CHAPTER S I X
6 International
Economics
Twelfth Edition
Economies of Scale,
Imperfect Competition, and
International Trade
Dominick Salvatore
John Wiley & Sons, Inc.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
Learning Goals:
Explain how international trade can result from economies of scale
Explain how product differentiation leads to intra-industry trade
Understand the technological gap and product cycle models of
trade
Understand the relationship between transportation costs and
environmental standards in international trade
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
6.1 Introduction
We have seen that the Heckscher–Ohlin theory based comparative
advantage on differences in factor endowments among nations
The theory, however, leaves a significant portion of today’s international trade unexplained
The effect of relaxing each of the assumptions on which the
Heckscher–Ohlin theory rests
Examines international trade based on economies of scale.
Shows the importance of imperfect competition as the basis of a great deal of today’s
international trade
Presents models that base international trade on differences in dynamic changes in
technology among nations
examines the effect of transportation costs and environmental standards on the location of
industry and the flow of international trade.
6.2 The Heckscher-Ohlin Model
H-O assumptions
1. There are two nations (Nation 1 and Nation 2), two commodities
(commodity X and commodity Y), two factors of production (labor and
capital).
2. Both nations use the same technology in production.
3. Commodity X is labor intensive, and commodity Y is capital intensive in
both nations.
4. Both commodities are produced under constant returns to scale in both
nations.
5. There is incomplete specialization in production in both nations.
6.2 The Heckscher-Ohlin Model
H-O assumptions
6. Tastes are equal in both nations.
7. There is perfect competition in both commodities and factor
markets in both nations.
8. There is perfect factor mobility within each nation but no
international factor mobility.
9. There are no transportation costs, tariffs, or other obstructions to
the free flow of international trade.
10. All resources are fully employed in both nations.
11. International trade between the two nations is balanced
6.2 The Heckscher-Ohlin Model and New Trade Theories
Effect of relaxing H-O assumptions
1. Relaxing assumption 1 by adding more nations, commodities, and factors
complicates but does not change the theorem, as long as the number of factors is
less than the number of countries.
One complication that arises in dealing with more than two factors is that we can no longer classify
a commodity simply as L or K intensive but will require the construction of a factor-intensity index
to predict the pattern of trade.
This can be complex but should still be possible
2. The second assumption that both nations use the same technology is not valid
Nations generally do use different technologies, but if technology is viewed as a factor of production, H-O is
valid. Dynamic changes are explained by technological gap and product cycle models.
6.2 The Heckscher-Ohlin Model and New Trade Theories
Effect of relaxing H-O assumptions
1. The 3rd assumption that X is L-intensive, etc., implies that there is no factor-
intensity reversal, which is largely true in the real world.
Factor-intensity reversal would lead to the rejection of the H–O model.
Empirical studies, however, indicate that factor-intensity reversal is not very common in
the real world.
It seems that the Leontief paradox could be eliminated by the inclusion of human capital,
the exclusion of commodities intensive in natural resources, and comparing the K/L ratio
in production versus consumption rather than in exports versus imports.
6.2 The Heckscher-Ohlin Model and New Trade Theories
Effect of relaxing H-O assumptions
4. Assumption 4: H-O assumes constant returns, but there are often increasing returns
to scale. This theory is complementary to H-O.
5. H-O assumes incomplete specialization. If there were complete specialization,
factor prices would not equalize.
6. H-O assumes identical tastes, which has largely been verified empirically.
Tastes are certainly not sufficiently different across nations to overcome differences in the relative
physical availability of factors of production in explaining different relative commodity prices and
trade among nations.
6.2 The Heckscher-Ohlin Model and New Trade Theories
Effect of relaxing H-O assumptions
7. Dropping the assumption of perfect competition is troublesome.
Significant trade is based on product differentiation and economies of
scale.
Intra-industry trade
8. Relaxing the factor mobility assumption, as in the specific factor model,
modifies but does not invalidate H-O.
international factor mobility can be a substitute for international trade in bringing
about equality of relative commodity and factor prices among nations.
With some, but less than perfect, international factor mobility, the volume of trade
required to bring about relative commodity and factor–price equalization would be
less. This modifies the basic H–O model but does not take away its validity
6.2 The Heckscher-Ohlin Model and New Trade Theories
Effect of relaxing H-O assumptions
7. Transportation and other costs reduce the volume of and gains from trade
but only modify H-O.
8. Resources are usually fully employed in the long run, at least in industrial
countries.
The H–O theory would then incorrectly predict the pattern of trade.
However, aside from temporary economic recessions and frictional
unemployment (i.e., unemployment arising in the process of changing jobs),
the full employment assumption is for the most part satisfied, at least in
industrial countries.
6.3 Economies of Scale and International Trade
Increasing returns to scale
Production situation where output grows proportionately more than the increase in inputs
(doubling inputs more than doubles output).
