[Music] today we're gonna be talking about a new trade theory model it's an increasing returns to scale model in a monopolistically competitive market so why is this so different from the other trade models we've done up to this point so think back to those three models right Ricardian model specific factors and heckscher-ohlin what was true in each of those cases they the one kind of common theme or one of the common themes that came out of each case is that you had what we call inter industry trade which means that you would export one good and import the other remember those were all too good to country models if you had multiple goods you would export some goods import some others but you never had cases right none of those models ever predicted a scenario where you would both import and export the same good well the model that we're gonna talk about today predicts exactly that all right we predict what we call intra-industry trade and so we got this important distinction between inter industry and intra industry trade and why is that important well I think about a lot of the goods that we consume today they are characterized by intra industry trade as far as international trade goes now you think about things like golf clubs that's the example that you find in the textbook we export and import golf clubs automobiles pharmaceuticals all these are great examples of products or groups categories of products where we both are an importer and an exporter and so what why does that happen why would we want to say export some golf clubs and yet at the same time obviously we're producing them import them as well well a key thing here is that what we're talking about is a good where we have differentiated products yeah in other words not all the golf clubs are the same if there's something different about the varieties of golf clubs that are being produced by the different manufacturers in different countries and same thing with pharmaceuticals the same thing with with automobiles really any example that you can think of where we have intra-industry trade we have some degree of differentiation right they have different features it could be differences in quality all right so it could be a kind of vertical differentiation or it could be a horizontal differentiation we just have different characteristics and breakfast cereal is another good example of differentiated good so why is that important well when you have goods that are differentiated so they all have some characteristics that make them different from each other but they're still pretty close substitutes for each other then what that does that gives this aspect of monopoly power to each variety of the good yeah and that's why we call this the monopolistic competition model okay monopolistic competition and if you think back to your principles of micro class hopefully you covered this this type of industry but if not just think back to the two types of industries for sure you should have covered perfectly competitive and monopolistic monopolistic competition incorporates aspects of both so we have some key assumptions here right well first off because we have these differentiated goods that's what gives us the aspect of monopoly what does that mean for us if you think back to a monopoly so a monopolist faces the entire market demand curve right and it's a downward typically assume a downward sloping demand curve and what's important here is to think about the marginal revenue curve so what does marginal revenue look like now for a competitive firm marginal revenue was just equal to price right any firm can sell as much of the good as it wants at that price so if I'm selling 100 boxes of cereal and I can in the going price for a box of cereals four dollars if I go to sell a 100 first box of cereal my revenues going to go up by that $4 but that's not true for monopolistic competition so what does marginal revenue look like in this case I think the easiest way to to think about this is just to make up a simple example so let's say you start off with a price of $10 when you're selling 10 units are the good now let's say that you want to sell one more you want to go to 11 well what's the first thing you should notice you should notice that in order to sell that 11th unit of the good you're gonna have to drop your price a little bit and let's say that that price goes down to 950 and so the firm in order to sell an 11th unit of the good is going to have to drop the price to 950 now we're assuming this is a single price monopolist meaning that the firm is going to charge that same price across all units of the good there's no price discrimination in this simple model so what does what does marginal revenue look like in this case well they're going to get $9.50 for selling that that 11th unit of the good and so that's our new price but at the same time they're gonna end up losing 50 cents for each of the first 10 Goods and so what's that 50 cents well that's the change in price that results from changing our quantity by one you multiply that by the initial quantity so in this specific example what does that look like well where does that work out to marginal revenue is equal to the 950 that they get for the 11th unit - 50 cents on each of the 10 units that they used to sell right so if I highlight this in here graphically the that first term that P represented by this rectangle here this is the increase in marginal revenue that comes from selling the 11th unit and this one up here is the decrease in marginal revenue that comes from the drop in price that's required to sell that 11th unit so what does that work out to in total well so 950 - what's the 50 cents times 10 comes out to five so in the end you have 950 minus five which works out to you or 50 so in the end marginal revenue is still positive but it's much much lower than that price at 950 so if I were to draw the marginal revenue curve it would be somewhere like here and this would hold true at any point along the demand curve right marginal revenue is always less than the price meaning the marginal revenue curve is lower than the demand curve and so that's the important important result here the fact that we get with this these differentiated products giving a degree of monopoly power means each of the firm's will face a downward sloping demand curve for its variety of the good now this is a model of monopolistic competition which also includes increasing returns to scale of production so what does that mean for us well you can imagine an industry where production is characterized by a pretty sizable fixed cost of production and a constant marginal cost as well so what does that mean for us well that means that from the firm's perspective let's actually take a quick