Modern Trade Theories International Economics Chapter 3

Modern Trade Theories

International Economics

Chapter 3

Chapter 3 Modern Trade Thoeries

3.1 Existence of Intraindustry Trade 3.2 Technological gap, Product life Cycle and

International Trade 3.3 Theory of Overlapping Demands 3.4 Economies of Scale, Imperfect

competition, and International Trade 3.5 Reciprocal Dumping

3.1 Existence of Intraindustry Trade

Advanced industrial countries have increasingly emphasized intraindustry trade —two-way trade in a similar commodity.

Intraindustry trade involves flows of goods with similar factor requirements. countries that are net exporters of manufactured goods embodying sophisticated technology also purchase such goods from other countries.


Intraindustry Trade in the U.S., 2002 ( in Billion of Dollars)

Category Exports Imports

Motor Vehicles 60.39 168.1

Electrical machinery 82.7 81.2

Office machines 39.7 76.9

Telecommunications equipment 24.9 66.3

Power-generating equipment 34.4 34.0

Industrial machinery 31.8 35.2

Scientific instruments 29.2 20.9

Transportation equipment 46.1 20.2

Chemicals 16.8 30.2

Apparel and clothing 8.0 63.8


Reasons for Intraindustry TradeTransportation costsSeasonalManufacturers in each country produce for the

“majority” consumer tastes within their country while ignoring “minority” consumer tastes

Overlapping demand segments in trading countriesEconomies of scale





3.2 Technological Gap, Product Life Cycle and International Trade

Technological gap is a cause of international trade and determines the flow of international trade.

Export of Country A and B

Time

Production of Country A

Export of Country B

Imitation Lag

T1T0 T2 T3

Production of Country B

Demand Lag

Response Lag

Grasp Lag


T0-T1: the stage of demand lag the time lag from the invention of new products in innovating countries to

the acceptance of importing countries.

T0-T3: the stage of imitation lag the time interval from the invention of new products in innovating countries

to generic production until the import is zero.

T0-T2: the stage of response lag the time lag from the invention of new products to imitation of importing

countries.

T2-T3: the stage of grasp lag from imitation to no import until the generic production can meet domestic

demand and turn to export.

T1-T3 is the trading period caused by technological gap.


The technological gap theory explains the causes of trade among different countries from the perspective of comparative advantage, and proves that leading technology can form comparative advantage even among the countries with close endowments and tastes.

However, the theory hasn’t explained the transfer of trade flow and the causes of the emergence and disappearance of technological gap.


The life cycle of products means all products will experience the course of innovation, growth, maturity and decline. The stage of new productsThe stage of mature techniqueThe stage of standardization


Model of Product Life CycleTime

Stage 1

Consumption in Inventing CountriesQuantity

Stage 2 Stage 3 Stage 4 Stage 5

T1 T2 T3 T4O

Export

Import

Import

Export

Production in Inventing Countries

Production in Imitating Countries

Consumption in Imitating Countries


O- t1

the introduction of new products

t1-t2

the growing period of products

t2-t3

the maturing period of products

t3-t4

The innovating country can manufacture the identical cheaper products than the inventing country by native cheap non-skilled labor, sell in the international market and compete with the inventing country.

After t4

Imitation countries begin to sell products to the inventing country, and the output of the inventing country will decrease so substantially as to come to a full stop. And the life cycle of the products will finish.





3.3 Theory of Overlapping Demands

Wealthy (industrial) countries will likely trade with other wealthy countries, and poor (developing) countries will likely trade with other poor countries. The Linder hypothesis is thus known as the theory of overlapping demands.

Linder does not rule out all trade in manufactured goods between wealthy and poor countries.There will always be some overlapping of demand

structures: some people in poor countries are wealthy, and some people in wealthy countries are poor.

However, the potential for trade in manufactured goods is small when the extent of demand overlap is limited.

3.3 Theory of Overlapping Demands





3.4 Economies of Scale, Imperfect Competition, and International Trade

Many industries are characterized by economies of scale (also referred to as increasing returns), so that the more efficient production is, the larger the scale at which it takes place.


Where there are economies of scale, doubling the inputs to an industry will more than double the industry’s production.

Relationship of Input to Output for a Hypothetical Industry

OutputTotal Labor

InputAverage Labor

Input

5 10 2

10 15 1.5

15 20 1.3

20 25 1.25

25 30 1.2

30 35 1.17


Economies of Scale as a Basis for Trade

Price (dollars)

10,000

8,0007,500

O100 275

A

B C

Average Cost

Autos (thousands)200


Economies of scale provide additional cost incentives for specialization in production. Instead of manufacturing only a few units of each and every

product that domestic consumers desire to purchase, a country specializes in the manufacture of large amounts of a limited number of goods and trades for the remaining goods.

Specialization in a few products allows a manufacturer to benefit from longer production runs which lead to decreasing average costs.


Trade and Specialization under Decreasing Costs

125 D

Tons of Steel100

A

The United States

B

C

Computers

South Korea


As South Korea moves to the right of Point A along its PPF, the relative cost of steel continues to decrease until South Korea totally specializes in steel production at Point C.

Similarly, as the United States moves to the left of Point B along its PPF, the relative cost of computers continues to fall until the United States totally specializes in computers.

Both countries can attain consumption points that are superior to those attained in the absence of trade.


In monopolistic competition models, two key assumptions are made to get around the problem of interdependence. First, each firm is assumed to be able to differentiate

its product from that of its rivals. Second, each firm is assumed to take the prices

charged by its rivals as given.


Equilibrium in Monopolistically Competitive Market

Average Cost, AC and Price, P

CC

PP

Number of Firms, n

E

n2 n3n1

AC3

P1

P2, AC2

AC1

P3


The number of firms in a monopolistically competitive market, and the prices they charge, are determined by two relationships. On one side, the more firms there are, the more

intensely they compete, and hence the lower is the industry price. This relationship is represented by PP.

On the other side, the more firms there are, the less each firm sells and therefore the higher is its average cost. This relationship is represented by CC.

The equilibrium price and number of firms occur when price equals average cost, at the intersection of PP and CC.


Monopolistic Competition and Trade The number of firms in a monopolistically competitive

industry and the prices they charge are affected by the size of the market.

In larger markets there usually will be both more firms and more sales per firm; consumers in a large market will be offered both lower prices and a greater variety of products than consumers in small markets.


An increase in the size of the market allows each firm, given other things equal, to produce more and thus have lower average cost. This is represented by a downward shift from CC1 to CC2.The result is a simultaneous increase in the number of firms (and hence in the variety of goods available) and a fall in the price of each.

Average Cost, AC and Price, P

PP

Number of Firms, n

1

n2n1

P1

P2

CC2

CC1

2





3.5 Reciprocal Dumping

In general, the practice of charging different customers different prices is called price discrimination.

The most common form of price discrimination in international trade is dumping, a pricing practice in which a firm charges a lower price for exported goods than it does for the same goods sold domestically.

Each firm has an incentive to “raid” the other market, selling a few units at a price that is lower than the home market price but still above marginal cost.

If both firms do this, however, the result will be the emergence of trade even though there is no initial difference in the price of the good in the two markets and there are some transportation costs.

The situation in which dumping leads to a two-way trade in the same product is known as reciprocal dumping.

3.5 Reciprocal Dumping

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Modern Trade Theories International Economics Chapter 3