade reservation price is R P = A - 6h12.
This point will be further explained and used in the development of the model.
First, we define the equilibrium of the two separate closed economies, given the
above assumptions. The demand function that the producer in h (or in H ) faces is
given by equation (1’):
P = A - 6Y12, (1‘)
where Y denotes the quantity demanded.
Thus, the marginal revenue function faced by the Home monopoly, denoted by
MRh, is
MRh = A - 6Y. (2)
Furthermore, assume that the marginal costs of producing and marketing one unit
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zyxwvuts ON NATIONS’ SIZE AND TRANSPORTATION COSTS 237

of output in the Home and in the Foreign countries are equal to a constant, say c ,
i.e., MCh = MCH = c. Therefore, in equilibrium, marginal revenue is equal to

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marginal costs in the two countries, i.e., MRh(Y) = MC and MRH(Y) = MC.
However, these Ys may be equal to y < h or Y < H , where y is the quantity
demanded at h. These indicate that not necessarily all h consumers at home (or H

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consumers abroad) will consume the product which is sold in their corresponding

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CBDs. Since it is assumed that every consumer both at home and abroad buys the
product, conditions ( 3 ) and (4) are satisfied:
MRh(y = h ) > MC,,
MRH(Y = H ) 2 MCH
C,

C,

or, in other words, if equation (4) is satisfied with the equality

A - ( 2 6 H ) / 2 = A - 6H = MC C,
(3)
(4)

(5)
and then
A - c = 6H. (5’)
Conditions ( 3 ) and (4) are plotted in figure 1 for the case where equation (5’) is
satisfied. The monopoly pretrade solutions for the two producers in economies h and
H , respectively, are:
(I) p r = A - 6h/2, (11) Q,” = h,
(111) p$ = A - 6H/2, (IV) Q!! = H,
where p r , P$ represent equilibrium pre-international-trade monopoly prices in the
two countries and Qr, QZ represent the respective equilibrium quantities.

Figure 1. zyxwvut
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6
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238

CS," =zyxwvut
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(A - p f ) h / 2
= 6h2/4.
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Yochanan Shachmurove and Uriel Spiegel

Now define the total consumer surplus for the closed Home economy, denoted by

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CS," (and ignoring the income effect), using the formula for a triangle, as
(p,,, - p,")Q,"/2 [A - (A - 6h/2)]h/2

Using equation ( 5 ' ) . the producer surplus in the Home country, denoted by PS,",
can be calculated as follows:
(6)

PSY = [pf c]h = [A 6h/2 c ] h > 6h2/2.

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- - - (7)
Similarly, total consumer surplus in the Foreign country, denoted by CS;, is
defined as
CS; = [ A - P E ] H / 2 = [ A - ( A

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- 6 H / 2 ) ] H / 2= 6 H 2 / 4 .
(8)
Using equation ( 5 ' ) , the producer surplus in country H , denoted by PS;, is
defined as
PSE = [ P E - c ] H = [ A - SH/2 - c ] H = b H 2 / 2 . (9)
The closed-economy equilibrium solutions for quantities and prices in the two
economies, as well as their consumers' and producers' surpluses, are drawn in
figure 2 .

PE, price in the large country in autarky;

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Notes: P f , price in the small country in autarky;

CS?, total consumer surplus in h = SAEE' = 2SAEp:;

CS;, total consumer surplus in H = S A m . = 2 S A e ;
pshM , producer's surplus in h = S E E . ~ H
= ,2 S E H ( ; e ;
PSHM , producer's surplus in H = SFF.HH, = 2 S F H I e .
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ON NATIONS' SIZE AND TRANSPORTATION COSTS

The scene is now set to ask what will happen as a result of opening the border
between the two countries and allowing for free international trade. Free trade
239

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creates a price war between the two former monopolies. Now, they are in an

