INTERNATIONAL TRADE AND

IMPERFECT COMPETITION

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 Road Map
Theory Lectures

▪ TODAY: a) Monopolistic competition

▪ NEXT WEEK: b) Dumping.

Exercise Lectures

▪ THIS Thursday: Monopolistic Competition”.

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a) MONOPOLISTIC COMPETITION

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 Motivation
▪ Models of comparative advantage (Ricardo and Heckscher-Ohlin) predict that:

▪ The more countries are different, the more they should trade.
▪ For example, a country exports agricultural goods and imports manufactured goods. This type of
trade is referred to as inter-industry trade.

▪ However,

▪ We observe a lot of trade between countries with similar technologies and endowments. For
example, between developed countries.
▪ Countries often export and import within the same sector. For example, a country exports and
imports cars, wine, … This type of trade is referred as intra-industry trade.

▪ We need an alternative model to explain these observations.

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 INTRA - industry trade
• Accounts for almost 50% of world trade

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As usual…

Closed Economy

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 First the
MARKET STRUCTURE

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 Perfect Competition

We say that a market has perfect

competition model when buyers (as well
as sellers) are price takers.

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 Price Takers

A buyer (or a seller) is a price taker if

s/he cannot influence the price of the
good that is bought/sold.

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!10
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 Competitive Markets
When can we expect the buyers and the
sellers to be price takers?
When there are many buyers and sellers
interested in the same good (an homogenous
good).
We call this type of markets, competitive
markets.

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 Other Market Structures

A. Monopoly A single seller

B. Oligopoly Few number of sellers
C. Monopolistic Competition Many
sellers but with slightly different products

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Monopoly X
Perfect Competition X
Monopolistic Competition Many sellers
but with slightly different products YES!!
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INTERNATIONAL TRADE AND
IMPERFECT COMPETITION

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 Assumptions
▪ 2 countries: Spain and France

▪ 1 good, many varieties: wine (horizontal differentiation)

▪ Endowments: the same in both countries (L workers)

▪ Preferences: the same in both countries and symmetric between varieties (if all varieties
have the same price, they will sell the same quantity)

▪ Technologies:
▪ SAME in both countries
▪ Economies of scale (if Q increases, average cost drops)
▪ Each firm produces a (different) variety. Each firm faces a downward sloping demand curve.
▪ A lot of firms, so that no firm can affect the average market price.

▪ Free entry and exit: in the long run, all firms make zero profits.

*Note: Red assumptions are the basic assumptions of the monopolistic competition model.

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 Demand

▪ Demand Function of Firm i:

▪ where S = total quantity sold in industry, Qi quantity sold by firm i, n number of firms (varieties), Pi price of variety i,
and P average price of all varieties in the industry.
▪ if Pi=P, Qi=S/n
▪ S does not depend on P, and we assume that each firm is small enough such that Pi doesn’t affect P.

▪ Inverse Demand Function:

(Notice the Slope and the intersection with the vertical axis)

▪ Total Revenue:

▪ Marginal Revenue:
&'"# 1 2
!"# = = [ + .] − (#
&(# +, 2,

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 Technology (COSTS)

▪ Total Cost:

▪ where f is fixed cost and cQi is variable cost.

▪ Average Cost:

▪ The average cost is decreasing in the quantity produced: economies of scale.

▪ Marginal Cost:
%&"#
!"# = =(
%'#

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 EXPLAINING PROFIT
MAXIMIZATION!!!

Assume that:

Demand
Price Quantity Total revenue Marginal revenue
(P) (Q) (IT=PxQ) (IM= IT/ΔQ)
11 0 0
10 1 10 10
9 2 18 8
7 3 21 3
6 4 24 3
5 5 25 1
4 6 24 -1
… … … …

IF MARGINAL COST EQUAL TO 4, how many units are `produced ? At which price are they
sold?
 Graphical analysis of one firm (short run)

Pi
Profit maximization requires that MCi = MRi.
(1/bn + P)
With this condition, we can pin down the equilibrium
values of Q*i, P*i y AC*i.

