Monopolistic Competition and Trade
Underlying the application of the monopolistic competition model to trade is the idea that
trade increases market size. In industries where there are economies of scale, both the
variety of goods that a country can produce and the scale of its production are constrained
by the size of the market. By trading with each other, and therefore forming an integrated
world market that is bigger than any individual national market, nations are able to loosen
these constraints. Each country can thus specialize in producing a narrower range of products
than it would in the absence of trade; yet by buying from other countries the goods
that it does not make, each nation can simultaneously increase the variety of goods available
to its consumers. As a result, trade offers an opportunity for mutual gain even when
countries do not differ in their resources or technology.
Suppose, for example, that there are two countries, each with an annual market for 1
million automobiles. By trading with each other, these countries can create a combined
market of 2 million autos. In this combined market, more varieties of automobiles can be
produced, at lower average costs, than in either market alone.
The monopolistic competition model can be used to show how trade improves the
trade-off between scale and variety that individual nations face. We will begin by showing
how a larger market leads, in the monopolistic competition model, to both a lower average
price and the availability of a greater variety of goods. Applying this result to international
trade, we observe that trade creates a world market larger than any of the national markets
that comprise it. Integrating markets through international trade therefore has the same
effects as growth of a market within a single country.
The Effects of Increased Market Size
The number of firms in a monopolistically competitive industry and the prices they charge
are affected by the size of the market. In larger markets there usually will be both more
firms and more sales per firm; consumers in a large market will be offered both lower
prices and a greater variety of products than consumers in small markets.
n2 P2
n2
P3 AC3
n2 n3
P1 AC1
n2 n1
To see this in the context of our model, look again at the CC curve in Figure 8-3, which
showed that average costs per firm are higher the more firms there are in the industry. The
definition of the CC curve is given by equation (8-6):
Examining this equation, we see that an increase in total industry output S will reduce average
costs for any given number of firms n. The reason is that if the market grows while
the number of firms is held constant, output per firm will increase and the average cost of
each firm will therefore decline. Thus if we compare two markets, one with higher S than
the other, the CC curve in the larger market will be below that in the smaller one.
Meanwhile, the PP curve in Figure 8-3, which relates the price charged by firms to the
number of firms, does not shift. The definition of that curve was given in equation (8-10):
The size of the market does not enter into this equation, so an increase in S does not shift
the PP curve.
Figure 8-4 uses this information to show the effect of an increase in the size of the market
on long-run equilibrium. Initially, equilibrium is at point 1, with a price and a number
of firms n1. An increase in the size of the market, measured by industry sales S, shifts
P1
P = c + 1/(b * n).
AC = F/Q + c = n * F/S + c.
CHAPTER 8 Firms in the Global Economy 165
Cost, C and
Price, P
P2
Number of
firms, n
n2 n1
PP
P1
1
2
CC1
CC2
Figure 8-4
Effects of a Larger Market
An increase in the size of the market allows each firm, other things equal, to produce
more and thus have lower average cost. This is represented by a downward
shift from CC1 to CC2. The result is a simultaneous increase in the number of firms
(and hence in the variety of goods available) and a fall in the price of each.
166 PART ONE International Trade Theory
the CC curve down from to , while it has no effect on the PP curve. The new
equilibrium is at point 2: The number of firms increases from to , while the price falls
from to .
Clearly, consumers would prefer to be part of a large market rather than a small one. At
point 2, a greater variety of products is available at a lower price than at point 1.
Gains from an Integrated Market: A Numerical Example
International trade can create a larger market. We can illustrate the effects of trade on
prices, scale, and the variety of goods available with a specific numerical example.
Imagine that automobiles are produced by a monopolistically competitive industry. The
demand curve facing any given producer of automobiles is described by equation (8-5),
with b = 1/30,000 (this value has no particular significance; it was chosen to make the
example come out neatly). Thus the demand facing any one producer is given by
where Q is the number of automobiles sold per firm, S is the total number sold for the
industry, n is the number of firms, P is the price that a firm charges, and is the average
price of other firms. We also assume that the cost function for producing automobiles is
described by equation (8-3), with a fixed cost and a marginal cost
per automobile (again, these values were chosen to give nice results). The
total cost is
The average cost curve is therefore
Now suppose there are two countries, Home and Foreign. Home has annual sales of
900,000 automobiles; Foreign has annual sales of 1.6 million. The two countries are
assumed, for the moment, to have the same costs of production.
