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Summary week 5 of International Trade and Investment
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Summary of the course International Trade and Investment. Including Chapter 8 and 9.
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Summary of the book 'International Trade: Theory and Policy' by Krugman, Obstfeld and Melitz
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Chapter 8: Firms in the Global Economy: Export Decisions, Outsourcing, and MultinationalEnterprises.
Internal economies of scale imply that a firm’s average cost of production decreases the more
output it produces. Perfect competition that drives the price of a good down to marginal cost would
imply losses for those firms because they would not be able to recover the higher costs incurred from
producing the initial units of output. As a result, perfect competition would force those firms out of
the market, and this process would continue until an equilibrium featuring imperfect competition is
attained. Modeling imperfect competition means that we will explicitly consider the behavior of
individual firms. This will allow us to introduce two additional characteristics of firms that are
prevalent in the real world: (1) In most sectors, firms produce goods that are differentiated from one
another. In the case of certain goods (bottled water, staples), those differences across products may
be small, while in others (cars, phones) the differences are much more significant. (2) Performance
measures (such as size and profits) vary widely across firms.
The Theory of Imperfect Competition
In a perfectly competitive market firms are price takers. In imperfect competition, then, firms are
aware that they can influence the prices of their products and they can sell more only by reducing
their price. This situation occurs in one of two ways: when there are only a few major producers of a
particular good, or when each firm produces a good that is differentiated from that of rival firms. This
type of competition is an inevitable outcome when there are economies of scale at the level of the
firm: The number of surviving firms is forced down to a small number and/or firms must develop
products that are clearly differentiated from those produced by their rivals. Under these
circumstances, each firm views itself as a price setter. The simplest imperfectly competitive market
structure to examine is that of a pure monopoly, a market in which a firm faces no competition.
Monopoly: A Brief Review
The marginal revenue curve corresponds to the demand curve. Marginal revenue is the extra or
marginal revenue the firm gains from selling an additional unit. Marginal revenue for a monopolist is
always less than the price because to sell an additional unit, the firm must lower the price of all units
(not just the marginal one). Thus, for a monopolist, the marginal revenue curve, MR , always lies
below the demand curve.
Marginal Revenue and Price
Marginal revenue is always less than the price. The relationship between marginal revenue and price
depends on two things. First, it depends on how much output the firm is already selling: A firm not
selling very many units will not lose much by cutting the price it receives on those units. Second the
gap between price and marginal revenue depends on the slope of the demand curve, which tells us
how much the monopolist has to cut his price to sell one more unit of output. If the curve is very flat,
then the monopolist can sell an additional unit with only a small price cut. So marginal revenue will
be close to the price per unit. On the other hand, if the demand curve is very steep, selling an
additional unit will require a larger price cut, implying that marginal revenue will be much less than
the price.
,Q= A−B × P
Where Q is the number of units the firm sells, P is the price it charges per unit, and A and B are
constants.
MR=P−Q / B
Implying that
P−MR=Q / B
This equation reveals that the gap between price and marginal revenue depends on the initial sales,
Q , of the firm and the slope parameter, B, of its demand curve.
AC represent the firm’s average cost of production, that is, its total cost divided by its output. MC
represents the firm’s marginal cost (the amount it costs the firm to produce one extra unit). If we
denote c as the firm’s marginal cost and F as the fixed cost, then we can write the firm’s total cost (
C ) as
C=F+ c × Q
AC=C / Q=F /Q+ c
Average cost is always greater than the marginal cost and declines with output produced Q . The
profit-maximizing output of a monopolist is that at which marginal revenue equals marginal cost.
When P> AC , the monopolist is earning some monopoly profits, as indicated by the shaded box.
Monopolistic competition
A firm making high profits normally attracts competitors. Thus, situations of pure monopoly are rare
in practice. In most cases, competitors do not sell the same products. This leads to a market where
competitors sell differentiated products. Thus, even when there are many competitors, product
differentiation allows firms to remain price setter for their own individual product “variety” or brand.
However, more competition implies lower sales for any given firm at any chosen price: Each firm’s
demand curve shifts in when there are more competitors. Lower demand, in turn, translates into
lower profits. The incentive for additional new competitors persists so long as such entry is
profitable. Once competition reaches a certain level, additional entry would no longer be profitable
and a long-run equilibrium is attained. In some cases, this occurs when there are only a small number
of competing firms in the market (oligopoly in chapter 12).
Let’s focus on a much simpler case of imperfect competition known as monopolistic competition.
This market structure arises when the equilibrium number of competing firms is large and no firm
attains a substantial market share. Then, the pricing decision of any given firm will not affect market
aggregates and the demand conditions for the other firms, so the pricing decisions of the firms are
no longer interrelated.
Q=S × [ 1 / n−b × ( P− Ṕ ) ]
Where Q is the quantity of output demanded, S is the total output of the industry, n is the number
of firms in the industry, b is a positive constant term representing the responsiveness of a firm’s sales
to its price, P is the price charged by the firm itself, and Ṕ is the average price charged by its
competitors. Note that in this initial model, we assume all firms are symmetric even though they
produce differentiated product: They all face the same demand curve an have the same cost
function. Our method for determining n and Ṕ involves three steps.
1. The number of firms and average cost. Since all firms are symmetric in this model, in
equilibrium they all will charge the same price, so Q=S / n. The average cost:
AC=F / Q+ c=( n × F / S ) +c
The more firms there are in the industry the higher is average cost. The reason is that the
more firms there are, the less each firm produces. AC is CC in Figure 8-3
2. The number of firms and the price. The marginal revenue for a typical firm is equal to their
marginal cost, so that: M R=P−Q / ( S × b ) =c , so that P=c+Q / ( S × b ) =c . Plugging in
, Q=S / n gives us P=c+1 /(b × n). The more firms there are in an industry, the lower price
each firm will charge. PP in Figure 8-3)
3. The equilibrium number of firms. If the number of firms increase, each firm will sell less, so
firms will not be able to move as far down their average curve.
In the equilibrium point E, n2 is the zero-profit number of firms in the industry. This is the long-run
monopolistic competition equilibrium.
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. If we compare to markets,
one with higher S than the other, the CC curve in the larger market will be below that in the smaller
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