Question

Using an appropriate equation OR diagram, explain why the PP curve is downward sloping in Krugman’s model of trade under monopolistic competition.

Answer 1

Production Possibility Curve downward sloping - Krugman's model of trade under monopolistic competition

Krugman model assumptions

• Internal economies of scale
• Monopolistic competition, and, non-homogeneous goods
• One factor of production - Labour
• Identical Preferences
• Full employment
• A large number of goods produced with the same technology

Monopolistic competition implies downward sloping PP curve.

• When there are n₁ profits, each firm makes profits, entry occurs
• When there are n₂ profits, each firm makes negative profits, exit occurs
• At n* firms in the industry, firms make zero profits, entry or exit do not occur
• It incorporates economies of scale

Price of good relative to the wage is on the vertical axis, and, per capita consumption is on the horizontal axis. Trade increases market size. Firms exploit returns to scale. Average cost decreases. Price decreases. The number of firms increases. A larger variety of products is available for a smaller price.