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Goods and Imperfect Competition

As early as 1936, Haberler noted that the theory of international trade needed further development to incorporate imperfectly competitive markets. Greater realism of the assumptions underlying trade theory was one of the main reasons behind Haberler's argument. Indeed, a casual observation of international and domestic markets would lead one to conclude that perfect competition is the exception rather than the norm. Similarly, the importance of intra-industry trade (trade in similar goods) in world markets remained unexplained within the classic trade framework, where the rationale for trade is based on either technological or endowment differences. In such a setting, producers specialize in the production of goods for which the countries where they are based have a comparative advantage (in either technological or endowment terms).  Obviously, this can only generate inter-industry trade (trade in different goods). The growing share of intra-industry trade in world markets was calling for an explanation. The introduction of the assumptions of product differentiation and economies of scale into trade models provided an answer. The presence of economies of scale creates incentives for countries to specialize in the production of a small number of differentiated products and therefore naturally leads towards intra-industry trade. But economies of scale are also at the root of imperfectly competitive markets.

Trade models based on imperfectly competitive markets began to be fully formalized in the late 1970s. The “new” trade theory starts from these new assumptions (imperfect competition, economies of scale and differentiated goods), and identifies new gains from international trade. The intuition is simple: by creating larger and more competitive markets, trade reduces the distortions that are associated with imperfect competition in a closed economy. As a result, trade protection is associated with greater losses. However, in the case of imperfectly competitive international markets, the literature has identified “strategic” gains from protection. That is, the use of sophisticated government intervention, known as “strategic trade policy”, can lead to better outcomes than free trade. These however have been quickly dismissed on empirical grounds, especially in the case of developing countries. 

1. Gains from trade under imperfect competition
In addition to the traditional gains from trade linked to a more efficient allocation of resources, the existence of imperfectly competitive markets generates four additional gains: i) pro-competitive gains, ii) gains from economies of scale, iii) gains from rationalization and iv) gains from variety.

i) Pro-competitive gains:  Pro-competitive gains refer to the effects of increased imports on the competitive behavior of firms in the domestic market. It is also known as the “import discipline hypothesis”, as imports can discipline the monopolistic or oligopolistic behavior of firms, forcing them to behave in a more competitive way. To illustrate this, think of the extreme case where under autarky there is only one firm serving the domestic market. This firm behaves as a monopolist and determines its monopolistic price and quantities sold in the domestic market where its marginal cost equals the marginal revenue of domestic demand. This equilibrium implies a much higher price (and smaller quantities) than at the socially optimal equilibrium where the marginal cost equals the marginal benefit (i.e., the demand function). Assume that this country opens up to trade and faces a perfectly elastic world supply at a price below the monopolistic price. Consumers in this country will not buy from the domestic firm unless it sells at the world price level. Thus, by opening up to trade, the domestic firm is forced to charge a price closer to the social optimal price. 

ii) Gains from economies of scale: Gain from economies of scale are associated with the idea that as the quantity produced by one firm increases its average cost decreases.  This may be due to economies of specialization (firms operating on a larger scale can match inputs more closely to tasks), to indivisibilities in production (firms can only produce 100 or 200 units) or to the fact that for technological reasons large machines are more efficient than small machines. This decline in average costs leads to lower prices. To understand how trade and (internal) economies of scale interact, it is useful to think of a market where firms produce a differentiated product. Under autarky each firm faces the domestic demand for the differentiated product it produces. As the economy opens up to trade the demand faced by each firm increases, as each firm is now facing world demand for that product. Quantities produced are therefore larger and due to economies of scale average cost declines. As a result, prices are lower and trade generates an additional gain from economies of scale. 

iii) Gains from rationalization: The gains from rationalization are also linked to the existence of economies of scale. As imports enter the domestic market, firms with the least productive technology may see their profits become negative. Import competition forces them to exit the market. As a result the number of domestic firms in the market declines, which in turn implies that the demand for each of the remaining firms in the market increases. This leads to a higher level of production by the remaining and more efficient domestic firms. In the presence of economies of scale, this leads to lower prices and therefore further gains from trade associated with rationalization. 

iv) Gains from variety: The assumption here is that a larger variety of products implies a higher level of consumer satisfaction. This could be due to the fact that variety per se is important for consumers or to the fact that variety allows heterogeneous consumers to purchase the product that matches their most desired characteristics. Thus, models where variety matters are inherently models of product differentiation. The literature generally distinguishes between vertical differentiation (e.g., shirts of different quality) and horizontal differentiation (e.g., shirts of different color). How does trade fit into the picture? When a country opens up to trade, a larger variety of products becomes available through imports from foreign firms. This, by the mechanisms described above, leads to a gain from trade associated with product variety. 

2. Trade policy under imperfect competition
As a result of these new gains from trade linked to the existence of imperfect competition, the welfare losses associated with tariffs should be much higher than under perfect competition. Moving from free-trade to a tariff-ridden equilibrium will lead to: a) pro-competitive losses as firms can now behave in a less competitive way since the demand curve they face is now less elastic. This gives more market power to domestic firms, which in turn yields higher prices; b) inefficient entry as protection increases profits which leads to the entry of less productive firms which will in turn yield loss of scale efficiency; c) loss of variety of products available in the domestic market as some foreign firms will not be able to sell in the domestic market given the high tariff.

Thus, the presence of increasing returns and product differentiation seem to increase the gains from trade liberalization.