P*i Profits

AC*i

ACi
MCi = c
MRi Di

Q*i Qi

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 Graphical analysis of one firm (long run)

Initial situation (short run): P*i, AC*i and

Pi Q*i, firm i (and all other firms) make
(1/bn + P) positive profits.
Free entry and exit implies that positive
(1/bn' + P) profits attract new firms to the market. The
number of varieties n increases.
Initial Profits The inverse demand and marginal revenue
P*i functions shift down.
Profits drop
P*i’ Profits drop because (i) price falls, (ii)
AC*i’ average cost rises, and (iii) quantity
AC*i produced declines.
MRi’ In the long run equilibrium all firms make
ACi
zero profits.
MRi Di
D i’
Q*i’ Q*i Qi

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 Short vs Long Run

The last figure shows that as the number

AC, P AC of firms, n, increases:
1. The price falls (because demand for
each variety decreases)
(Pi)1 2. The average cost rises (because
there are economies of scale and each
firm produces less)

AC* = P*

(ACi)1 If firms make profits, (Pi)1 > (ACi)1, new firms

will enter in the market.
The average margin of profits, (Pi)1 – (ACi)1,
P
falls and there is more entry until profits
disappear.
n1 n* In the long run equilibrium, P*i = AC*i (zero
n
profits), and the number of firms is n*.

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The horrible math

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 Effect of increasing the size of the market
(short and long run)

Let us study how the short (n constant) and long run (n endogenous) equilibrium depends on
the size of the market, S.

Short run

▪ Profit maximization condition: MRi = MCi

▪ MRi=(1/nb+P)-2/Sb Qi = Pi – 1/Sb Qi = MCi = c
▪ Therefore, Pi = c + 1/Sb Qi
▪ Remember that all firms are symmetric (they have the same cost functions and face the
same demand functions), thus, Pi = P, and, Qi= S/n
▪ Short run means that we take n as given.
▪ Plugging the above result into the price expression, we obtain
Pi = c + 1/bn
▪ Plugging the same result into the average cost function, we obtain
ACi = f/Qi + c = fn/S +c
▪ As we saw graphically, in the short run Pi doesn’t depend on S, while ACi decreases
with S.

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 Effect of increasing the size of the market
(short and long run)

Long run

▪ In the long run, n adjusts to equate P*i = AC*i. (zero-profits condition)

▪ Obviously, we still have the same profit maximization conditions. That is:
Pi = c + 1/bn
ACi = f/Qi + c = fn/S +c

▪ Combining the above equations, we obtain

c + 1/bn = fn/S +c

▪ Solving the above equation, we obtain

n* = (S/fb)1/2
P*i = AC*i = c + (f/Sb)1/2

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 Effect of increasing the size of the market (short run)
Let us start in the long run equilibrium
(Pi=ACi), thus, zero profits.
We now study what happens when the size
of the market (S) rises.
Remember that
Pi = (1/bn + P) - Qi/Sb

Pi =ACi = Pi’
MRi= (1/bn + P) – 2 Qi/Sb

ACi’ An increase in S shifts to the right both the

demand and the marginal revenue
ACi functions.
As you can see, in the short run (that is,
keeping n fixed) the price doesn’t change
MCi (the increase in demand offsets the
MR MR’ D D’ increase in supply), the average cost falls
(because production rises), and profits
q q’ q become positive.
Obviously, in the long run, there will be
entry and profits will fall back to zero (the
figure only represents the short run effect)

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 Effect of increasing the size of the market
(short and long run)

Initial situation: long-run equilibrium with

zero profits (point 1).
The size of the market, S, increases. AC1
AC, P
As we saw, in the short run (that is,
taking n as given) the average cost falls AC2
(AC1 shifts down to AC2) and prices do
not change (P curve doesn’t move).
As profits become positive, new firms 1
enter the market. This process lasts until P*1
we reach the new long-run equilibrium, 2
point 2. P*2

Consistent with our analytical results, we

can see that
P
n*2 > n*1

n*1 n*2 n
P*2 < P*1

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 Effect of increasing the size of the market
(short and long run)

Thus, in the long-run

n* = (S/fb)1/2
P*i = AC*i = c + (f/Sb)1/2

That is, an increase in the size of the market implies

▪ More varieties
▪ Lower prices.

Observe that when the market increases by 2 (that is,

S x 2) the number increases by less than 2 (n x 21/2).
Therefore, firms grow. The larger size of firms
generates economies of scale, which reduces prices.

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 Trade liberalization
Consider 2 symmetric countries (Spain and France). They have same size S1, technology and
preferences.