example here so if we say that our fixed cost is 100 and we're gonna have a constant marginal cost equal to 10 so if we go to produce different quantities here 1 2 3 all the way down to 10 then what is the average fixed cost I'm only producing one unit of the good then all of that fixed costs only gets split over one good if I produce two units of output I'm splitting that hundred dollars of fixed cost across two goods so that goes down to 50 33 and 1/3 and here we get down to 10 right now my average variable cost is just actually equal to my marginal cost and that's a constant $10 so what is my average cost overall that's the sum of the two so my average cost is equal to 110 60 40 3 and 1/3 20 and so on and so you can see as I increase output my average cost is declining oh it looks something like this I'm using a lowercase Q there to denote that that's the the firm's output not industry output you have something like this now what what happens when we put these two things together it so you've got an industry characterized by monopolistic competition so you have differentiated products each firm faces a downward sloping demand curve and you've got this downward sloping average cost run right declining average cost so what what does equilibrium look like in this industry well this is where you have to go in and incorporate the aspects of competition and we have free entry and free exit in this in this industry so what does that mean let's start off with a scenario and let's say that demand for this firms variety is pretty high so we ever relatively say small number of firms so we end up with something like this this is the demand for this this firms product and marginal revenue he's gonna look say something like this so the firm produces where marginal revenue equals marginal cost so that's going to be its output and then we go up to the demand curve to find the price well what can we notice here you see look at here what we see is that price is greater than average cost which means that profits are gonna be positive remember you should can write profit as [Music] price minus average cost times quantity and what happens if we have positive profits well that's going to induce other firms to enter the market where we have free entry and free exit so if so these firms the existing firms or the incumbent firms are making positive economic profits other firms are gonna enter the industry and what does that see well that takes this demand curve and it shifts it down they think about it you have a total demand that's out there for this product what'll potential demand but as more and more competitors come into the market the existing firms will lose market share right the demand for their variety will go down and that continues to the point until the demand curve for the firm is just tangent to the average cost curve and at that point also marginal revenue is would intersect right there as well that's what we would end up getting right so you'd get firms entering the market pushing the demand curve down now what would happen if if the you have too many firms in the industry you'd get the exact opposite now you'd have a case where the demand residual demand left for each firm is just way too low they're producing or prices below average cost firms would exit the industry and then firms demand and marginal revenue curves would shift up rather than down and we'll illustrate that example when we work through this model when we open up the trade because that's exactly what we'll see happening so these are the basics this is the setup for the monopolistic competition model next we've got to take this model and embed it into a context where a country is going to open up the trade [Music] okay so now that we've developed the basics or hopefully from any of you refresh the basics on monopolistic competition depending on whether you covered that model in your principles of micro class we now need to put this model in the context of of international trade so we have here again downward downward sloping average cost curve and so again increasing returns of the scale right constant marginal cost with fixed cost D is the demand in the total or the total industry the D over and a curve that's the demand curve faced by the individual firm when all of the firm's all the competitors are charging the same price and what is that D over na so na reflects the number of firms in autarky so D of Renee what we're saying is that each firm is just splitting by getting an equal share of the market since we're all charging the same price this curve d1 that is the firm's demand curve if it changes unilaterally changes its price from what all the other firms are charging so what should you notice here you should notice that this d1 curve is flatter so what does that mean and think about that in the context of the elasticity of demand alright d1 is flatter than D over na which means that it's more elastic what think about what that that means if demand is more elastic that means that consumers are going to be more responsive to price changes and that's gonna play a very key role in the analysis that's that's gonna that's gonna follow out of this okay so the last thing I need to do in here for you guys we'll put in our initial equilibrium right so our marginal revenue curve is somewhere like in here okay and here's our equilibrium price and in fact call this QA and PA right so that's our equilibrium in autarky now what happens when we open up to trade so what we're gonna we're gonna make some important assumptions here and so now we're going to assume that the two countries are identical and this is important for for a variety of reasons so first off of course it makes the analysis much simpler but there's actually an even more important reason for making that assumption and that is we want to focus on how this structure of the industry can lead to gains from trade so in order to really focus on how having monopolistic competition with increasing returns to scale and the latter part is key how having an industry characterized by those two features can lead to gains from trade we need to just make everything else right it's easy we just make everything else between the two countries identical and so here is the second thing that you should notice that makes this trade model very different from the preceding three trade models we covered in class if you think about heckscher-ohlin specific factors in each case there we were looking at how differences between the two countries could be the catalyst and the driving force behind international trade in gains from trade you were taking the exact opposite approach here we're saying that even if two countries are identical they could still benefit from trading with each