Antweiler and Trefler (2002) found that a third of all goods-producing industries are
characterized by increasing returns to scale.
With increasing returns to scale, mutually beneficial trade can occur even if nations are
identical in every way.
If the two nations are assumed to be identical in every respect, we can use
a single production frontier and a single indifference map to refer to both
nations.
In Figure 6.1, the PPF is convex because costs fall with specialization.
Implies complete specialization.
Both nations again gain from trade.
Increasing returns to scale result in production
frontiers that are convex from the origin, or
inward-bending.
With identical production frontiers and
indifference maps, the no-trade equilibrium-
relative commodity prices in the two nations
are also identical
PX /PY= A in both nations and is given by the
slope of the common tangent to the
production frontier and indifference curve I at
point A.
FIGURE 6-1 Trade Based on Economies of
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
Scale.
With trade, Nation 1 could specialize
completely in the production of commodity X
and produce at point B.
Nation 2 would then specialize completely in
the production of commodity Y and produce
at point B′
By then exchanging 60X for 60Y with each
other, each nation would end up consuming at
point E on indifference curve II, thus gaining
20X and 20Y
FIGURE 6-1 Trade Based on Economies of Scale.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
6.3 Economies of Scale and International Trade
Several things must be clarified: Increasing returns to scale
Pattern of trade is unclear and may simply result from historical
accident.
Nations need not be identical (as in Figure 6.1) for trade to be beneficial.
If there are large economies of scale, this may result in monopoly or
oligopoly production.
There are also international economies of scale.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
6.3 Economies of Scale and International Trade
Significant international economies of scale from:
Outsourcing – purchase by firm of parts and components abroad in
order to keep costs down.
Offshoring – firm producing in its own plants abroad some of the parts
and components used in its products.
External economies refers to the reduction of the firm’s average
cost curve when the industry’s output increases, and are
different from economies of scale.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
6.4 Imperfect Competition and International Trade
In this section, we examine the very important relationship
between imperfect competition and international trade,
first from an intuitive level and then with a formal model
International trade can involve the exchange of differentiated
products of the same industry or broad product group.
Leads to intra-industry trade in differentiated products, as opposed
to inter-industry trade in completely different products.
Arises due to economies of scale.
Benefits consumers through additional choice.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
6.4 Imperfect Competition and International Trade
Contrasts to H-O Model
1. Intra-industry trade is based on product differentiation and economies of
scale, and will likely be larger for nations of similar size and factor
proportions.
2. With differentiated products produced under economies of scale, pre-trade
relative commodity prices may not accurately predict patterns of trade.
a large country may produce a commodity at lower cost than a smaller
country in the absence of trade because of larger national economies of scale.
With trade, however, all countries can take advantage of economies of scale
to the same extent, and the smaller country could conceivably undersell the
larger nation in the same commodity
6.4 Imperfect Competition and International Trade
Contrasts to H-O Model
3. In contrast to the H–O model, which predicts that trade will lower the return
of the nation’s scarce factor, with intra-industry trade based on economies of
scale, it is possible for all factors to gain.
This may explain why the formation of the European Union and the great
postwar trade liberalization in manufactured goods met little resistance from
interest groups.
4. Intra-industry trade is related to sharp increases in trade in parts and
components of a product, or outsourcing.
The utilization of each nation’s comparative advantage to minimize total production costs
can be regarded as an extension of the basic H–O model to modern production conditions.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
6.4 Imperfect Competition and International Trade
Comparative advantage seems to determine patterns of inter-
industry trade.
More likely with dissimilar factor endowments.
Economies of scale in differentiated products gives rise to
intra-industry trade.
More likely with similar factor endowments.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
6.4 Imperfect Competition and International Trade
Formal Model of Intra-Industry Trade
Many firms, differentiated products, easy entry and exit–
monopolistic competition.
Elastic demand since many competing products.
MR<P for monopolistically competitive firms.
Increasing returns to scale, so downward-sloping AC (and MC<AC if
AC is decreasing).
Optimal output at MR=MC.
With easy entry, long run profit must be zero, and P=AC.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
• D is the demand curve for the product sold by a firm,
while MR is the corresponding marginal revenue curve.
• D is downward sloping because the product is
differentiated. As a result, MR < P.
• The best level of output for the monopolistically
competitive firm is 3 units and is given by point E, at
which MR = MC.
• At Q = 3, P = AC = $4 (point A) and the firm breaks
even (i.e., earns only a normal return on investment in
the long run).
• AC is the average cost curve of the firm. AC is
downward sloping because of economies of scale.
FIGURE 6-2 Production and Pricing Under Monopolistic
Competition.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
6.5 Trade Based on Dynamic Technological Differences
Technological Gap Model (Posner, 1961)
Advanced industrialized countries develop and introduce new
products, with temporary monopoly power (patents and
copyrights) as the sole exporter of the product.
As the technology producing the product becomes more widespread,
production will spread to other nations.