Under autarky, the number of varieties that each country produces and the price level is:

n*1 = (S1/fb)1/2
P*1 = AC*1 = c + (f/S1b)1/2

When the two countries open up to trade, comparative advantage (differences in prices) does
not play any role. However, this does not mean that there will be no trade. Consumers now
have access to more varieties (Spaniards can buy French wine, and Frenchmen can buy
Spanish wine). Moreover, firms can take advantage of the economies of scale that a bigger
market creates.

After trade liberalization, the market size is S2 = S1 + S1 = 2 S1. Therefore, under free trade, the
long run equilibrium is:

n*2 = (S2/fb)1/2 = (2)1/2 (S1/fb)1/2 = (2)1/2 n*1

P*2 = AC*2 = c + (f/S2b)1/2 = c + (f/2S1b)1/2

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 Trade liberalization

Summing up.

Autarky:
n*1 = (S1/fb)1/2
P*1 = AC1 = c + (f/S1b)1/2
Free trade:
n*2 = (S2/fb)1/2 = (2)1/2 (S1/fb)1/2 = (2)1/2 n*1
P*2 = AC*2 = c + (f/S2b)1/2 = c + (f/2S1b)1/2

Effect on price level: the price falls (positive effect of liberalization)

Effect on the number of varieties:

▪ Number of varieties produced in the world decreases: n*2 < n*1 + n*1
▪ Number of varieties that each consumer can purchase increases: n*2 > n*1
▪ Since varieties are useful only if they can be consumed, this effect is also positive.

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 Trade liberalization

In the monopolistic competition model, trade liberalization has the same effect as an increase in
the size of the market.

As an alternative to the comparative advantage models, this model can explain

▪ Trade between identical countries

▪ Intra-industry trade (each country exports and imports varieties of the same good)

▪ Economies of scale as a source of international trade.

This does not mean that comparative advantage models are worse (or better). Both types of
models (comparative advantage and monopolistic competition) are complementary. Depending
on the country and the sector, one model will be more appropriate than the other.

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2.2. DUMPING

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 Dumping: Introduction

▪ A common practice is that firms sell in the international market at a lower price than in the
domestic market. This practice is known as dumping.

▪ However, it is important to note that dumping is nothing more than an example of price
discrimination. That is, firms set different prices for different consumers. There are a lot of
examples of price discrimination: transport ticket discounts for children, price reduction in
museums for students, …

▪ Two conditions are required:

▪ Segmentation of markets.
▪ Imperfect competition in, at least, one of the two markets.

▪ As the world becomes more globalized (trade liberalization and tariffs reductions), firms and
countries rely more antidumping measures to protect the domestic industry.
▪

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 An Example

C,p Before trade liberalisation In the domestic market there is only one firm
(monopoly).

MC
If the firm doesn’t export, it equates MR and
p1 MC, and sells q1 at price p1.

D
q1 q
MR

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 An Example

Consider that the firm also wants to export.

C,p The firm decides to export
▪ In the foreign market there is perfect
competition, thus, the firm is price-taker: D*
= MR*. MC
▪ Foreign firms cannot sell in the domestic p2
market, so that the firm can keep its monopoly
position at home.
p* D* = MR*

As before, profits are maximized when marginal MR D

cost = marginal revenue. But, which marginal
revenue should we consider, MR o MR*? q2 qT q
Domestic Exports
sales

For each unit sold, the firm will choose the Note that for 0< q < q2, MR > MR*, so that the firm
market with the highest marginal revenue. That chooses to sell the first q2 units in the domestic
is, it will set price p2 in the domestic market and market at the price given by the demand curve (p2).
p* in the international market, so that it will
produce qT. For q>q2, MR < MR*, so the firm sells to the foreign
market at price p*. It produces up to qT which is
where MC=MR*.

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 Dumping: Concluding Remarks
▪ As we saw in the last figure, the domestic price is higher than the international price: dumping.

▪ But if the domestic price is higher, wouldn’t the profits increase if the firm were to sell one more
unit in the domestic market and one less unit in the foreign market?

▪ The answer is “no” because this price comparison between markets is not relevant.

▪ What matters is the comparison between marginal revenues. If the firm sells one more unit in the
domestic market and one less in the foreign market, the firm would lose, because MR would be
below MR*.

▪ In our analysis, we have defined dumping as the practice of selling in the international market to a
lower price than in the domestic market. However, dumping is sometimes also defined as selling
below cost. In this context, dumping is seen as unfair competition (even though it’s very difficult to
prove that a firm sets the price below cost).

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The horrible math

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