Question

Consider the Krugman model of intra industry trade. When we have a country trading with an identical trading economy, what are the levels of exports relative to output? What if both countries are still identical except in size?

Answer 1

Each will increase production of the good or service in which it has a comparative advantage up to the point where the opportunity cost of producing it equals the terms of trade. Free international trade can increase the availability of all goods and services in all the countries that participate in it.

Assuming a situation where are all agents have identical comparative costs, technologies, and tastes, and there is only one factor, there are none of the standard reasons for trade. But, that there are internal economies of scale. Internal economies of scale occur as long as the average cost per unit of output falls as total output increases. The easiest reasons to cite for internal economies are high fixed costs, where more output allows the firm to spread this fixed cost. If there are internal economies of scale, markets are not perfectly competitive. Instead, there will be less firms, and each firm will produce more. Each firm will also have an incentive to differentiate their product from those of their competitors if they are close/imperfect substitutes, to compete for profits. The total number of firms can be said to be determined by average cost and price. As long as price is higher than average cost, it might pay for new firms to enter the market to compete; but, when price equals average cost, profits won’t be high enough for new firms to recover their fixed cost investment.