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oligopolistic market. Each producer tries to attract cross-border shoppers from the
neighboring country while trying to hold on to his old constituency. Each producer
maximizes his profits by choosing an optimal price, given the price set by his new
competitor across the border.
When will the cross-shopping phenomenon be possible? A number, so, of con-
sumers will cross-shop from H to h if
p N + 6(h/2 + SO) = P,v + 6 ( H / 2 - SO). (10)
which implies:
so = ( P N - ppJ)/(26)+ ( H - h)/4. (1 1)
Some notation, as well as figure 3, will be helpful. Accordingly, define s, as the

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number of consumers who refrain from buying the commodity once free trade is
established. These are the Foreign consumers for whom the price P plus the trans-
portation costs are such that the total cost will be higher than their reservation price,
A , i.e.,
P + 6(H/2 - sl] = A,

~1 = [ P - A]/6 + H/2.
Once the sizes of so and s1 are defined, it is possible to express the two objective
functions of the two producers who are located at CBDh and CBDH, respectively, as
follows:

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Substituting for the values of so and s1 from equations (11) and (12') yields:

max
P
nH= ( P - c ) [ ( H + h)/4 - (3P - p ) / ( 2 b ) + A/d]. (14')

Differentiating equations (13') and (14') with respect t o p and P , respectively, and
equating the derivatives to zero' yields the two response functions of the producers in
h and H as follows:
RC,,: p = (6/3)(3h+ H ) + (P + ~ ) / 2 . (15)
RCH: P = (6/12)(H + h ) + A/3 + ~ / +2 p/6. (16)

Figure 3. 00
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Yochanan Shachrnurove and Uriel Spiegel

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3. The Properties of the Nash Equilibrium
Given equations (15) and (16), the noncooperative Nash equilibrium values of p and
P set by the two rivals in h and H , respectively, can be determined as follows:
p; = [6(19h + 7 H ) + 4 A + 18~1122,
= [6(3H + 5 h ) + 8 A + 14c]/22.
Equations (I), (II), (17), and (18) allow for a comparison between the two
economies before and after international trade, via the following propositions:
(18)
(17)

PROPOSITION
1. The noncooperative free-trade Nash (NCFTN) equilibrium price in
the small country is higher than the corresponding price in the large country, i.e.,
P; - p; < 0.

PROOF.Using equations ( 5 7 , (17), and (18) yields:

[P; -
]:I/ = [-(14h + 4H)6 + 4 ( A - ~ ) ] / 2 2
= -[146h - 46H + 46H]/22 = -146h/22 < 0. (19)
QED
PROPOSITION

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2. For the small country, opening the border to free trade may result in
an ambiguous price change and werfare effect. The small-country producer is not
necessarily worse off.

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PROOF.First, note that even when free trade is allowed, the producer in H has no
motivation to increase the volume of its sales because of the initial autarky equilib-
rium assumed: M R ( H R ) = MC = c. This implies that cross shopping may occur
only if consumers from H will cross the border and shop at h . because in the closed-
economy case the producer in h is producing according to the condition MR(hI2) >
MC = c. Thus, only two outcomes are possible:
A . No cross shopping occurs when free trade is established, the producer in h does
not attract foreign consumers, and thus the autarky and the free-trade equilibria
are the same.
B . Cross shopping from H to h will take place, although the direction of the price
change in h is ambiguous.
Point B can be proved by using equations ( l l ) , (17) and (18). Then, it can be shown
that so is positive if so = ( P E - p;)/[26 + ( H - h ) / 4 ]> 0 ; or, using equation (19), it
follows that SO = -146h/446 + ( H - h ) / 4 = [ I l H - 25h1144 > 0 , which is satisfied
for
H > 25h/ll. (20)
Similarly, using equations (I) and (17), the value of p f - p r can be derived as
follows:
p r - p ; = A - (6h)/2 - [6(19h + 7 H ) + 4 A + 1 8 ~ ] / 2 2
= [18(A - C ) - 306h - 7 6 H ] / 2 2 . (21)
Substituting equation ( 5 ' ) into equation (21) yields:
pf - p; = (116H - 306h)/22 > 0. (21')
In order to satisfy the condition p f > p;, it is necessary to require a stronger
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H > 30h/l1.
ON NATIONS' SIZE AND TRANSPORTATION COSTS 241

constraint, namely that equation (21") will be satisfied rather than equation (20):
(21")
Three cases are possible when one compares equations (20) and (21"):

Case 1. H > 30hlll > 2 5 h / l l ; then opening the border to free trade leads to a
decrease in the price in the small country. Thus, it follows that the consumer surplus
for citizens of h in a free-trade environment is increased by the following:

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ACS, = ( p r - p r ) h = ( 6 h ) ( l l H - 30h)/22, (22)
where A denotes the change in the variable.

