ECONOMICS 3150B

Lecture 11
October 28

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 New Trade Theory

Economies of Scale
• External economies of scale – clustering effects
– Productivity levels within each firm depends on size of
industry – min. AC depends upon size of industry
– Compatible with perfect competition
– Specialized suppliers – feasible with larger market of
customers
– Labour market pooling – multiple employment
opportunities reduce unemployment risks for labour
with specialized skills, increase availability of such
workers
– Knowledge spillovers – informal diffusion through
personal contacts

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 New Trade Theory

Economies of Scale
• Internal economies of scale – production,
distribution, R&D
– Productivity levels within each firm depends upon size
of each firm
– Learning curves – dynamic increasing returns
– Economies of scale stem from selection of production
technology
• Information re. available technologies
• R&D to generate new technologies
– Not compatible with perfect competition

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Economies of Scale: Imperfect Competition

Internal economies of scale

• Natural monopoly case
– Pricing: P > MC
– X-inefficiency  incentives for senior management

• Oligopoly case
– Minimum efficient scale of operations (MES)
– Interaction between size of market and MES determines number of firms
– P > MC

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 Prisoner’s Dilemma

• Classic Model:

Prisoner B

Confess Don’t Confess

Confess -5, -5 -1, -10

Prisoner A

Don’t Confess -10, -1 -2, -2

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 Models of Imperfect Competition

Profit Maximization
• Monopoly
• Oligopoly – interdependence
– Cournot model: output competition  P > MC
– Bertrand model: price competition  P = MC
– Prisoners’ dilemma  P = MC
– Repeated version of P.D.
• Fixed endpoint  P = MC
• Indefinite endpoint  P > MC

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 External Economies of Scale

• Small country-large country model

• Assumptions:
– Two countries: A (small country); B (large country)
– Two factors of production
– Two products
– Same tastes
– Same production technologies
– Same relative availabilities
– Y1: external economies of scale
– Y2: constant returns to scale

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 External Economies of Scale
 i : unit cost (AC) for product i

• [1]A > [1]B

• [2]A = [2]B

• Perfect competition: P = AC (zero economic profits)

– Pi = i  {P1/P2}A > {P1/P2}B

• Country B has comparative advantage in Y1, country A in Y2

– Large country will produce Y1 to fully exploit economies of scale
• Industry 1 expands in country with initial cost advantage (B) and contracts in
the other (A)
– Gains from trade result from expansion of industry with external
economies of scale

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 Internal Economies of Scale

• Small country-large country model

• Assumptions:
– Two countries: A (small country); B (large country)
– Two factors of production
– Two products
– Same tastes
– Same production technologies
– Same relative availabilities
– Y1: internal economies of scale
– Y2: constant returns to scale

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 Internal Economies of Scale
• Internal economies of scale for Y1  imperfect
competition
– P1 > AC1 = 1

• No assurance that {P1/P2}A > {P1/P2}B

– Monopolist: may produce Y1 in both A and B, but not necessarily
with same technologies  different degrees of economies of scale
• Competitive advantage  How was monopoly position obtained?
– Oligopoly: possible that more than one firm will produce Y1 in the
large country because economies of scale may be exploited at well
below market demand level (MES < D)
• P/AC may be lower than in case of monopoly  depends on degree
of rivalry
• Smaller number of oligopolists in small country, thus P/AC margin
may be greater than in large country
• Competitive advantage  How did oligopolists arise?

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 Monopolistic Competition Model
• Large number of competitors (large undefined) producing different,
yet similar products (product differentiation)
• Problems:
– Competitive advantage and creation and introduction of different varieties
of product – why does one firm produce a particular brand/variety?
– Defining industry boundaries
– Stability – tendency for consolidation if there is value in brand names –
imperfect information and brand names as signal for quality
– First mover advantages – distribution channels, brand name reputation,
market pre-emption

• Linear model
• Circular model
– Full price to consumers of variety j: Pj + disutility of variety j differing
from desired variety {t[abs(Zj – Z*)]}

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 Monopolistic Competition Model
• Entry/exit process in circular model
– Pre-emption
– Fighting brands
– Distribution channels – economies of scale, transactions costs

• If Y1 characterized by monopolistic competition and Y2 is

homogeneous product with constant returns to scale
– Intra-industry trade
– Inter-industry trade based on comparative advantage
– Trade will lead to lower prices, lower unit costs and more varieties 
gains from trade greater than in standard trade model with constant
returns to scale

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 Monopolistic Competition Model

• Standard m.c. model

– Equilibrium: no. of firms, economies of scale, production point relative to
MES
– No. of firms and no. of varieties
– Who created first variety? Competitive advantage

• Effects of entry  resulting from increase in D

– P, output, production efficiency, profits, no. of firms and varieties

• In industries with economies of scale, variety of goods and scale of

production constrained by size of country’s market

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 Monopolistic Competition Model

• Trade results from economies of scale and multiple varieties of

product
– Trade expands size of market  each country can specialize in narrow
range of products

• Gains from trade: lower per unit costs and prices (increased
production per firm); less excess capacity; more varieties thus wider
range of choices
– More firms serving combined markets, more output per firm  closer to
most efficient scale of production, less excess capacity

• Internal economies of scale and comparative advantage

– What country produces what varieties?
– Intra-industry trade

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 Monopolistic Competition Model

• Extension of H-O model with internal economies of scale and

monopolistic competition
– Assumptions:
• Two countries
• Two products: Y1– heterogeneous product subject to economies of scale; Y2 –
homogeneous product with constant returns to scale
• Two factors of production
• Y1 uses X1 relatively more intensively
• A has relative abundance of X1

• Outcomes:
– A: net exporter of Y1, net importer of Y2
– Both intra-industry (Y1) and inter-industry trade (Y1, Y2)
• B will produce and export some varieties of Y1, but be a net importer

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 Monopolistic Competition Model

• Outcomes (cont’d):
– No income distribution effects from intra-industry trade
– Pattern of intra-industry trade cannot be predicted
• A will produce more varieties, but cannot predict which ones

• Adjustment costs as some producers of Y1 disappear in both countries

• Relative importance of intra and inter-industry trade depends on how

similar are the two countries – the more similar the more important
intra-industry trade

• If B larger country, no differences in relative availabilities of factors

of production and no differences if factor intensity of production
– B: net exporter of Y1 – more firms and varieties pre-trade

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