Figure 8-5a shows the PP and CC curves for the Home auto industry. We find that in
the absence of trade, Home would have six automobile firms, selling autos at a price of
$10,000 each. (It is also possible to solve for n and P algebraically, as shown in the
Mathematical Postscript to this chapter.) To confirm that this is the long-run equilibrium,
we need to show both that the pricing equation (8-10) is satisfied and that the price equals
average cost.
Substituting the actual values of the marginal cost c, the demand parameter b, and the
number of Home firms n into equation (8-10), we find
so the condition for profit maximization—marginal revenue equaling marginal cost—is
satisfied. Each firm sells 900,000 units/6 firms = 150,000 units/firm. Its average cost is
therefore
Since the average cost of $10,000 per unit is the same as the price, all monopoly profits
have been competed away. Thus six firms, selling each unit at a price of $10,000, with
each firm producing 150,000 cars, is the long-run equilibrium in the Home market.
AC = ($750,000,000/150,000) + $5,000 = $10,000.
= $5,000 + $5,000,
P = $10,000 = c + 1/(b * n) = $5,000 + 1/[(1/30,000) * 6
AC = (750,000,000/Q) + 5,000.
C = 750,000,000 + (5,000 * Q).
c = $5,000
F = $750,000,000
P
Q = S * [(1/n) - (1/30,000) * (P - P)],
P1 P2
n1 n2
CC1 CC2
CHAPTER 8 Firms in the Global Economy 167
2 4 6 8 10 12
Price per auto,
in thousands of dollars
Number
of firms, n
(a) The Home market: With a market size of 900,000 automobiles, Home’s equilibrium, determined by the
intersection of the PP and CC curves, occurs with six firms and an industry price of $10,000 per auto. (b) The
Foreign market: With a market size of 1.6 million automobiles, Foreign’s equilibrium occurs with eight firms and
an industry price of $8,750 per auto. (c) The combined market: Integrating the two markets creates a market for
2.5 million autos. This market supports ten firms, and the price of an auto is only $8,000.
168 PART ONE International Trade Theory
What about Foreign? By drawing the PP and CC curves (panel (b) in Figure 8-5), we
find that when the market is for 1.6 million automobiles, the curves intersect at
. That is, in the absence of trade, Foreign’s market would support eight
firms, each producing 200,000 automobiles, and selling them at a price of $8,750. We can
again confirm that this solution satisfies the equilibrium conditions:
and
Now suppose it is possible for Home and Foreign to trade automobiles costlessly with
one another. This creates a new, integrated market (panel (c) in Figure 8-5) with total sales
of 2.5 million. By drawing the PP and CC curves one more time, we find that this integrated
market will support ten firms, each producing 250,000 cars and selling them at a
price of $8,000. The conditions for profit maximization and zero profits are again satisfied:
and
We summarize the results of creating an integrated market in Table 8-1. The table compares
each market alone with the integrated market. The integrated market supports more
firms, each producing at a larger scale and selling at a lower price than either national market
does on its own.
Clearly everyone is better off as a result of integration. In the larger market, consumers
have a wider range of choices, yet each firm produces more and is therefore able to offer
its product at a lower price. To realize these gains from integration, the countries must engage
in international trade. To achieve economies of scale, each firm must concentrate its
production in one country—either Home or Foreign. Yet it must sell its output to customers
in both markets. So each product will be produced in only one country and
exported to the other.
This numerical example highlights two important new features about trade with monopolistic
competition relative to the models of trade based on comparative advantage that we
covered in Chapters 3 through 6: (1) First, the example shows how product differentiation
AC = ($750,000,000/250,000) + $5,000 = $8,000.
= $5,000 + $3,000,
P = $8,000 = c + 1/(b * n) = $5,000 + 1/[(1/30,000) * 10]
AC = ($750,000,000/200,000) + $5,000 = $8,750.
