North-North Trade
AED/IS 4540
International Commerce
and the World Economy
Professor Sheldon
[email protected]
North-North Trade
 For North-North trade, observe countries with
similar endowments and technology trading
similar products – intra-industry trade
 Cannot be explained by Heckscher-Ohlin model
which predicts trade in different products –
inter-industry trade
 North-North trade characterized by imperfectly
competitive firms, realizing scale economies,
and selling differentiated products
 Models developed in 1970s by economists such
as Paul Krugman based on monopolistic
competition, used to explain North-North trade
Intra-Industry Trade
US Intra-Industry Trade (2009)*
Metalworking Machinery
*Index of intra-industry trade:
0.97
Inorganic Chemicals
0.97
Power-Generating Machines
0.86
Medical/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
I=
min {exports , imports }
(exports + imports ) / 2
where: min {exports , imports } refers to
smallest value between exports and
imports, and denominator is average of
exports and imports
e.g., if imports = 0, then I = 0, but if
imports = exports, then I = 1
Economies of scale
 Suppose a firm’s technology is one where total
costs (TC) consist of fixed costs (FC) and
constant marginal costs (c):
TC = FC + cQ
where Q is firm’s output
 Therefore, average costs (AC) are:
AC = TC/Q = (F/Q)+c
 As Q increases, average cost (AC) falls, fixed
costs (FC) being spread over more output
Product differentiation
 If single firm produces with this technology,
sets output Q where marginal revenue (MR) is
equal to marginal cost (MC)
 Firm makes monopoly profits of area pefAC
 Unlikely profits will go uncontested, so assume
firms with same technology enter industry
selling differentiated products
 Firms
continue to enter until p'=AC
equilibrium – monopolistic competition
 Each firm sells Q' of differentiated product
in
Monopoly equilibrium
p,c
p
e
AC
f
AC
MC
MR
0
Q
D
Q
Monopolistic competition
p,c
p'=AC
e
AC
MC
MR
0
Q'
D
Q
Industry equilibrium - autarky
p,c
CC
p1
AC3
E
p2=AC2
p3
PP
AC1
1
2
3
Number of firms
Industry equilibrium - autarky
 Number of firms in market and prices they
charge determined by two relationships:
 the more firms in industry, the more intense
is competition and hence the lower the price
(PP)
 the more firms there are, the less each firm
sells, and hence the higher is industry
average cost (CC)
 In equilibrium, two firms enter under autarky,
each selling a differentiated product
Industry equilibrium - trade
p,c
p1
CC1
E1
CC2
E2
p2
PP
2
4
Number of firms
Industry equilibrium - trade
 Suppose two countries in North have exactly
same industry equilibrium under autarky
 If countries integrate through trade, size of
market doubles, allowing firms to produce
more at lower average cost – CC1 shifts to CC2
 End result is increase in number of firms from
2 to 4, and fall in prices from p1 to p2
 One can imagine two firms based in one
country, and two in the other, all producing for
their home and the foreign market
Industry equilibrium - trade
 Intra-industry
trade occurs, benefits being
more product varieties, sold at lower prices
and produced at lower average cost
 Model does good job of explaining why we
observe two-way trade in automobiles between
Germany and France
 However, model assumes firms are symmetric,
and so says nothing about which firms may
survive after markets integrated through trade
 Important question: why do some firms trade?