Lecture Notes: New Trade Theory Model

Introduction

• Focus on a new trade theory model: Increasing Returns to Scale in a Monopolistically Competitive Market.
• Distinct from previous models: Ricardian, Specific Factors, Heckscher-Ohlin.

Key Differences from Previous Models

• Inter-Industry Trade in old models: Export one good, import another.
• Intra-Industry Trade in new model: Import and export the same good (e.g., golf clubs, automobiles, pharmaceuticals).

Intra-Industry Trade and Differentiated Products

• Occurs with differentiated products.
  • Differentiation: Variations in quality or features (vertical and horizontal differentiation).
  • Examples: Golf clubs, automobiles, pharmaceuticals, breakfast cereal.
• Leads to monopolistic competition where firms have monopoly power over their product variety.

Monopolistic Competition Model

• Monopoly Power: Due to differentiated products.
• Demand and Revenue:
  • Downward sloping demand curve.
  • Marginal Revenue (MR) curve is always below the demand curve.

Increasing Returns to Scale in Production

• Characterized by significant fixed costs and constant marginal costs.
• Average Cost declines with increased production.

Market Dynamics

• Entry and Exit:
  • Positive profits attract new firms (entry).
  • Negative profits force firms out (exit).
• Equilibrium reached when demand curve is tangent to average cost curve.

Impact of Trade in Monopolistic Competition

• Identical Countries Assumption:
  • Simplifies analysis, focusing on industry structure and trade gains.
  • Predicts intra-industry trade even with identical countries.
• Market Expansion:
  • Opening trade doubles demand and firms, initially not shifting demand per firm.
  • Increased elasticity with more firms, impacting pricing and production.

Long-Run Effects

• Firms Exit:
  • Due to initial losses, leading to fewer firms sharing increased market demand.
• Price and Quantity:
  • Lower Prices, higher quantities benefit consumers.
  • Economies of Scale: Surviving firms produce more efficiently.

Consumer Welfare

• Price Reduction: Benefit due to larger market share per firm.
• Variety Increase: Access to more varieties from international trade, improving consumer utility.
  • Love of Variety: Consumers enjoy more variety.
  • Ideal Variety: Closer match to consumer preferences.

Gravity Model of Trade

• Origin: Adapted from physics' gravity equation.
• Trade Flow: Function of economic size (GDP) and distance between countries.
• Logarithmic Transformation: Used for empirical estimation.

Important Insights

• Explains Trade: Large volume trade with nearby, economically large countries.
• Flexible Model: Can incorporate variables like free trade agreements, common language.
• Empirical Applications: Study of border effects on trade.

Conclusion

• The gravity model is a powerful tool in understanding trade patterns and the role of physical and economic factors in determining trade volumes.