P = $8,750 = c + 1/(b * n) = $5,000 + 1/[(1/30,000) * 8] = $5,000 + $3,750,
n = 8, P = 8,750
TABLE 8-1 Hypothetical Example of Gains from Market Integration
Home Market,
Before Trade
Foreign Market,
Before Trade
Integrated Market,
After Trade
Industry output
(# of autos)
900,000 1,600,000 2,500,000
Number of firms 6 8 10
Output per firm
(# of autos)
150,000 200,000 250,000
Average cost $10,000 $8,750 $8,000
Price $10,000 $8,750 $8,000
CHAPTER 8 Firms in the Global Economy 169
and internal economies of scale lead to trade between similar countries with no comparative
advantage differences between them. This is a very different kind of trade than the one
based on comparative advantage, where each country exports its comparative advantage
good. Here, both Home and Foreign export autos to one another. Home pays for the imports
of some automobile models (those produced by firms in Foreign) with exports of different
types of models (those produced by firms in Home)—and vice versa. This leads to what is
called intra-industry trade: two-way exchanges of similar goods. (2) Second, the example
highlights two new channels for welfare benefits from trade. In the integrated market after
trade, both Home and Foreign consumers benefit from a greater variety of automobile models
(ten versus six or eight) at a lower price ($8,000 versus $8,750 or $10,000) as firms are
able to consolidate their production destined for both locations and take advantage of
economies of scale.6
Empirically, is intra-industry trade relevant and do we observe gains from trade in the
form of greater product variety and consolidated production at lower average cost? The
answer is yes.
The Significance of Intra-Industry Trade
The proportion of intra-industry trade in world trade has steadily grown over the last halfcentury.
The measurement of intra-industry trade relies on an industrial classification
system that categorizes goods into different industries. Depending on the coarseness of
the industrial classification used (hundreds of different industry classifications versus
thousands), intra-industry trade accounts for one-quarter to nearly one-half of all world
trade flows. Intra-industry trade plays an even more prominent role in the trade of manufactured
goods among advanced industrial nations, which accounts for the majority of
world trade.
Table 8-2 shows measures of the importance of intra-industry trade for a number of U.S.
manufacturing industries in 2009. The measure shown is intra-industry trade as a proportion of
6Also note that Home consumers gain more than Foreign consumers from trade integration. This is a standard
feature of trade models with increasing returns and product differentiation: A smaller country stands to gain more
from integration than a larger country. This is because the gains from integration are driven by the associated
increase in market size; the country that is initially smaller benefits from a bigger increase in market size upon
integration.
TABLE 8-2 Indexes of Intra-Industry Trade for U.S. Industries, 2009
Metalworking Machinery 0.97
Inorganic Chemicals 0.97
Power-Generating Machines 0.86
Medical and Pharmaceutical Products 0.85
Scientific Equipment 0.84
Organic Chemicals 0.79
Iron and Steel 0.76
Road Vehicles 0.70
Office Machines 0.58
Telecommunications Equipment 0.46
Furniture 0.30
Clothing and Apparel 0.11
Footwear 0.10
170 PART ONE International Trade Theory
overall trade.7 The measure ranges from 0.97 for metalworking machinery and inorganic
chemicals—industries where U.S. exports and imports are nearly equal—to 0.10 for footwear,
an industry in which the United States has large imports but virtually no exports. The measure
would be 0 for an industry in which the United States is only an exporter or only an importer,
but not both; it would be 1 for an industry in which U.S. exports exactly equal U.S. imports.
Table 8-2 shows that intra-industry trade is a very important component of trade for the
United States in many different industries. Those industries tend to be ones that produce sophisticated
manufactured goods, such as chemicals, pharmaceuticals, and specialized machinery.
These goods are exported principally by advanced nations and are probably subject to important
economies of scale in production. At the other end of the scale are the industries with very little
intra-industry trade, which typically produce labor-intensive products such as footwear and
apparel. These are goods that the United States imports primarily from less-developed countries,
where comparative advantage is the primary determinant of U.S. trade with these countries.
What about the new types of welfare gains via increased product variety and economies
of scale? A recent paper by Christian Broda at the Chicago Booth School of Business and
David Weinstein at Columbia University estimates that the number of available products
in U.S. imports tripled in the 30-year time-span from 1972 to 2001. They further estimate
that this increased product variety for U.S. consumers represented a welfare gain equal to
2.6 percent of U.S. GDP!8
Table 8-1 from our numerical example showed that the gains from integration generated
by economies of scale were most pronounced for the smaller economy: Prior to integration,
production there was particularly inefficient, as the economy could not take
advantage of economies of scale in production due to the country’s small size. This is
exactly what happened when the United States and Canada followed a path of increasing
economic integration starting with the North American Auto Pact in 1964 (which did not
include Mexico) and culminating in the North American Free Trade Agreement (NAFTA,
which does include Mexico). The Case Study that follows describes how this integration
led to consolidation and efficiency gains in the automobile sector—particularly on the
Canadian side (whose economy is one-tenth the size of the U.S. economy).