3. Strategic trade policy
The new trade theory has also identified a new case for protection in the presence of “strategic” interactions among firms in domestic and international markets. Strategic interactions among firms occur when a change in the behavior of firm 1 leads to a change in the optimal behavior of firm 2 (a strategic response). By affecting the behavior of firms, “strategic trade policy” can influence domestic and international markets by altering the strategic relationship between firms. This can be used to the advantage of domestic firms, which could therefore increase domestic welfare.

By choosing an optimal import tariff or subsidy the government can affect the strategic game played by firms in international markets to the advantage of domestic firms. The now classic Boeing-Airbus example of Brander and Spencer (1985) can illustrate this. Assume that there is only room for one firm in the international aircraft market. If two firms produce, then both will incur losses. But if only one firm produces, then there are important profits for the producing firm. In this scenario, if the European government can commit to subsidizing the production of aircrafts by Airbus by a larger amount than the expected loss if both firms remain in the market, then Boeing will quit and Airbus will get the whole market (and its profits). Thus there is a role for intervention when firms play strategically in international markets. 

However, assumptions are crucial to obtain this result. For example, if the US government can retaliate (i.e. commit to subsidize Boeing), then it is not clear that subsidizing Airbus is an optimal policy for the European government. Moreover, the amount of information needed to correctly implement these types of strategic trade policies is rarely available (e.g., if the subsidy is too small, then it is useless). The information problem is further complicated if one does not consider the industries in isolation. By subsidizing the aircraft industry in Europe, the government will be drawing resources from other industries, which will lead to increases to their costs.

Also, the timing and structure of the game is crucial. If governments first decide whether to intervene or not, and then in a second stage choose the optimal level of the intervention, it is very likely that if one government chooses not to intervene in the first stage, then the optimal equilibrium will imply absence of intervention by both governments. In essence, separating the policy decision into two steps yields a very different game.

Generally, the strategic trade policy literature gives rise to contradictory results depending on the type of market structure and the form of competitive rivalry. For example, an optimal tariff can become an optimal subsidy if one assumes that firms, instead of being Cournot players in the international markets, would compete on prices (see Eaton and Grossman, 1986). Due to the lack of consistent results in the new trade theory, the literature has generally been considered of very little use in the guidance of governments’ trade policy. 

Some authors have questioned the relevance of strategic interaction among firms. While it is certainly the right setup for the world aircraft market, it is not the case for the world wheat market. This further raises the question of their relevance for trade policy in less developed countries, which tend to be primary product exporters. The production of primary products is rarely characterized by large economies of scale. Therefore strategic trade policy is of little relevance for developing countries. Moreover, the relatively small size of developing countries home markets, makes it very unlikely that firms, subject to the type of strategic interaction illustrated with the Airbus-Boeing example, would choose them as home base. Also, when the country is small, the credibility of the government on its commitment to intervene may be relatively small.

Finally, one should note that government’s intervention may be influenced by interest group pressures. In such a world, the kind of very specific interventions at the firm level which the strategic trade policy literature suggests, are very likely to be captured by interest groups. The result may be one of excessive intervention that benefits a small group of producers at the expense of a large number of non-represented agents. Thus, political economy concerns and the difficulty of formulating useful interventions create a new case for free-trade in a world of strategic trade policy.

Further Readings and  links:

  • Baldwin, Richard and Paul Krugman (1988), “Market Access and International Competition: A Simulation Study of 16K Random Access Memories”, in Robert Feenstra, ed.: Empirical Methods for International Trade, Boston: MIT Press.
  • Brander, James and Barbara Spencer (1985), “Export subsidies and market share rivalry”, Journal of International Economics 18:83-100.
  • Brander, James (1995), “Strategic trade policy”, in Gene Grossman and Kenneth Rogoff, eds: Handbook of International Economics, vol. III, Amsterdam: North Holland.
  • Dixit, Avinash (1988), “Optimal trade and Industrial Policy for the US automobile”, in Robert Feenstra, ed.: Empirical Methods for International Trade, Boston: MIT Press.
  • Davis, Donald (1995), “Intra-industry trade: A Heckscher-Ohlin Ricardo approach”, Journal of International Economics 28: 1-23.
  • Eaton, Jonathan and Gene Grossman (1986), “Optimal trade and industrial policy under oligopoly”, Quarterly Journal of Economics 101: 383-406.
  • Gandolfo Giancarlo (1998), “International trade theory and policy”, ch. 11.
  • Helpman, Elhanan (1983), “Increasing returns, imperfect markets, and trade theory”, in: Ronald Jones and Peter Kenen, eds.: Handbook of International Economics, vol. I, Amsterdam: North Holland.
  • Hwang, H.-S and C. Schulman (1992), “Strategic non-intervention and the choice of trade policy for international oligopoly”, Journal of International Economics 24:373-380.
  • Krugman, Paul (1987), “Is free trade passe?”, Journal of Economic Perspectives 1:131-144.
  • Krugman, Paul and Maurice Obstfeld (1991), International Economics, chapter 6 and 11.
  • Krugman, Paul (1995), “Increasing returns, imperfect competition, and the positive theory of international trade”, in: Gene Grossman and Kenneth Rogoff, eds.: Handbook of International Economics, vol. III, Amsterdam: North Holland.
  • Krugman, Paul (1986), “New trade theory and the less developed countries”, in: Guillermo Calvo et al., eds: Debt, Stabilization and development: essays in memory of Carlos Diaz Alejandro, London: Basil Backwell.
  • Mark Roberts and Jim Tybout (1996)," Industrial evolution in developing countries: micro patterns of turnover, productivity and market structure", Oxford: Oxford University Press.
  • Venables, Anthony and Alasdair Smith (1986), “Trade and industrial policy under imperfect competition”, Economic Policy 3: 621-72.

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