Page 84 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

International Trade and Finance

Notes increasing returns to industry size. A small nation might occasionally develop a scale economy
industry; rely on export sales to justify production. So difference in the sizes of economy could have
provided the inducement for trade.
Increasing return internal to the firm in industry gives a different situation incompatible with
competitive model. For increasing returns external to the firm, costs fall with the size of the industry
not with the size of firms comprising it and hence marginal cost pricing would not lead to losses.
External economies are not incompatible with the perfectly competitive structure as it will merely
lead to distortions leading to net welfare loss from trade and can be corrected by appropriate
government intervention (i.e. taxes and subsidies). It is only when the firms are alone enjoying
economies of scale (internal to the firms) that the firms realize the advantage of being alone in the
market. It is this hostility to the new entrants and/or a tendency towards merger that threatens the
validity of traditional trade theories. Empirical evidence, however, shows that most firms experience
internal economies of scale as production expands. This prepares the ground for discussing the third
approach to modeling.
Imperfect Competition

The 1970s were marked by substantial progress in the theoretical modeling of imperfect competition.
Several trade theorists developed models of trade incorporating non-perfectly competitive market
structure. The literature divides itself into two distinct categories in their approach: one strand models
the role of scale economies as a cause of trade and keeps the issue of market structure out of the way
by assuming Chamberlinian monopolistic competition in market structure. The second strand takes
imperfect competition as the base and investigates IRS as a cause of imperfect competition. This falls
under the purview of 'oligopoly and trade'.

Krugman has been awarded Nobel Prize in Economics in 2008 for his major
contribution in this field.

Monopolistic Competition Models
Intuitively it would seem that scale economies would increase the payoff to intra-industry
specialization and two way trade in any type of commodity and therefore would be positively
associated with the degree of importance of scale effects in an industry. However, as discussed by
Greenaway and Milner, even though these models all rely on some type of scale effects to generate
IIT, it is not necessarily the case that intensity of such effects determine its share of an industry's
trade. For example, Helpman and Krugman (1985), in an alternative to the Chamberlinian framework,
modeled IIT by monopolistically, competitive producers of single varieties who are constrained to
average cost pricing by freedom of entry. In the 1970s, however, two approaches to this problem
were developed. The first, identified with the work of Dixit and Stiglitz (1977) and Spence (1976),
made the assumption that each consumer has a taste for many different varieties of a product. As
there are alternative approaches, Lancaster (1979), for example, assumed a primary demand for
'attributes' of varieties, with consumers differing in their preferred mix of attributes. Product
differentiation here takes the form of offering a variety having attributes that differ from those of
existing varieties. Since all these models assume different types of differentiation, a brief taxonomy
of terms for product differentiation is given below:
(i) Horizontal differentiation: It refers to differentiation by attributes or characteristic and every
consumer has his most preferred "package" of characteristics. Within a given "group" (e.g., in
automobiles category as compared to apparels) all products will share certain core characteristics
the combination of which determines the products' specifications. It is often called locational
differentiation (Hotelling 1919, Lancaster (1980), Helpman (1981)). Pseudo differentiation occurs
when the core characteristics of all products in the group are identical, but differentiated by
brand image.

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