Lecture 3 - Trade and Economies of Scale

from last time
trade facts
shifts in demand
external economies
monopolistic competition
gains and losses from opening up trade

From Last Time

The Stolper-Samuelson theorem simply says that a move to free trade benefits resources used intensively in the export sector and hurts the resources used intensively in the import-competing sector.
The Factor Price Equalization theorem says that, under certain assumptions, resources prices will be the same everywhere under free trade. For example, NAFTA ought to encourage the importation of unskilled labor-intensive products from Mexico into the United States. The demand for unskilled labor in Mexico will rise, causing wages to go up there. The demand for unskilled labor in the U.S. will fall due to the competition from imports. So, the demand for unskilled labor in this country will fall along with wages. Under certain assumptions, wages in the U.S. and Mexico will eventually be the same.
There is a relationship between government budget deficits and the trade deficit. The budget deficit raises interest rates. Higher interest rates attract foreign investors, but to invest here they need dollars. The resulting higher demand for dollars raises the exchange rate value of the dollar. A stronger dollar makes U.S. products more expensive for foreign buyers and foreign products cheaper to American buyers. So, we export less and import more. The result is a bigger trade deficit.
The idea behind immiserizing growth is that if a country experiences growth in its export sector, the resulting increase in supply will push down the price of its exports. Even though it is exporting a larger quantity, the price might fall so much that its revenues for exports will be smaller than before.

Trade Facts

Over the last 30 years, a rising share of world trade has been in knowledge intensive products.
Comparative advantage in knowledge intensive products shifts rapidly.
Trade between industrial countries rose from 45% to 55% of world trade.
Intra-industry trade has grown fastest.

Shifts in Demand

Income growth shifts demand toward luxuries, and knowledge-intensive goods and product variety are both luxuries.

External Economies

If demand were the whole story, the relative price of luxuries should have risen, but it hasn't.

Economies of scale exist when an x% increase in all inputs leads to a more than x% increase in output. With economies of scale, average costs drop as output increases. Therefore, when demand increases, price can actually fall.

One source of economies of scale is external economies. These are the productivity gains and cost reductions that an individual firm reaps from the expansion of other firms in the same industry. In a knowledge-intensive industry, new knowledge is available to every firm either as direct information or as knowledge carried by skilled workers changing firms, e.g. New York's garment district, Silicon Valley.

With external economies, the more an industry expands its scale of production, the lower each firm's costs fall. When industry output rises, average costs for all firms fall.

external economies Initially the industry is at point A when new export business increases demand. The price initially rises causing firms to produce more output. This is when the external economies kick in. The expansion of output lowers costs and shifts the industry supply curve to the right. Producers surplus has risen so domestic producers gain. The price falls so consumers benefit and foreign producers lose.
The idea is that the country gained access to export markets and external economies magnified its success. The first country to gain access to new markets and supply them captures a big expansion of exports and lowers its costs. Comparative advantage can be acquired from historical luck or government policy.

Monopolistic Competition

Internal economies occur when expanding the firm's own scale of operation cuts only its average costs. Internal economies tend to lead to imperfect competition.

characteristics of monopolistic competition

many buyers and sellers
different products
free entry and exit
perfect information

In a monopolistically competitive market, firms use product differentiation more than price to compete. Toothpaste is basically toothpaste, but consumers are convinced that Crest is different than Aim. So, the makers of Crest have a monopoly in the market for Crest while the makers of Aim have a monopoly in the market for Aim. In the short run, monopolistic competitors can earn economic profits. They produce the quantity of output at which MR = MC.

monopolistic competition in the short run

Entry into the market causes the demand curve for all other competitor's products to decrease. New products are introduced as long as economic profits are positive. In the long run, free entry and exit allows only for normal profits.

Suppose an export market opens up so that the demand curve shifts up to the right. The firm is able to earn above-normal profits which attract new firms. The demand curve shifts down to the left and the firm ends up at point B. The price has fallen so consumers gain and foreign producers lose. There is no long run change in profits so there is only a temporary gain for domestic producers.

Economies of scale do not determine comparative advantage but do translate any comparative advantage into lower prices and a greater expansion of output and trade.

Gains and Losses from Opening Up Trade

	competition	external economies	monopolistic competition
Exporting Country	gain	gain	gain
producers	gain	gain	temporary gain
consumers	lose	gain	gain
Importing Country	gain	gain	gain
producers	lose	lose	lose
consumers	gain	gain	gain
Whole World	gain	gain	gain

David A. Latzko
318 COB
Department of Business and Economics
Wilkes University
Wilkes-Barre, PA 18766
phone: (717) 408-4718
fax: (717) 408-4917
dlatzko@wilkes.edu
wilkes1.wilkes.edu/~dlatzko