Lectures 4 and 5 Modern Trade Theories

Modern Trade Theories

Introduction

• Technology Theories of Trade– Imitation lag hypothesis– Product cycle theory

• Economies of Scale and Trade

• Intra industry trade– Product differentiation, monopolistic

competition & intra industry trade– Oligopoly & intra industry trade– Linder’s Demand-based Theory

Imitation Lag HypothesisPosner 1961

• Same technology not available in all countries.

• R&D results in new product in Country A.• Demand lag before consumers in country B

want to buy.• Imitation lag before firms in country B start to

produce.• During net lag (i.e. imitation lag - demand lag)

country A can export to Country B without competition.

Product Life Cycle TheoryVernon 1966

3 stages of product life-cycle:

• New Product Stage– produced & consumed only in home country

• Maturing Product Stage– standardisation of production & exports to other

high-income countries

• Standardised product Stage– production may shift to LDCs with lower labour

costs

Theory of dynamic comparative advantage

Product Life Cycle TheoryVernon 1966

Production/Consumptionof product

Economies of Scale External to Firm

H0

Q0

AC ACi Aci(Q0)

H0=F0

q0

qiQi

Industry level Firm level

Economies of Scale External to Firm

H0

H1

Q0 Q1

AC ACi Aci(Q0)

Aci(Q1)

H0=F0

H1

q0

qiQi

Industry level Firm level

Economies of Scale External to Firm

Internal Economies of Scale: Monopoly

APH

E

MC

AC

DH

C

qH MR q0

Internal Economies of Scale: Monopoly

APHE

MCAC

C

qH MRH

qW

DH=MRH+FDH+F

B

FG

Internal Economies of Scale: Monopoly

APHE

MCAC

C

qH MRH

qW

DH=MRH+FDH+F

B

FG

Intra Industry Trade

• What is intra industry trade?

• The aggregation problem

• Why does intra industry trade occur?

• Product differentiation, monopolistic competition & intra industry trade

• Oligopoly & intra industry trade

• Linder’s demand-based theory

What is Intra Industry Trade?

Country

Country

Insulin

Bacon

H

F

Inter-industry trade only

Insulin

Bacon

Intra-industry trade only

What is Intra Industry Trade?

Country

Country

Insulin

Bacon

H

F

Partly inter-industry trade & partly intra-industry trade

What is Intra Industry Trade?

• Grubel & Lloyd measured intra industry trade as:Bi = (Xi + Mi) - |Xi - Mi| . 100 %

(Xi + Mi)

where (Xi + Mi) is total trade in industry i and |Xi - Mi| is the degree of non-overlap

• Values range from – 0% (no intra industry trade) to – 100% (pure intra industry trade)

The Aggregation Problem

• Firms are grouped into industries using the SITC (Standard International Trade Classification).

• Controversy centres on 2 issues– industry definition– how much is “substantial” intra industry trade?

Why does Intra Industry Trade Occur?

• Several minor cases– Entrepot trade– Seasonality– Transport costs

Transport Costs & IIT

Country A Country B

FA • • CB

CA • • FB

Why does Intra Industry Trade Occur?

• Several minor cases– Entrepot trade– Seasonality– Transport costs

• Differentiated products – monopolistic competition

• Oligopoly

• Overlapping demand

Product Differentiation, Monopolistic Competition & IIT

Krugman’s model

• Assume:– identical firms with each firm facing downward

sloping demand curve and differentiated products.

• In a closed economy:No. of firms = Industry demand

Profit max. output of a firm

Oligopoly & IIT: Reciprocal Dumping (Brander & Krugman 1983)

• Assume 2 countries with identical monopoly producers.

• In fully integrated international market there would be a duopoly.

• In a simple Cournot model, free trade will cause each to increase production, so price will fall

Oligopoly & IIT: Reciprocal Dumping (Brander & Krugman 1983)

Country H Country F

Producer H Producer F

Consumers Consumers

1 243

Oligopoly & IIT: Reciprocal Dumping (Brander & Krugman 1983)

• In practice, full market integration doesn’t happen.

• Producer in H will export if:

PF > MC + transport costs

( given market segmentation PH not affected)

• A parallel argument applies to producer in F, who exports if:

PH > MC + transport costs

• So 2-way IIT occurs

Oligopoly & IIT: Reciprocal Dumping (Brander & Krugman 1983)

PH0

qH0 MRH

DH

MCH

qH

PHPF

PF0

PF1

qF0 qF1

MRF

MRHF

DF

MCF

MCH+TC

Country H Country F

Imports

qF

Linder’s Demand-based Theory 1961

• Steffan Linder distinguished sharply between:– Trade in primary goods (explained by

Heckscher-Ohlin);– Trade in manufactures (explained by

demand factors).

• Main determinant of demand in a country was income /head. With high income average consumer buys better quality goods.

Linder’s Demand-based Theory 1961 (continued)• Empirical tests support Linder’s analysis,

but countries with similar per capita incomes are often close geographically.

• Linder doesn’t predict direction of trade flows (could be 2-way).

• Growth of travel & communications since he wrote may have changed factors he stressed.

Empirical Work

• Typically industrialised countries have a high GL index of 60-80% – (e.g. see Culem & Lundberg 1986)

• Japan is exceptionally low (40-50%)

• Little IIT between industrialised & developing countries

• IIT increases with economic development

Porter’s DiamondBusiness strategy, market structure & competition

Factors of production

Domestic demand

Suppliers & affiliated companies

Porter’s Diamond

Business strategy, market structure & competition

Factors of production

Domestic demand

Suppliers & affiliated companies

Government

Summary

We have looked at various modern theories of international trade

• Technology based theories – from Posner & Vernon

• Economies of scale & trade• Theories on intra industry trade

– Imperfect competition theories from Krugman– Linder’s demand-based theory

• Porter’s Diamond

Summary

• Trade between industrialised countries can be explained by a combination of comparative & competitive advantage.

• Modern theories can add to our understanding of international trade, but we shouldn’t reject the more traditional theories