INTERNATIONAL ECONOMIC POLICY AND DEVELOPMENT AA 2019-2020

NEW and (OLD NEW) TRADE THEORIES

PROF. PIERLUIGI MONTALBANO [email protected] Why countries trade Unit : US DollarUSA's thousand main exports to Germany

United States of America's exports to Germany Product code Product label Value in 2011 Value in 2012 Value in 2013 TOTAL All products 48779200 48354852 47442249 '87 Vehicles other than railway, tramway 6721872 7297720 6051037 '90 Optical, photo, technical, medical, etc apparatus 5828342 5858626 5996439 '84 Machinery, nuclear reactors, boilers, etc 6039220 5894851 5884932 '88 Aircraft, spacecraft, and parts thereof 5674397 5656078 5809280 '85 Electrical, electronic equipment 4441704 4176456 4265620 '30 Pharmaceutical products 2515682 2561810 2208824 '71 Pearls, precious stones, metals, coins, etc 1806466 1487383 1984524 '38 Miscellaneous chemical products 1503566 1458161 1580185 '99 Commodities not elsewhere specified 1448146 1389431 1360073 '29 Organic chemicals 1337973 1357339 1288524 '39 Plastics and articles thereof 1308694 1196360 1188499 '27 Mineral fuels, oils, distillation products, etc 1350587 1054978 863414 '12 Oil seed, oleagic fruits, grain, seed, fruit, etc, nes 352425 940514 812558 '08 Edible fruit, nuts, peel of citrus fruit, melons 434239 466485 649739 '70 Glass and glassware 597946 540389 563711 '97 Works of art, collectors pieces and antiques 390647 363781 360520 Inorganic chemicals, precious metal compound, '28 isotopes 565399 440523 343005 '73 Articles of iron or steel 346606 343240 334642 '33 Essential oils, perfumes, cosmetics, toileteries 283269 314646 321851

'03 Fish, crustaceans, molluscs, aquatic invertebrates nes 289951 284451 314551 '74 Copper and articles thereof 274593 305286 301160 '47 Pulp of wood, fibrous cellulosic material, waste etc 292599 309415 270139 '40 Rubber and articles thereof 332220 285797 270080 Paper and paperboard, articles of pulp, paper and '48 board 290031 269107 267940 '22 Beverages, spirits and vinegar 181023 184968 259122 USA's main imports from Germany United States of America's imports from Germany Product code Product label Value in 2011 Value in 2012 Value in 2013 TOTAL All products 100392798 110602812 116924737 '87 Vehicles other than railway, tramway 25005279 29992279 33168142 '84 Machinery, nuclear reactors, boilers, etc 20696991 22469147 22374261 '30 Pharmaceutical products 8509406 10185517 11174901 '90 Optical, photo, technical, medical, etc apparatus 8865467 8926945 9036842 '85 Electrical, electronic equipment 7657145 7849851 7808184 '99 Commodities not elsewhere specified 3212837 3492118 3717551 '29 Organic chemicals 2921629 3137577 3444239 '88 Aircraft, spacecraft, and parts thereof 1570659 1523341 2973561 '39 Plastics and articles thereof 2306547 2504781 2643734 '73 Articles of iron or steel 1646913 2156193 1913667 '38 Miscellaneous chemical products 1328337 1463370 1707361 '71 Pearls, precious stones, metals, coins, etc 1414710 903251 1209582 '40 Rubber and articles thereof 1128266 1202111 1200480 Inorganic chemicals, precious metal compound, '28 isotopes 1340807 1293421 1097083 '72 Iron and steel 1300607 1265146 1078080 Paper and paperboard, articles of pulp, paper and '48 board 936960 915384 835700 '97 Works of art, collectors pieces and antiques 462857 853995 834437 '82 Tools, implements, cutlery, etc of base metal 649169 737781 815718 '94 Furniture, lighting, signs, prefabricated buildings 600225 599737 677175 '74 Copper and articles thereof 675953 646996 626613 '76 Aluminium and articles thereof 675225 663743 619956

'32 Tanning, dyeing extracts, tannins, derivs,pigments etc 517686 566919 598737 '70 Glass and glassware 537270 546710 542178 '22 Beverages, spirits and vinegar 555586 487750 468667 '83 Miscellaneous articles of base metal 391987 440838 466874 Why do countries export and import the same goods and/or services?