Similar gains from trade have also been measured for other real-world examples of closer
economic integration. One of the most prominent examples has taken place in Europe over
the last half-century. In 1957 the major countries of Western Europe established a free trade
area in manufactured goods called the Common Market, or European Economic Community
(EEC). (The United Kingdom entered the EEC later, in 1973.) The result was a rapid growth
of trade that was dominated by intra-industry trade. Trade within the EEC grew twice as fast
as world trade as a whole during the 1960s. This integration slowly expanded into what has
become the European Union. When a subset of these countries (mostly, those countries that
had formed the EEC) adopted the common euro currency in 1999, intra-industry trade
among those countries further increased (even relative to that of the other countries in the
European Union). Recent studies have also found that the adoption of the euro has led to a
substantial increase in the number of different products that are traded within the Eurozone.
7To be more precise, the standard formula for calculating the importance of intra-industry trade within a given industry is
where min{exports, imports} refers to the smallest value between exports and imports. This is the amount of
two-way exchanges of goods that is reflected in both exports and imports. This number is measured as a proportion
of the average trade flow (average of exports and imports). If trade in an industry flows in only one direction,
then since the smallest trade flow is zero: There is no intra-industry trade. On the other hand, if a country’s
exports and imports within an industry are equal, we get the opposite extreme of I = 1.
I = 0
I =
min{exports, imports}
(exports + imports)/2
,
8See Christian Broda and David E. Weinstein, “Globalization and the Gains from Variety,” Quarterly Journal of
Economics 121 (April 2006), pp. 541–585.
CHAPTER 8 Firms in the Global Economy 171
Case Study
Intra-Industry Trade in Action: The North American Auto Pact of 1964
An unusually clear-cut example of the role of economies of scale in generating beneficial
international trade is provided by the growth in automotive trade between the
United States and Canada during the second half of the 1960s. While
the case does not fit our model exactly since it involves multinational
firms, it does show that the basic concepts we have developed are useful
in the real world.
Before 1965, tariff protection by Canada and the United States produced
a Canadian auto industry that was largely self-sufficient, neither
importing nor exporting much. The Canadian industry was controlled
by the same firms as the U.S. industry—a feature that we will address
later on in this chapter—but these firms found it cheaper to have largely
separate production systems than to pay the tariffs. Thus the Canadian
industry was in effect a miniature version of the U.S. industry, at about
1/10 the scale.
The Canadian subsidiaries of U.S. firms found that small scale was
a substantial disadvantage. This was partly because Canadian plants
had to be smaller than their U.S. counterparts. Perhaps more importantly,
U.S. plants could often be “dedicated”—that is, devoted to
producing a single model or component—while Canadian plants had
to produce several different things, requiring the plants to shut down
periodically to change over from producing one item to producing
another, to hold larger inventories, to use less specialized machinery,
and so on. The Canadian auto industry thus had a labor productivity about 30 percent
lower than that of the United States.
In an effort to remove these problems, the United States and Canada agreed in 1964
to establish a free trade area in automobiles (subject to certain restrictions). This allowed
the auto companies to reorganize their production. Canadian subsidiaries of the
auto firms sharply cut the number of products made in Canada. For example, General
Motors cut in half the number of models assembled in Canada. The overall level of
Canadian production and employment was, however, maintained. Production levels for
the models produced in Canada rose dramatically, as those Canadian plants became one
of the main (and many times the only) supplier of that model for the whole North
American market. Conversely, Canada then imported the models from the United
States that it was no longer producing. In 1962, Canada exported $16 million worth of
automotive products to the United States while importing $519 million worth. By 1968
the numbers were $2.4 and $2.9 billion, respectively. In other words, both exports and
imports increased sharply: intra-industry trade in action.
The gains seem to have been substantial. By the early 1970s the Canadian industry
was comparable to the U.S. industry in productivity. Later on, this transformation of the
automotive industry was extended to include Mexico. In 1989, Volkswagen consolidated
its North American operations in Mexico, shutting down its plant in Pennsylvania. This
process continued with the implementation of NAFTA (the North American Free Trade
Agreement between the United States, Canada, and Mexico). In 1994 Volkswagen
started producing the new Beetle for the whole North American market in that same
Mexican plant. We discuss the effects of NAFTA in more detail later on in this chapter.