other that's it's a pretty important insight to have because again this is another dimension where the predictions from these new trade models differ very dramatically from the old trade models and we've already talked about how the old trade models predicted inter or between industry trade this model generates a prediction of intra or within industry trade the other key distinction is that here we're saying two countries that are very similar to each other will trade whereas in the old trade models the countries that were diff print from each other found benefits from trading together so again we have really important differences in that the observed patterns of trade that can be explained so here what you're talking about is something like we refer to north north trade right why does the United States trade so much with Canada and with the UK with Germany countries who are very similar to us in terms of level of economic development how much skilled labor how much capital we have my relative to other factors of production these models are good at explaining why we trade with those countries or as those old trade models are much better at explaining why countries like the US Canada and Germany trade with lesser developed or lower income countries and so as we continue to work through the course I want you to keep that that big picture in mind of comparing the old trade models with the new trade models so if these countries are identical what does that mean well so here when we say identical really mean identical so same production technologies right so the average cost and the marginal cost curves for the firms and the home and the foreign country are the same the demand curve is going to be the same that also means that in equilibrium and a which is the number of firms in autarky will also be the same so what does that mean from an individual firms perspective when we open up to trade so if this D over na curve this reflects taking the total market demand and just splitting that evenly across all na firms and that gives us B the residual or the you know demand curve for the firm when they all charge the same price well what does that look like now that we've opened up two trade well now demand is doubled all right so if we look at this what what does the demand curve you know the overall market demand curve look like well we've doubled D right but at the same time we've also doubled na we now have two times and they firms at least initially and when we initially open up the trade so what does that mean for our D over and a curve and so this curve you can imagine right this goes to 2d so now you might have a much higher aggregate demand curve but D over na is simply to D over Q n a so this curve actually doesn't shift right you can imagine if we had a market size where you're selling a million boxes of cereal a year and you've got a hundred firms making cereal right so you split that million boxes over a hundred firms now when you open up the trade well we're selling a million boxes of cereal in the US and a million boxes of cereal in the EU the European Union but now you've got 200 firms competing to sell those two million boxes so this curve doesn't shift but what does change in here go back to this d1 curve remember d1 is the firm's demand curve when it deviates from that that price right so if it changes a price different than what all the other in autarky 99 or now in trade 199 other firms are charging well why would that change when we open up the trade what's exactly for that reason we're now competing against more firms and so think about it again we already said that d1 right it's flatter compared to D over na it's more elastic so why was it more elastic well there are two things going on right do n it over na is downward sloping meaning that if we if everybody in the industry lowers its price we're all going to sell more because consumers are willing to buy more at that lower price but if I lower the price of my good and all of my competitors keep their price the same not only do I sell more because consumers are willing to buy more at a lower price I'm now able to steal market share away from my competitors who kept that higher price now continue with that logic now when we have instead of hundred firms producing we have 200 firms I can now steal market share not from 99 other firms but 100 in 99 other firms so that means that this demand curve will become even more elastic all right so it'll become even flatter and that means the same thing right the marginal revenue curve will also become a bit flatter so what does that mean it means it might intersect somewhere like out here right call that Q 2 so we have notice the average cost is here right so I'm producing marginal revenue intersects marginal cost here to produce it Q 2 average cost is here but we go up to this new D 2 to get the price so what's happening here price is greater than average cost right so if this were to hold true rate the firm's now making positive profit I remember that profit is price minus average cost times the quantity there's one problem with with this analysis so far though remember that all the firm's are identical here so if this holds true for one firm its holds true for all of them so if it makes sense for me to to deviate from this original price of P a to try to drop my price to P to steal market share I produce all the way up at q2 at the expense of my competitors makes sense for the other firms to do the same thing as well so what would happen if everybody follows that same TAF what do we end up with we end up with instead of being at on D 2 we just end up if we all charge a price of P 2 we'd all end up right back on this D over na curve and so at this point here so we'd actually end up producing Q 3 at a price at that p2 price but now an average cost is up here so if you look at this I'm just gonna circle that for you guys at that point the price is below p2 is less than average cost at q3 that means that this is negative that's going to induce firms to exit the industry yeah really important to to keep that in mind here so again individually the firm has the incentive to try to lower price in steel market share and if only one firm did that they'd end up producing out at q2 at that price of of p2 which is higher than average cost but since the same logic applies to all firms in the market if they all drop their price to p2 then their sales would only be q3 right we'd read that off of the d over na or the to D over 2 na curve so that means that they actually end up producing at a loss where price is less than average cost so what's going to happen in this case well remember before we said if firms are making positive profits that induces firms to enter the industry but with