. The Ricardian model and the H-O model explain why countries trade but do not predict the simultaneous import and export of the same product . In those models, markets were perfectly competitive and goods are homogeneous: • many small producers of identical product not able to influence the market price

. To explain trade of the same product, we need to change those assumptions The New Trade Theory

New trade theory (NTT) is a collection of economic models in international trade - developed in the late 1970s and early 1980s -which focuses on the role of increasing returns to scale.

“Thirty years have passed since a small group of theorists began applying concepts and tools from industrial organization to the analysis of international trade. The new models of trade that emerged from that work didn’t supplant traditional trade theory so much as supplement it, creating an integrated view that made sense of aspects of world trade that had previously posed major puzzles. The “new trade theory” – an unfortunate phrase, now quite often referred to as “the old new trade theory” – also helped build a bridge between the analysis of trade between countries and the location of production within countries”. THE INCREASING RETURNS REVOLUTION IN TRADE AND GEOGRAPHY, Prize Lecture, December 8, 2008, Paul Krugman The New Trade Theory

2 key assumptions:

. Imperfect competition: monopolistic competition, duopoly, oligopoly, where producers are able to exert some control over the market price. . Differentiated goods: goods are differentiated, differently from perfectly competitive markets where the goods produced are homogeneous (identical). Monopolistic competition: introduction

Monopolistic competition has two key features: • The goods produced by different firms are differentiated (hence firms are able to exert some control over the price). • Firms enjoy increasing returns to scale, by which we mean that the average costs for a firm fall as more output is produced . By selling not only in the home market but also in the foreign market firms can increase their returns to scale – Note: increasing returns to scale create a reason for trade to occur when the countries are similar in their technologies and factor endowments – Intra-industry trade deals with imports and exports in different varieties of the same type of product (i.e. in the

same industry) Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers ModelK e y of T monopolistic e r m competition: KEY POINTS

• The monopolistic competition model assumes differentiated products, many firms, and increasing returns to scale. Firms enter whenever there are profits to be earned, so profits are zero in the long-run equilibrium. • When trade opens between two countries, the demand curve becomes more elastic, as consumers have more choices and become more price-sensitive. • Firms then lower their prices in an attempt to capture consumers from their competitors and obtain profits. When all firms do so, however, some firms incur losses and are forced to leave the market. • Additional gains from trade: • (i) lower prices as firms expand their output and lower their average costs; • (ii) more imported product varieties available to consumers. • There are also short-run adjustment costs, such as unemployment, as some firms exit the market. Conclusion: The assumption of differentiated goods allows to understand why countries often import and export varieties of the same type of good. Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Trade under Monopolistic Competition Assumptions of the model of monopolistic competition: The first 2 assumptions are about the demand facing each firm:

Assumption 1: Each firm produces a good that is similar to but slightly differentiated from the goods that other firms in the industry produce. • Each firm faces a downward-sloping demand curve for its product and has some control over the price it charges.

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers 1 Basics of Imperfect Competition Monopoly Equilibrium The extra revenue earned from selling one more unit is called the marginal revenue. FIGURE 6-1

Monopoly Equilibrium The monopolist chooses the profit-maximizing quantity, QM, at which marginal revenue equals marginal cost. From that quantity, we trace up to the demand curve and over to the price axis to see that the monopolist charges the price PM. The monopoly equilibrium is at point A.

Trade under Monopolistic Competition

Assumption 2: There are many firms in the industry

• If the number of firms is N, then D/N is the share of demand that each firm faces when the firms are all charging the same price. • When only one firm lowers its price, however, it will face a flatter demand curve d.

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers 1 Basics of Imperfect Competition Demand with Duopoly FIGURE 6-2 (1 of 2) Demand Curves with Duopoly When there are two firms in the market and they both charge the same price, each firm faces the demand curve D/2.

At the price P1, the industry produces Q1 at point A

and each firm produces Q2 = Q1/2 at point B. If both firms produce identical products and one firm lowers

its price to P2, all consumers will buy from that firm only; the firm that lowers its price will face the demand curve, D,

and sell Q3 at point C. 1 Basics of Imperfect Competition Demand with Duopoly FIGURE 6-2 (2 of 2) Demand Curves with Duopoly Alternatively, if the products are differentiated, the firm that lowers its price will take some, but not all, sales from the other firm;

it will face the demand curve,

d, and at P2 it will sell Q4 at point C′. Trade under Monopolistic Competition

The 3th assumption is about each firm’s cost structure Assumption 3: Firms produce using a technology with increasing returns to scale. FIGURE 6-3 Increasing Returns to Scale This diagram shows the average cost, AC, and marginal cost, MC, of a firm. Increasing returns to scale cause average costs to fall as the quantity produced increases. Marginal cost is below average cost and is drawn as constant for simplicity.

