Question

1) What is intra-industry trade? To which countries does the Krugman model apply? - Intra-industry trade is trade between industrial countries. 2) What are economies of scale? Describe the number and size of firms in an industry with large “internal” economies of scale. 3) What are the other two characteristics of the Krugman model? Give examples. 4) What potential industrial policies can government enact to foster growth of industries with economies of scale? 5) Explain the product cycle hypothesis.

Answer 1

1. a) Intra-industry trade refers to the exchange of similar products belonging to the same industry. The term is usually applied to international trade, where the same types of goods or services are both imported and exported.

b) This model uses economies of scale, differentiated products and heterogenous preferences to explain intra industry trade. The essence of the model is as follows: i) Preferences are heterogeneous between and within countries ii) Production experiences economies of scale iii) Products are differentiated

Industries within a country will produce goods which are targeted for the majority of their home consumers, thereby, exploiting economies of scale. However, not all consumers have the same preferences. Some minority will have preferences for the styles etc. produced elsewhere. Domestic firms find small production runs costly and forgo this segment of the market. This minority then winds up buying imported goods. The converse is also true that some portion of foreign consumers will have a greater preference for home country goods and home country winds up exporting to foreign's minority's share of the market. The implications for this model transcends a simple explanation of intra-industry trade. It lies at the heart of the controversy of managed trade and industrial policy. With economies of scale there are only a feasible small number of firms to satisfy world demand (aircraft, for example). Under these conditions, the principle of first movers winning market share makes for compelling logic for advocates of managed trade. Countries are like United States, China are the examples for the same.

2. a) Economies of scale is the competitive advantage that large entities have over smaller ones. The larger the business, non-profit, or government, the lower its per-unit costs. It can spread fixed costs, like administration, over more units of production.

b) There are five main types of internal economies of scale

i) Technical economies of scale result from efficiencies in the production process itself. Manufacturing costs fall 70-90 percent every time the business doubles its output. Larger companies can take advantage of more efficient equipment.

ii) Managerial economies of scale occur when large firms can afford specialists. They more effectively manage particular areas of the company.

iii) Financial economies of scale means the company has cheaper access to capital. A larger company can get funded from the stock market with an initial public offering. Big firms have higher credit ratings. As a result, they benefit from lower interest rates on their bonds.

iv) Network economies of scale occur primarily in online businesses. It costs almost nothing to support each additional customer with existing infrastructure. So, any revenue from the new customer is all profit for the business. A great example is eBay.

v) Monopsony power is when a company buys so much of a product that it can reduce its per unit costs.

3. a) An increasing returns to scale occurs when the output increases by a larger proportion than the increase in inputs during the production process. For example, if input is increased by 3 times, but output increases by 3.75 times, then the firm or economy has experienced an increasing returns to scale.

b) Monopolistic competition is a market structure which combines elements of monopoly and competitive markets. Essentially a monopolistic competitive market is one with freedom of entry and exit, but firms can differentiate their products. Therefore, they have an inelastic demand curve and so they can set prices. For example, Hairdressers - A service which will give firms a reputation for the quality of their hair-cutting.

4. Industrial Policies are as follows:

1. Protection to Indian Industries: Local industries were given shelter from international competition by introducing partial physical ban on the imports of products and high imports tariffs. Protection from imports encouraged Indian industry to undertake the manufacture of a variety of products. There was a ready market for all these products.

2. Import-Substitution Policy: Government used its import policy for the healthy development of local industries. Barring the first few years after Independence, the country was facing a shortage of foreign exchange, and so save scarce foreign exchange imports-substitution policy was initiated i.e.   Government encouraged the production of imported goods indigenously.

3. Financial Infrastructure: In order to provide the financial infrastructure necessary for industry, the Government set up a number of development banks. The principal function of a development bank is to provide medium and long-term investments. They have to also play a major role in promoting the growth of enterprise.

4. Control over Indian Industries: Indian industries were highly regulated through legislations such as Industrial licensing, MRTP Act, 1969 etc. These legislations restricted the production, expansion and pricing of output of almost all kinds of industries in the country.

5. Regulations on Foreign Capital under the Foreign Exchange and Regulation Act (FERA): FERA restricted foreign investment in a company to 40 percent. This ensured that the control in companies with foreign collaboration remained in the hands of Indians. The restrictions were also imposed on technical collaborations and repatriations of foreign exchange by foreign investors.

6. Encouragement to Small Industries: Government encouraged small-scale industries (SSIs) by providing a number of support measures for its growth. Policy measures addressed the basic requirements of the SSI like credit, marketing, technology,entrepreneurship development, and fiscal, financial and infrastructural support.

7. Emphasis on Public Sector: The Government made huge investments in providing infrastructure and basic facilities to industries. This was achieved by establishing public sector enterprises in the key sectors such as power generation, capital goods, heavy machineries, banking, tele- communication, etc.

5. Product Cycle Hypothes is the progression of an item through the four stages of its time on the market. The four life cycle stages are: Introduction, Growth, Maturity and Decline. Every product has a life cycle and time spent at each stage differs from product to product. Stages are as follows:

Stage 1: Introduction : This is where the new product is introduced to the market, the customers are unaware about the product. To create demand, producers promote the new product to stimulate sales. At this stage, profits are low and there are only a few competitors. As more units of the product sell, it enters the next stage automatically. Characteristics of the product and the production process are in a state of change during this stage as firms familiarize themselves with the product and the market. No international trade takes place.

Stage 2: Growth : In this stage, demand for the product increases sales. As a result, production costs decrease and profits are high. The product becomes widely known and competitors enter the market with their own version of the product. To attract as many consumers as possible, the company that developed the original product increases promotional spending. When many potential new customers have bought the product, it enters the next stage

Stage 3: Maturity : In the maturity stage of the Product life cycle, the product is widely known and many consumers own it. In the maturity phase of the product life cycle, demand levels off and sales volume increases at a slower rate. There are several competitors by this stage and the original supplier may reduce prices to maintain market share and support sales. Profit margins decrease, but the business remains attractive because volume is high and costs, such as for development and promotion, are also lower. In addition, foreign demand for the product grows, but it is associated particularly with other developed countries, since the product is catering to high-income demands.

Stage 4: Decline : By this time in the product’s life cycle, the characteristics of the product itself and of the production process are well known; the product is familiar to consumers and the production process to producers. This occurs when the product peaks in the maturity stage and then begins a downward slide in sales. Eventually, revenues drop to the point where it is no longer economically feasible to continue making the product. Investment is minimized. The product can simply be discontinued, or it can be sold to another company. Production may shift to the developing countries. Labor costs again play an important role, and the developed countries are busy introducing other products.