The Ambassador bridge connects
Detroit in the United States to
Windsor in Canada. On a typical
day, $250 million worth of cars
Underlying the application of the monopolistic competition model to trade is the idea that
trade increases market size. In industries where there are economies of scale, both the
variety of goods that a country can produce and the scale of its production are constrained
by the size of the market. By trading with each other, and therefore forming an integrated
world market that is bigger than any individual national market, nations are able to loosen
these constraints. Each country can thus specialize in producing a narrower range of products
than it would in the absence of trade; yet by buying from other countries the goods
that it does not make, each nation can simultaneously increase the variety of goods available
to its consumers. As a result, trade offers an opportunity for mutual gain even when
countries do not differ in their resources or technology.
Suppose, for example, that there are two countries, each with an annual market for 1
million automobiles. By trading with each other, these countries can create a combined
market of 2 million autos. In this combined market, more varieties of automobiles can be
produced, at lower average costs, than in either market alone.
The monopolistic competition model can be used to show how trade improves the
trade-off between scale and variety that individual nations face. We will begin by showing
how a larger market leads, in the monopolistic competition model, to both a lower average
price and the availability of a greater variety of goods. Applying this result to international
trade, we observe that trade creates a world market larger than any of the national markets
that comprise it. Integrating markets through international trade therefore has the same
effects as growth of a market within a single country.
The Effects of Increased Market Size
The number of firms in a monopolistically competitive industry and the prices they charge
are affected by the size of the market. In larger markets there usually will be both more
firms and more sales per firm; consumers in a large market will be offered both lower
prices and a greater variety of products than consumers in small markets.
n2 P2
n2
P3 AC3
n2 n3
P1 AC1
n2 n1
To see this in the context of our model, look again at the CC curve in Figure 8-3, which
showed that average costs per firm are higher the more firms there are in the industry. The
definition of the CC curve is given by equation (8-6):
Examining this equation, we see that an increase in total industry output S will reduce average
costs for any given number of firms n. The reason is that if the market grows while
the number of firms is held constant, output per firm will increase and the average cost of
each firm will therefore decline. Thus if we compare two markets, one with higher S than
the other, the CC curve in the larger market will be below that in the smaller one.
Meanwhile, the PP curve in Figure 8-3, which relates the price charged by firms to the
number of firms, does not shift. The definition of that curve was given in equation (8-10):
The size of the market does not enter into this equation, so an increase in S does not shift
the PP curve.
Figure 8-4 uses this information to show the effect of an increase in the size of the market
on long-run equilibrium. Initially, equilibrium is at point 1, with a price and a number
of firms n1. An increase in the size of the market, measured by industry sales S, shifts
P1
P = c + 1/(b * n).
AC = F/Q + c = n * F/S + c.
CHAPTER 8 Firms in the Global Economy 165
Cost, C and
Price, P
P2
Number of
firms, n
n2 n1
PP
P1
1
2
CC1
CC2
Figure 8-4
Effects of a Larger Market
An increase in the size of the market allows each firm, other things equal, to produce
more and thus have lower average cost. This is represented by a downward
shift from CC1 to CC2. The result is a simultaneous increase in the number of firms
(and hence in the variety of goods available) and a fall in the price of each.
166 PART ONE International Trade Theory
the CC curve down from to , while it has no effect on the PP curve. The new
equilibrium is at point 2: The number of firms increases from to , while the price falls
from to .
Clearly, consumers would prefer to be part of a large market rather than a small one. At
point 2, a greater variety of products is available at a lower price than at point 1.
Gains from an Integrated Market: A Numerical Example
International trade can create a larger market. We can illustrate the effects of trade on
prices, scale, and the variety of goods available with a specific numerical example.
Imagine that automobiles are produced by a monopolistically competitive industry. The
demand curve facing any given producer of automobiles is described by equation (8-5),
with b = 1/30,000 (this value has no particular significance; it was chosen to make the
example come out neatly). Thus the demand facing any one producer is given by
where Q is the number of automobiles sold per firm, S is the total number sold for the
industry, n is the number of firms, P is the price that a firm charges, and is the average
price of other firms. We also assume that the cost function for producing automobiles is
described by equation (8-3), with a fixed cost and a marginal cost
per automobile (again, these values were chosen to give nice results). The
total cost is
The average cost curve is therefore
Now suppose there are two countries, Home and Foreign. Home has annual sales of
900,000 automobiles; Foreign has annual sales of 1.6 million. The two countries are
assumed, for the moment, to have the same costs of production.