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Trade under Monopolistic Competition

Numerical Example of Increasing Returns to Scale TABLE 6-2

Cost Information for the Firm This table illustrates increasing returns to scale, in which average costs fall as quantity rises.

Whenever the price charged is above average costs, then a firm earns monopoly profits.

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Trade under Monopolistic Competition

The 4th assumption is about profit:

Assumption 4: Because firms can enter and exit the industry freely, monopoly profits are zero in the long run.

• Firms will enter as long as it is possible to make monopoly profits, and the more firms that enter, the lower profits per firm become. • Profits for each firm end up as zero in the long run, just as in perfect competition.

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Trade under Monopolistic Competition

Next, we will examine monopolistic competition: • in the short run without trade • in the long run

• in the short run • in the long run with free trade

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Trade under Monopolistic Competition Equilibrium without Trade Short-Run Equilibrium

FIGURE 6-4

Short-Run Monopolistic Competition Equilibrium without Trade The short- run equilibrium under monopolistic competition is the same as a monopoly equilibrium. The firm chooses to

produce the quantity Q0 at which the firm’s marginal

revenue, mr0, equals its marginal cost, MC.

The price charged is P0. Because price exceeds average cost, the firm makes monopoly profits.

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Trade under Monopolistic Competition Equilibrium without Trade Long-Run Equilibrium FIGURE 6-5 (1 of 2) Long-Run Monopolistic Competition Equilibrium without Trade Drawn by the possibility of making profits in the short-run equilibrium, new firms enter the industry (drawing demand away from existing firms and producing more product varieties)

and the firm’s demand curve, d0, shifts to the left and becomes more

elastic (i.e., flatter), shown by d1. The long-run equilibrium under monopolistic competition occurs at

the quantity Q1 where the marginal revenue curve, mr1 (associated with demand curve d1), equals marginal cost. At that quantity, the no-trade price, PA, equals average costs at point A.

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Trade under Monopolistic Competition Equilibrium without Trade Long-Run Equilibrium FIGURE 6-5 (2 of 2) Long-Run Monopolistic Competition Equilibrium without Trade In the long-run equilibrium, firms earn zero monopoly profits and there is no entry or exit. The quantity produced by each firm is less than in short-run

equilibrium. Q1 is less than Q0 because new firms have entered the industry. With a greater number of firms and hence more varieties available to consumers, the demand for each

variety d1 is less then d0. The demand curve D/NA shows the no- trade demand when all firms Firm’s demand curve in the long-run (flatter than d0) (quantity demanded depending on the price charged by that firm) charge the same price.

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Trade under Monopolistic Competition Equilibrium with Free Trade

Short-Run Equilibrium with Trade

Assume Home and Foreign are exactly the same. • Same number of consumers • Same technology and cost curves • Same factor endowments • Same number of firms in the no-trade equilibrium

Given the above conditions, if there are economies of scale, there is reason for trade. Even two identical countries will engage in trade because increasing returns to scale exist.

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Trade under Monopolistic Competition Equilibrium with Free Trade Short-Run Equilibrium with Trade • The number of firms in the no-trade equilibrium in each country is NA. • When trade opens, the number of customers available to each firm doubles as does the number of firms • Since there are twice as many consumers, but also twice as many firms, the demand curve is the same (2D/2NA=D/NA)). • The product varieties also double. • With the greater number of varieties available, the demand for each individual variety will be more elastic. • If one firm drops its price below PA, it can attract a greater number of (Home and Foreign) customers away from other firms

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Trade under Monopolistic Competition Equilibrium with Free Trade Short-Run Equilibrium with Trade FIGURE 6-6 (1 of 2) Short-Run Monopolistic Competition Equilibrium with Trade When trade is opened, the larger market makes the firm’s demand curve more elastic, as

shown by d2 (with corresponding marginal

revenue curve, mr2). The firm chooses to produce

the quantity Q2 at which marginal revenue equals marginal costs; this quantity corresponds to a

price of P2 (point B). With sales of Q2 at price P2, the firm will make monopoly profits because price is greater than AC. Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Trade under Monopolistic Competition Equilibrium with Free Trade Short-Run Equilibrium with Trade FIGURE 6-6 (2 of 2) Short-Run Monopolistic Competition Equilibrium with Trade When all firms lower their

prices to P2, however, the relevant demand curve is D/NA, which indicates that they can

sell only Q′2 at price P2. At this short-run equilibrium (point B′), price is less than average cost and all firms incur losses. As a result, some firms are forced to exit the industry.