free entry there's also potentially free exit so when some firms are making losses some of those firms are now going to exit from the industry so what happens in the long run all right so what we just showed there was our short-run analysis but what happens in the long run right so initially we have that to D over na curve there and what's going to happen to to this curve as firms exit the industry that 2d / 2n a curve that we had over here and we'll go ahead and show thee I'll recreate and here the initial autarky equilibrium right we had that 2d over na curve right in here that curve is now going to shift out to the right because we have fewer and fewer firms over which we are splitting the market output so that curve is going to shift out say it'll look something like like this and now we get this to D over to call it n T where n T is the number of firms in autarky or in trade rather in each country okay and so what we're going to see is right so firms are exiting so n T is less than n a it's going to happen in both countries the home country and the foreign country everything that we're seeing here remember they're the firm's are identical the demand everything's identical in the two countries so whatever holds true in one country is going to hold true in the other as well so what happens when this is curve shifts out well now we're going to end up with right also the other demand curve is also going to shift out and so we end up with an equilibrium that might look something like like this so there is your I'll call this DT for trade and then the marginal revenue curve intersects somewhere out here and you get something that looks like like this and then the price in trade would be here so what are some of the things you can notice remember before we had at our price up here all right that was our Auto key price each firm produced QA at a price of PA now after we opened up the trade right so this was our short-run analysis here and this here is our long-run analysis what happened in the short run when we opened up the trade firms said hey I can now steal market share if I lower my price from even more firms they had an incentive to try to lower the price but they all end up doing the same thing which ends up causing them and when they drop the price to p2 to lose end up having negative profits price to is less than average cost so in the short run firms we're making economic losses in the long run firms exit from the industry that causes for the remaining firms in the industry it causes this these demand curves this 2d this one that's the share of the market we all charge the same price that one plus the individual demand firm demand curve when it deviates from charging the same price those curves shift out those demand curves and we get to a new equilibrium at a lower price and a higher quantity and in fact the two have to go together so how is it that in the trade equilibrium the firm's can end up surviving at the lower price well it's because we now have fewer firms splitting up the market right the existing firms have a higher market share it allows them to move down their average cost curve so they can survive at these lower prices because they're taking advantage of these economies of scale so we have two really important things going on here at the same time and they go in hand-in-hand so what does this mean from a welfare perspective so if you think about it from a consumer perspective we've already shown one important thing that happens that benefits consumers the price has gone down all right this is good for consumers because we have fewer firms competing so they each get a larger market share and can work down their average cost curve they're able to produce at a lower price definitely a benefit for consumers there's also a second very important benefit for consumers from opening up to free trade and that is an increase in the number of varieties that are available at first this this might not seem quite that intuitive because we said hey we actually have fewer firms producing worldwide than we did before which is true but the key thing to keep in mind is that before opening up to trade you can only buy the varieties that are produced in your country so just to take an example let's say that initially I'll stick with what I started the example I started before let's say that there are ten firms producing in each country in autarky and when we open up to trade let's say that three producers fall out of the industry in each country well so what's my na is is ten to na the global number of producers is twenty but without trade I can only consume the ten varieties that are produced domestically then what happens when we open up to trade well now let's say I end up with seven producers in each country which means that globally there are fourteen varieties being produced with trade I can consume any one of these fourteen varieties that are being produced so even though there are fewer varieties my fewer producers are the good fewer varieties being produced globally from any individual consumers perspective they have access to more varieties because they're no longer restricted to consuming the varieties produced in their country and the notion here is that of course that greater variety is better now there are two ways we can think about that there's the love a variety approach which simply says that you know consumers like to have more varieties of a good it gives them greater utility one example I always like to think about here is like breakfast cereal so if you eat breakfast cereal let's say you eat it every day for breakfast seven days a week 365 days a year now imagine that you have to consume the same cereal every single day for breakfast 365 days a year year after year now maybe for some of you you're alright with that but what if you could actually throw a 2nd one into the mix right so maybe you can alternate which one you eat every day yeah well what if you could choose from 3 different ones so that's kind of this notion of a love of variety that even if I hold my level of consumption the same as a consumer I'm better off when I have greater variety available out there another way we can think about how variety benefits consumers is this notion of ideal variety so we have love a variety and then you have this notion of ideal variety so imagine if there was only one type of automobile being produced but that's it we all gonna drive the same midsize sedan in probably a medium gray or something like that right with all the same features same horsepower same cabin size everything now that may fit some families some households needs well but for others it's not gonna work at all so what happens if we now increase the number of varieties well now every