In the meantime, innovating countries develop more new products.
But no explanation of size of gaps or how they arise and are
eliminated.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
6.5 Trade Based on Dynamic Technological Differences
Product Cycle Model (Vernon, 1966)
A Generalization of the technology gap model.
A new product requires highly skilled labour to produce.
As it matures, it becomes standardized and can be produced by less
skilled labor and standardized techniques.
Production moves to nations where labor is cheaper, as comparative
advantage shifts.
Possibly accompanied by foreign direct investment in the low-wage nation by the
innovating nation.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
6.5 Trade Based on Dynamic Technological Differences
High-income and labor-saving products are most likely to be developed in
rich countries.
Market is larger.
Development of new products requires proximity to the market to benefit from
consumer feedback.
There is a need to provide service.
Technological gap model stresses the time lag in the imitation process;
The product cycle model stresses the standardization process.
According to these models, the most highly industrialized economies
are expected to export non-standardized products embodying new and
more advanced technologies and import products embodying old or
less advanced technologies.
Trade Based on Dynamic Technological Differences
Product Cycle Model (Vernon, 1966)
As production becomes standardized, the original introducer of the
product loses its technologically based comparative advantage in the
production of the product and becomes an importer of the product.
the diffusion lag of new techs have shorten recently.
Examples of products that seem to have gone through such product
cycles are radios, stainless steel, razor blades, television sets, and
semiconductors.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
6.5 Trade Based on Dynamic Technological Differences
Stage I: New Product
New product is produced and consumed only in the innovating country.
Stage II: Product Growth
Production is perfected and product is sold at home and abroad.
Stage III: Product Maturity
Product becomes standardized and the imitating country produces goods for domestic
consumption.
Stage IV: Product Decline (as price competition begins)
Imitating country begins to undersell the innovator abroad.
Stage V: Product Decline (and rapid decline of production in the imitating
country)
Imitating country undersells everywhere.
FIGURE 6-4 The Product Cycle Model.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
6.6 Costs of Transportation, Environmental Standards and
International Trade
Transportation costs
Transport or logistics costs are the freight charges, warehousing
costs, costs of loading and unloading, insurance premiums, and
interest charges incurred while goods are in transit between nations.
Homogeneous goods will be trade internationally only if the pretrade
price difference exceeds transport costs.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
6.6 Costs of Transportation, Environmental Standards and
International Trade
Transportation costs
Nontraded goods and services are goods for which transport costs exceed price
differences across nations.
the price of nontraded commodities is determined by domestic demand and supply
conditions
Examples:
Cement is not traded internationally because of its high weight-to-value ratio.
Average people do not travel from New York to London for a haircut.
Traded goods and services
the price of traded commodities is determined by world demand and supply conditions.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
6.6 Costs of Transportation, Environmental Standards and
International Trade
Two ways to analyze transport costs
General equilibrium analysis
Uses production frontiers or offer curves, and expresses transport costs in terms
of relative commodity prices.
Partial equilibrium analysis
Analyze absolute cost by holding constant exchange rates, income, and all else
in the two nations except amount of good produced, consumed and traded.
More straightforward method than general equilibrium analysis.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
6.6 Costs of Transportation, Environmental Standards and
International Trade
Figure 6.5
Assume that transport cost is shared between the
two nations.
Transport costs reduce the amount of trade and the
level of specialization in production.
Absolute and relative commodity prices will differ
between nations.
Thus factor prices will not completely equalize even
if all the other H-O assumptions hold.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
The common vertical axis measures the dollar
price of commodity X in the two nations.
A movement to the left from the common
origin measures increasing quantities of
commodity X for Nation 1.
In the absence of trade, Nation 1 will produce
and consume 50X at $5.
PX = Nation 2 will produce and consume 50X
at $11.
PX = With transport costs of $2 per unit, $7
PX = in Nation 1 and PX = $9 in Nation 2.
At $7, PX = Nation 1 will produce 70X,
consume 30X, and export 40X.
At $9, PX = Nation 2 will produce 30X,
FIGURE 6-5 Partial Equilibrium Analysis o
Transport Costs.
import 40X, and consume 70X
6.6 Costs of Transportation, Environmental Standards and
International Trade
Transport costs influence location of production and industry:
Resource-oriented industries locate near the source of raw materials used by
the industry.
Market-oriented industries produce goods that become heavier or more
difficult to transport during production, so they locate near the markets for
their products.
Footloose industries face neither substantial weight gains nor losses during
production, and can locate where availability of other inputs leads to lower
manufacturing costs.
6.6 Costs of Transportation, Environmental Standards and
International Trade
Environmental standards
Refers to levels of air, water and thermal pollution resulting from garbage
disposal that a nation allows.
Causes trade problems because price of traded goods and services does not
fully reflect social environmental costs.
A nation with lower environmental standards can use the environment as
a resource endowment, achieving comparative advantage in polluting
goods and services.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc.