Case 2. .30h/l1 > H > 2 5 h / l l ; then p r > p r and still there will be cross shopping

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from H to h , and the producer in h will sell to foreigners who cross-shop from H , but
consumers at home will lose from opening the borders to free competition.

trade.

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PROPOSITION zy
Case 3. 30hlll > 25h/11 > H . This is the case where opening the border will not
affect the autarky equilibrium. This is when the two countries do not gain from
QED

3. The NCFTN equilibrium price for foreign consumers who continue lo

shop in the large country, is higher than rhe autarky monopoly equilibrium price.

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PROOF.Using the expression for the closed-economy monopoly price charged in the
foreign country, i.e., f i = A - bH/2, and the NCFTN equilibrium price given by
equation ( 2 0 ) , it follows that
P g - PE = A - 6H/2 - [6(3H + 5 h ) + 8A
= [14(A - C) - 146H - 56h]/22.
+ 1&]/22

Using equation ( 5 ' ) it follows that P E - PE = (-56h)/22 < 0. OED

Opening the large economy H to free trade increases the price charged by the
foreign producer to its loyal consumers who continue to shop in CBDH.'
(23)

PRoPosrnoN 4. International trade causes a decrease in the wedge between the prices in

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the two countries.

PROOF.Under the closed-economy regime, the difference between the prices charged
at home and abroad was
Pg = A - 6h/2 - ( A - 6 H / 2 ) = [6(H - h ) ] / 2> 0.
Substituting equation (21") into equation (24) implies that
p f - P g = [ 6 ( H - h ) ] / 2> (6/2)[30h/11- h ] = (196h)/22.
The last expression on the right-hand side satisfied
(24)

p f - P g = (196h)/22 > (146h)/22 = p r - PE. (24')

Equations (19) and (24') imply that the gap between the prices in the two
countries has narrowed as a result of opening trade, although it has been proven that
consumers in h pay a higher price than the price paid by consumers in H . QED
Based on the propositions presented above, the following two claims can be
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242 Yochanan Shachmurove and Uriel Spiegel

proved. One, once free trade is established, producer surplus in the small country
increases. Second, once the border barriers are lifted, producer surplus in the large
country decreases.

4. Conclusions
This paper constructs a model of noncooperative Nash equilibrium between countries
differing in size. The following propositions are proved. First, the noncooperative
free-trade Nash ( N C F M ) equilibrium price in the small country is higher than the
corresponding price in the large country. The producer in the small country exploits
the fact t h a t , as borders are opened, some Foreigners find i t cheaper to cross-shop
than to travtl to CBDH. The producer in the large country loses customers, some

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cross-shopping and some not buying the product at all, and thus charges a higher
price relative to the autarky case. So, for the large country, and in some cases for
the small country as well, more competition does not lead to lower prices. This is a
case where free trade causes an increase in the prices in the two countries relative to
the autarky regimes. Second, opening the border to free trade results in an ambigu-
ous price change and welfare effect in the small country, h , but t h e producer in h is
not necessarily worse off. Third, the NCFTN equilibrium price for foreign consumers
who continue to shop in the large country is higher than the nontrade monopoly
equilibrium price. Fourth. international trade causes a decrease in the wedge between
the prices in the two countries. This is the anticipated result where more competition
and free trade reduces the gap between the two prices.