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Trade under Monopolistic Competition Equilibrium with Free Trade Long-Run Equilibrium with Trade • Since firms are making losses, some of them will exit the industry. • Firm exit will increase demand for the remaining firms’ products and decrease the available product varieties to consumers. • We now have NT firms which is fewer than the NA firms we had before. • The new demand D/NT >D/NA (because the reduction of firms increases the share of demand facing each one)

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Trade under Monopolistic Competition Equilibrium with Free Trade Long-Run Equilibrium with Trade

FIGURE 6-7 (1 of 2)

Long-Run Monopolistic Competition Equilibrium with Trade The long-run equilibrium with trade occurs at point C. At this point, profits are maximized for each firm

producing Q3 (which satisfies W mr3 = MC) and charging price P (which equals AC). Since monopoly profits are zero when price equals average cost, no firms enter or exit the industry.

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Trade under Monopolistic Competition Equilibrium with Free Trade Long-Run Equilibrium with Trade

FIGURE 6-7 (2 of 2)

Long-Run Monopolistic Competition Equilibrium with Trade (continued) Compared with the long-run equilibrium without trade, d3 has shifted out as domestic firms exited the industry and has become more elastic due to the greater total number of varieties with trade.. Compared with the long-run equilibrium without trade at point A, the trade equilibrium at point C has a lower price and higher sales by all surviving firms.

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Trade under Monopolistic Competition Equilibrium with Free Trade Gains from Trade The long-run equilibrium at point C has two sources of gains from trade for consumers: 1. A drop in price:  The lower price is a result of increased productivity of the surviving firms coming from increasing returns to scale. 2. Gains from trade to consumers:  Although there are fewer product varieties made within each country (by fewer firms), consumers have more product variety because they can choose products of the firms from both countries after trade.

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Trade under Monopolistic Competition Equilibrium with Free Trade Adjustment Costs from Trade • There are adjustment costs associated with monopolistic competition, as some firms shut down or exit the industry. • Workers in those firms experience a spell of unemployment. • Over the long run, however, we could expect those workers to find new jobs, so these costs are temporary.

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Conclusions of the model

• When firms have differentiated products and increasing returns to scale, there is a potential for gains from trade that did not exist in earlier models. • The model of monopolistic competition shows that trade will occur between countries even if these countries are identical. • There is trade within the same industries across countries because there is a potential to sell in a larger market. • This will induce firms to lower their prices below those charged in the absence of trade. • As firms exit, remaining firms increase their output and average cost falls. Lower costs results in lower prices for consumers in the importing country.

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Conclusions-2

• Lower prices and higher product variety are the gains from trade under monopolistic competition. • However, since some firms exit the market, there are short-run adjustment costs due to worker displacement.

Book: Feenstra/Taylor, 2011 , International Trade,Worth Publishers Why countries trade A brief introduction to the New New trade theory: firms in international trade (or heterogeneous firms) Firms in international trade

• Under Ricardian Model and H-O Model firms are black boxes • Under New trade theories:  firms' dimension counts with increasing return to scale, but all domestic firms will export after opening up to trade;  there is a firm-exit effect, but it is indeterminate which firms exit the market • Micro-level empirical evidence (see the many papers by Bernard, et al. starting in the mid-90s) show stylized facts unexplained under these theories Firms in international trade -2

• Firms are very different in terms of productivity • Only a minority of firms are exporters • Usually exporters are more productive • Exporting is characterized by fixed costs

What effects on gains from trade? • Opening up to trade kicks out the least productive firms and enhances average productivity. Hence, need a framework that could account for firms‘ heterogeneity The “New” new trade theory

This framework is called the “New” new trade theory (or the theory of heterogeneous firms) • Melitz (2003) constructed a model in which only a few highly productive firms are engaged in export:  these firms are able to make sufficient profits to cover the large fixed costs required for export operations. • Helpman et al. (2004) expanded the Melitz (2003) model into one in which the productivity of exporting firms is lower than that of firms engaged in local production overseas (FDI).  only productive firms can cover the enormous fixed costs (local factory construction, etc.) entailed in local production overseas. These "Melitz-type models" constituted the theoretical foundations for empirical research based in particular on firm-level data. The “New” new trade theory -2

New source of trade gains: • When lowered trade barriers stimulate competition on a global scale, low-productivity firms that had been protected are forced to withdraw from the market, replaced by the increased production volume of high-productivity firms. • As a consequence, the average productivity of a country on the whole rises. This rise in average productivity means a rise in people's real income; people become wealthier through the natural selection of firms on a global scale.