household can find a variety that's a much closer to fit to what they're actually looking for so that's another that's a good example when you're thinking about how variety by benefit consumers you could think of it either in terms of this love of variety we like consuming different varieties of the same good even if you don't for the same consumer or an ideal variety where the more varieties that are out there I'm likely any individual consumer is likely to find a variety that's closer to what they really want so this wraps up the the trade you know what's the the response in trade and how consumers and societies can benefit from trade even when it's two identical countries trading with each other if you have monopolistic competition with increasing returns to scale the last thing I'm gonna I want to talk about in this in this lecture is the a very important really war course empirical model in international trade known as the gravity [Music] so the last thing I want to introduce in this video is the gravity model and I said this is has become really a workhorse empirical model in international trade and part of the beauty of the model is its simplicity now first question you might have is well why are we calling it the gravity model simple answer is because it was lifted straight from physics and it's the gravity equation right and so the ideas be you take the basic equation from from physics that the force of gravity exerted between two bodies is equal to G which is a gravitational constant the mass of object 1 and the mass of object 2 all over the distance between them squared and so we could say that's that the force exhibited between objects 1 & 2 or bodies 1 & 2 and and so we take this model and we actually and it was actually an economist who was trained initially as a physicist who saw and you know was familiar with with this this equation and said you know what I think this this might actually be able to explain patterns of trade so we take this and we of course replace the F with trade right so trade between two countries I and J it's gonna be equal to some constant and now it's not the mass of the two countries that matters but we we need something to represent sort of the economic weight of the two countries so the most common sense thing or the most practical thing we can think of is the GDP right the size economically of the two countries and then it is the distance of the two countries and here we're raising it to some unknown power end because this is on something that it's a it's an empirical open empirical question with the gravity model we know it's it's the distance squared buddy here we leave it it's to some power N and so this is the basic basic gravity model now what's amazing is just how powerful it actually is now when we go to estimate a gravity model typically we don't estimate it in this form we will talk about in class this empirical study that tried to get at an estimate for how much borders affect trade by actually estimating the model in this framework and we'll talk about that but most studies take a log transformation of of both sides and so what happens then is we write it as log tij plus equals the log of B so this just becomes our constant in the equation plus beta I log GDP of country I plus beta J log GDP of J and then there's that N and then the log of the distance between I and J and this is the functional form that the vast majority of studies that are empirically estimating the gravity equation will work with so why has this become such a workhorse model where there's a couple reasons one even this basic equation really helps to explain the the flow or the volume of trade between countries so here what what is t IJ well T IJ is often say listed as say exports from country I to country J all right so why is it that we export a lot to Canada and then why is it that Canada exports a lot to us right so if you think about tij this way there'll be two observations in your data set for US and Canada exports from u.s. to Canada and exports from Canada to the US other studies might do say total trade in which case that pair of countries would have one observation but regardless if you think about this so then what's you know why you know usually we do it as exports from I to J so then I is the exporting country J is the importing country so what we're saying here is look that the the volume of trade between US and Canada why is it so so large well the u.s. is a large country Canada is not as large but it's not tiny but then distance all right we share a large border and the distance is effectively you know at some points basically zero of course this raises an interesting question of how do you measure the distance between two countries like for example what's the distance between the US and China well what are you gonna use are you gonna use the capitals law our capital is on the east coast right in Washington DC but if you think about trade with China a lot of those goods are coming into port say in Los Angeles and that's where they arrive in the US and that you know California and the west coast in general has a sizable fraction of our of our population in our economic activity so it's not always clear how we want to measure distance you know you have a big country like the United States it's not a trivial question but that's some kind of some of the more nitty-gritty details of how these studies happen but this basic model has a you can go a pretty long way in explaining the differences in how much different pairs of countries trade the other reason why this model is such a workhorse and it's so powerful is its flexibility like what if I want to to get an understanding of how much free trade agreements effect levels of trade between countries well because of this linear form I can now add in another variable for whether countries I&J have a free trade agreement I can add in other variables like whether the two countries have a common language why would that matter I'll think about consuming cultural goods right if you some of you might like watching BBC shows right there in English you don't have to read subtitles or have horrible dubbing as often the case with a lot of programs it's a lot easier to read books to watch movies you know listen to radio programs whatever you know podcasts when you share a common language common culture things like that these are all different things that we you know different factors that we could event include into our model and the models very flexible now I will focus quite a bit in class on a one specific study that tried to estimate use estimates of this B here this constant right here which in our Log form is up here to try to see how much having a border write an international border affects train