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Consumers in the small country may improve their consumer surplus when h is
relatively small (as is specified by equation (21”)). What about consumers in the
large country? A priori, the results are ambiguous, because some of them, J ~ will ,
not consume the product at all under the new regime. However, some of the large-
country consumers, so, will buy the product in CBD,,. at a potentially lower price.
The remaining part of the large country’s population, i.e., H - so - sI,experiences
a decrease in consumer surplus. These consumers now face open borders and higher
prices. Thus, the aggregate effect of opening the border on the large country’s
consumers is ambiguous. This issue is left for further investigation.
The model has interesting consequences regarding gains and losses from free
trade. I t is clear that the producer in the small country is not worse off. In addition,
i f the two countries differ considerably wth respect to their sizes, all consumcrs in
the small country are better off. whereas in the large country some consumers are
worse off. This conclusion dovetails with the conclusions that have been derived in
recent papers based on the concept that optimal tariffs are closer to zero for smaller
countries (Kanbur and Keen, 1993; Markusen and Wigle. 1989). They all demon-
strate the notion that there are advantages in being small in international trade and
that opening the economy to free trade is not necessarily beneficial to all countries
on earth. The model presented is capable of reaching a similar conclusion without
invoking optimal-tariff or tariff-war arguments.
The above discussion may explain the conflicts that countries face when opening
their borders or lifting trade barriers. On the one hand, consumers located close to
the border are, in general, a n o n g the constituencies who encourage the trend
toward more free trade. O n the other hand, consumers residing far from the
common border may resist the move. They are the group who will ask for subsidies,
tariffs, and other trade barriers aimed at imposing obstacles to the flow of interna-
tional goods.
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ON NATIONS’ SIZE AND TRANSPORTATION COSTS 243

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References
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Bovard, James, The Fair Trade Fraud, New York: St. Martin’s Press, 1991.
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-, “Export Subsidies and International Market Share Rivalry,” Journal of International
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Cordella, Tito, “Trade Liberalization: Consumers Gains and Losses,” CORE Discussion
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Fishelson, Gideon, and Arye L. Hillman, “Domestic Monopoly and Redundant Tariff
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HeIpman, E., and Paul R. Krugman, Trade Policy and Market Structure, Cambridge, Mass.:
MIT Press, 1989.
Kanbur, Ravi, and Michael Keen, “Jeux Sans Frontieres: Tax Competition and Tax Coordin-
ation When Countries Differ in Size,” American Economic Review 83 (1993):877-92.
Kennan, John, and Raymond Riezman, “Do Big Countries Win Tariff Wars?” International
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, “Optimal Tariff With Customs Unions,”, Canadian Journal of Economics 23 (1990):
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and R. D. Willig (eds.), Handbook of Industrial Organization, Elsevier Science Publisher
Co., New York, 1989, pp. 1181-223.
Krugman, Paul R., and Raul Livas Elizondo, “Trade Policy and the Third World Metropolis,”
Washington, D.C.: Institute for Policy Reform, IPRSO, 1992.
Markusen, James R., and Randall M. Wigle, “Nash Equilibrium Tariffs for the United States
and Canada: The Role of Country Size, Scale Economies and Capital Mobility,” Journal of
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Notes
1. A recent survey of the literature is in Krugman (1989), and an exhaustive treatment of the
subject is given by Helpman and Krugman (1989).
2. For a similar assumption see Krugman and Elizondo (1992). Another motivation for this

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assumption is to consider consumers’ tastes to be different, such that the bigger countries have

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more diverse tastes and that consumers consume a particular kind or a particular variety of

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the good.
3. See, for example, Ethier (1979), Fishelson and Hillman (1979), and Brander and Spencer
(1981, 1985).
4. Again, X may be interpreted as a taste parameter instead of a distance. The results still
hold under this interpretation.
5. The value of s, can be determined by substituting P i from equation (18) and 6H from
equation ( 5 ’ ) for the respective variables in equation (12‘) to yield s, = 56H > 0. The
conclusion is that if so is equal to zero, s1 is also zero; but if so is positive, it follows that s1 is
also positive. Thus, some Foreign consumers who had consumed the product in autarky will
cease buying it under free trade, since P;”:< P i .