Figure 8-5a shows the PP and CC curves for the Home auto industry. We find that in
the absence of trade, Home would have six automobile firms, selling autos at a price of
$10,000 each. (It is also possible to solve for n and P algebraically, as shown in the
Mathematical Postscript to this chapter.) To confirm that this is the long-run equilibrium,
we need to show both that the pricing equation (8-10) is satisfied and that the price equals
average cost.
Substituting the actual values of the marginal cost c, the demand parameter b, and the
number of Home firms n into equation (8-10), we find
so the condition for profit maximization—marginal revenue equaling marginal cost—is
satisfied. Each firm sells 900,000 units/6 firms = 150,000 units/firm. Its average cost is
therefore
Since the average cost of $10,000 per unit is the same as the price, all monopoly profits
have been competed away. Thus six firms, selling each unit at a price of $10,000, with
each firm producing 150,000 cars, is the long-run equilibrium in the Home market.
AC = ($750,000,000/150,000) + $5,000 = $10,000.
= $5,000 + $5,000,
P = $10,000 = c + 1/(b * n) = $5,000 + 1/[(1/30,000) * 6
AC = (750,000,000/Q) + 5,000.
C = 750,000,000 + (5,000 * Q).
c = $5,000
F = $750,000,000
P
Q = S * [(1/n) - (1/30,000) * (P - P)],
P1 P2
n1 n2
CC1 CC2
CHAPTER 8 Firms in the Global Economy 167
2 4 6 8 10 12
Price per auto,
in thousands of dollars
Number
of firms, n
(a) The Home market: With a market size of 900,000 automobiles, Home’s equilibrium, determined by the
intersection of the PP and CC curves, occurs with six firms and an industry price of $10,000 per auto. (b) The
Foreign market: With a market size of 1.6 million automobiles, Foreign’s equilibrium occurs with eight firms and
an industry price of $8,750 per auto. (c) The combined market: Integrating the two markets creates a market for
2.5 million autos. This market supports ten firms, and the price of an auto is only $8,000.
168 PART ONE International Trade Theory
What about Foreign? By drawing the PP and CC curves (panel (b) in Figure 8-5), we
find that when the market is for 1.6 million automobiles, the curves intersect at
. That is, in the absence of trade, Foreign’s market would support eight
firms, each producing 200,000 automobiles, and selling them at a price of $8,750. We can
again confirm that this solution satisfies the equilibrium conditions:
and
Now suppose it is possible for Home and Foreign to trade automobiles costlessly with
one another. This creates a new, integrated market (panel (c) in Figure 8-5) with total sales
of 2.5 million. By drawing the PP and CC curves one more time, we find that this integrated
market will support ten firms, each producing 250,000 cars and selling them at a
price of $8,000. The conditions for profit maximization and zero profits are again satisfied:
and
We summarize the results of creating an integrated market in Table 8-1. The table compares
each market alone with the integrated market. The integrated market supports more
firms, each producing at a larger scale and selling at a lower price than either national market
does on its own.
Clearly everyone is better off as a result of integration. In the larger market, consumers
have a wider range of choices, yet each firm produces more and is therefore able to offer
its product at a lower price. To realize these gains from integration, the countries must engage
in international trade. To achieve economies of scale, each firm must concentrate its
production in one country—either Home or Foreign. Yet it must sell its output to customers
in both markets. So each product will be produced in only one country and
exported to the other.
This numerical example highlights two important new features about trade with monopolistic
competition relative to the models of trade based on comparative advantage that we
covered in Chapters 3 through 6: (1) First, the example shows how product differentiation
AC = ($750,000,000/250,000) + $5,000 = $8,000.
= $5,000 + $3,000,
P = $8,000 = c + 1/(b * n) = $5,000 + 1/[(1/30,000) * 10]
AC = ($750,000,000/200,000) + $5,000 = $8,750.
P = $8,750 = c + 1/(b * n) = $5,000 + 1/[(1/30,000) * 8] = $5,000 + $3,750,
n = 8, P = 8,750
TABLE 8-1 Hypothetical Example of Gains from Market Integration
Home Market,
Before Trade
Foreign Market,
Before Trade
Integrated Market,
After Trade
Industry output
(# of autos)
900,000 1,600,000 2,500,000
Number of firms 6 8 10
Output per firm
(# of autos)
150,000 200,000 250,000
Average cost $10,000 $8,750 $8,000
Price $10,000 $8,750 $8,000
CHAPTER 8 Firms in the Global Economy 169
and internal economies of scale lead to trade between similar countries with no comparative
advantage differences between them. This is a very different kind of trade than the one
based on comparative advantage, where each country exports its comparative advantage
good. Here, both Home and Foreign export autos to one another. Home pays for the imports
of some automobile models (those produced by firms in Foreign) with exports of different
types of models (those produced by firms in Home)—and vice versa. This leads to what is
called intra-industry trade: two-way exchanges of similar goods. (2) Second, the example
highlights two new channels for welfare benefits from trade. In the integrated market after
trade, both Home and Foreign consumers benefit from a greater variety of automobile models
(ten versus six or eight) at a lower price ($8,000 versus $8,750 or $10,000) as firms are
able to consolidate their production destined for both locations and take advantage of
economies of scale.6
Empirically, is intra-industry trade relevant and do we observe gains from trade in the
form of greater product variety and consolidated production at lower average cost? The
answer is yes.
The Significance of Intra-Industry Trade
The proportion of intra-industry trade in world trade has steadily grown over the last halfcentury.
The measurement of intra-industry trade relies on an industrial classification
system that categorizes goods into different industries. Depending on the coarseness of
the industrial classification used (hundreds of different industry classifications versus
thousands), intra-industry trade accounts for one-quarter to nearly one-half of all world
trade flows. Intra-industry trade plays an even more prominent role in the trade of manufactured
goods among advanced industrial nations, which accounts for the majority of
world trade.
Table 8-2 shows measures of the importance of intra-industry trade for a number of U.S.
manufacturing industries in 2009. The measure shown is intra-industry trade as a proportion of
6Also note that Home consumers gain more than Foreign consumers from trade integration. This is a standard
feature of trade models with increasing returns and product differentiation: A smaller country stands to gain more
from integration than a larger country. This is because the gains from integration are driven by the associated
increase in market size; the country that is initially smaller benefits from a bigger increase in market size upon
integration.
TABLE 8-2 Indexes of Intra-Industry Trade for U.S. Industries, 2009
Metalworking Machinery 0.97
Inorganic Chemicals 0.97
Power-Generating Machines 0.86
Medical and Pharmaceutical Products 0.85
Scientific Equipment 0.84
Organic Chemicals 0.79
Iron and Steel 0.76
Road Vehicles 0.70
Office Machines 0.58
Telecommunications Equipment 0.46
Furniture 0.30
Clothing and Apparel 0.11
Footwear 0.10
170 PART ONE International Trade Theory
overall trade.7 The measure ranges from 0.97 for metalworking machinery and inorganic
chemicals—industries where U.S. exports and imports are nearly equal—to 0.10 for footwear,
an industry in which the United States has large imports but virtually no exports. The measure
would be 0 for an industry in which the United States is only an exporter or only an importer,
but not both; it would be 1 for an industry in which U.S. exports exactly equal U.S. imports.
Table 8-2 shows that intra-industry trade is a very important component of trade for the
United States in many different industries. Those industries tend to be ones that produce sophisticated
manufactured goods, such as chemicals, pharmaceuticals, and specialized machinery.
These goods are exported principally by advanced nations and are probably subject to important
economies of scale in production. At the other end of the scale are the industries with very little
intra-industry trade, which typically produce labor-intensive products such as footwear and
apparel. These are goods that the United States imports primarily from less-developed countries,
where comparative advantage is the primary determinant of U.S. trade with these countries.
What about the new types of welfare gains via increased product variety and economies
of scale? A recent paper by Christian Broda at the Chicago Booth School of Business and
David Weinstein at Columbia University estimates that the number of available products
in U.S. imports tripled in the 30-year time-span from 1972 to 2001. They further estimate
that this increased product variety for U.S. consumers represented a welfare gain equal to
2.6 percent of U.S. GDP!8
Table 8-1 from our numerical example showed that the gains from integration generated
by economies of scale were most pronounced for the smaller economy: Prior to integration,
production there was particularly inefficient, as the economy could not take
advantage of economies of scale in production due to the country’s small size. This is
exactly what happened when the United States and Canada followed a path of increasing
economic integration starting with the North American Auto Pact in 1964 (which did not
include Mexico) and culminating in the North American Free Trade Agreement (NAFTA,
which does include Mexico). The Case Study that follows describes how this integration
led to consolidation and efficiency gains in the automobile sector—particularly on the
Canadian side (whose economy is one-tenth the size of the U.S. economy).
Similar gains from trade have also been measured for other real-world examples of closer
economic integration. One of the most prominent examples has taken place in Europe over
the last half-century. In 1957 the major countries of Western Europe established a free trade
area in manufactured goods called the Common Market, or European Economic Community
(EEC). (The United Kingdom entered the EEC later, in 1973.) The result was a rapid growth
of trade that was dominated by intra-industry trade. Trade within the EEC grew twice as fast
as world trade as a whole during the 1960s. This integration slowly expanded into what has
become the European Union. When a subset of these countries (mostly, those countries that
had formed the EEC) adopted the common euro currency in 1999, intra-industry trade
among those countries further increased (even relative to that of the other countries in the
European Union). Recent studies have also found that the adoption of the euro has led to a
substantial increase in the number of different products that are traded within the Eurozone.
7To be more precise, the standard formula for calculating the importance of intra-industry trade within a given industry is
where min{exports, imports} refers to the smallest value between exports and imports. This is the amount of
two-way exchanges of goods that is reflected in both exports and imports. This number is measured as a proportion
of the average trade flow (average of exports and imports). If trade in an industry flows in only one direction,
then since the smallest trade flow is zero: There is no intra-industry trade. On the other hand, if a country’s
exports and imports within an industry are equal, we get the opposite extreme of I = 1.
I = 0
I =
min{exports, imports}
(exports + imports)/2
,
8See Christian Broda and David E. Weinstein, “Globalization and the Gains from Variety,” Quarterly Journal of
Economics 121 (April 2006), pp. 541–585.
CHAPTER 8 Firms in the Global Economy 171
Case Study
Intra-Industry Trade in Action: The North American Auto Pact of 1964
An unusually clear-cut example of the role of economies of scale in generating beneficial
international trade is provided by the growth in automotive trade between the
United States and Canada during the second half of the 1960s. While
the case does not fit our model exactly since it involves multinational
firms, it does show that the basic concepts we have developed are useful
in the real world.
Before 1965, tariff protection by Canada and the United States produced
a Canadian auto industry that was largely self-sufficient, neither
importing nor exporting much. The Canadian industry was controlled
by the same firms as the U.S. industry—a feature that we will address
later on in this chapter—but these firms found it cheaper to have largely
separate production systems than to pay the tariffs. Thus the Canadian
industry was in effect a miniature version of the U.S. industry, at about
1/10 the scale.
The Canadian subsidiaries of U.S. firms found that small scale was
a substantial disadvantage. This was partly because Canadian plants
had to be smaller than their U.S. counterparts. Perhaps more importantly,
U.S. plants could often be “dedicated”—that is, devoted to
producing a single model or component—while Canadian plants had
to produce several different things, requiring the plants to shut down
periodically to change over from producing one item to producing
another, to hold larger inventories, to use less specialized machinery,
and so on. The Canadian auto industry thus had a labor productivity about 30 percent
lower than that of the United States.
In an effort to remove these problems, the United States and Canada agreed in 1964
to establish a free trade area in automobiles (subject to certain restrictions). This allowed
the auto companies to reorganize their production. Canadian subsidiaries of the
auto firms sharply cut the number of products made in Canada. For example, General
Motors cut in half the number of models assembled in Canada. The overall level of
Canadian production and employment was, however, maintained. Production levels for
the models produced in Canada rose dramatically, as those Canadian plants became one
of the main (and many times the only) supplier of that model for the whole North
American market. Conversely, Canada then imported the models from the United
States that it was no longer producing. In 1962, Canada exported $16 million worth of
automotive products to the United States while importing $519 million worth. By 1968
the numbers were $2.4 and $2.9 billion, respectively. In other words, both exports and
imports increased sharply: intra-industry trade in action.
The gains seem to have been substantial. By the early 1970s the Canadian industry
was comparable to the U.S. industry in productivity. Later on, this transformation of the
automotive industry was extended to include Mexico. In 1989, Volkswagen consolidated
its North American operations in Mexico, shutting down its plant in Pennsylvania. This
process continued with the implementation of NAFTA (the North American Free Trade
Agreement between the United States, Canada, and Mexico). In 1994 Volkswagen
started producing the new Beetle for the whole North American market in that same
Mexican plant. We discuss the effects of NAFTA in more detail later on in this chapter.
The Ambassador bridge connects
Detroit in the United States to
Windsor in Canada. On a typical
day, $250 million worth of cars
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