Question

Explain the Krugman model of trading cities based on Dixit-Stiglitz monopolistic competition. In particular, discuss the following using words and graphs (you do not need to use mathematical notation):

a) How are the number of firms and product varieties determined in the model. Graph the firm demand, marginal revenue, average cost, and marginal cost of a representative firm

b) What is the effect of opening trade between two cities? How does this make consumers better off?

c) If there are two sectors producing final consumption goods, what can you predict about the pattern of production and trade?

Answer 1

a) Krugman Model

• A special case of oligopoly
• Firms produce differentiated products and charge the same price.
• Free entry/exit of firms intro and out of the industry

Equilibrium without Trade:

in the Short Run: Profit maximization mr = MC

                in the long run: mr = MC & Profit = 0 (free entry condition)

  

• As new firms enter the market demand facing the monopoly, d, shifts in and becomes flatter in the long run
• D/N^A is the total market demand D divided by the number of domestic firms N^A producing differentiated product
• Why Curve D/N^A is steeper than curve d? Similarity of the products makes the demand facing each firm much more elastic than the demand facing the industry.

Short-Run Equilibrium with Trade

When trade is opened, the larger market makes the firm’s demand curve more elastic, as shown by d₂. By lowering its price to P₂, with sales of Q₂, the firms expect to make profits. However, when all firms lower their price to P₂ then the quantity sold is instead Q₂’, and the firms make losses. The losses lead some firms to exit, thereby shifting both demand curves to the right.

Long-Run Equilibrium with Trade

The long-run equilibrium with trade occurs at point C, with the quantity Q₃ and price P^w. As compared to the no-trade equilibrium at point A, there is a reduction in price and expansion of sales by all surviving firms

Let N^T be the umber of firms in each country after trade. N^T <N^A but the number of world variety after trade is larger than the number of varieties in autarky 2N^T >N^A

An alternative presentation of the concept:

The Price curve shows the relationship between the Number of varieties available in the market and the price that a firm can charge for its variety. As the number of varieties increase the price decreases, because the demand for each variety becomes more elastic (the demand curve facing each firm becomes flatter).

The Unit cost curve, UC, shows the relationship between the unit (or average) cost level for each variety and the number of varieties produced. Given the size of the market, unit cost increases as the number of varieties increases, because the production level for each variety declines as more varieties crowd out into the market.

Impact of trade under Monopolistic competition

• Little impact on domestic distribution of factor income
• Some firms go bankrupt and some expand in each country. Factors employed in losing firms will bear dislocation costs.
• Countries will completely specialize in different product varieties.
• All countries gain from trade. There are two sources of such gain:
  • Decrease in prices (due to scale economies)
  • Increase in consumer welfare due to greater product variety. Consumers like greater variety in their consumption.

• Short-run adjustment costs when some firms in each country shut down and exit the industry. Over the long-run, however, we expect that these workers can find new positions, so we view these costs as temporary.

Empirical Test of the Krugman Model

Recall that the Krugman model contains two predictions concerning the impact of trade on the productivity of firms:

• The scale effect, as surviving firms expand their outputs, and
• The selection effect, as least-efficient firms are forced to exit the average industry productivity is expected to increase.

b) Advantages of opening trade between two cities/countries:

Free trade means that countries can import and export goods without any tariff barriers or other non-tariff barriers to trade.

Essentially, free trade enables lower prices for consumers, increased exports, benefits from economies of scale and a greater choice of goods.

In more detail, the benefits of free trade include:

1. The theory of comparative advantage

This explains that by specialising in goods where countries have a lower opportunity cost, there can be an increase in economic welfare for all countries. Free trade enables countries to specialise in those goods where they have a comparative advantage.

2. Reducing tariff barriers leads to trade creation

Trade creation occurs when consumption switches from high-cost producers to low-cost producers.

• The removal of tariffs leads to lower prices for consumers (Prices fall from P1 to P2)
• This fall in prices enables an increase in consumer surplus of areas 1 + 2 + 3 + 4
• Imports will increase from Q3-Q2 to Q4-Q1
• The government will lose tax revenue of area 3. Tax revenue from imports was T (P1-P2) × (Q3-Q2)
• Domestic firms producing this good will sell less and lose producer surplus equal to area 1
• However, overall there will be an increase in economic welfare of 2+4 (1+2+3+4 – (1+3)
• The magnitude of this increase depends upon the elasticity of supply and demand. If demand elastic consumers will have a big increase in welfare
• Essentially, removing tariffs leads to lower prices for consumers – so the price of imported food, clothes and computers will be lower. When the UK joined the EEC – the price of many imports from Europe fell.

3. Increased exports

As well as benefits for consumers importing goods, firms exporting goods where the UK has a comparative advantage will also see a significant improvement in economic welfare. Lower tariffs on UK exports will enable a higher quantity of exports boosting UK jobs and economic growth.

4. Economies of scale

If countries can specialise in certain goods they can benefit from economies of scale and lower average costs; this is especially true in industries with high fixed costs or that require high levels of investment. The benefits of economies of scale will ultimately lead to lower prices for consumers and greater efficiency for exporting firms.

5. Increased competition

With more trade, domestic firms will face more competition from abroad. Therefore, there will be more incentives to cut costs and increase efficiency. It may prevent domestic monopolies from charging too high prices.

6. Trade is an engine of growth.

World trade has increased by an average of 7% since 1945, causing this to be one of the significant contributors to economic growth.

7. Make use of surplus raw materials

Middle Eastern countries such as Qatar are very rich in reserves of oil, but without trade, there would be not much benefit in having so much oil.
Japan, on the other hand, has very few raw materials; without trade, it would have low GDP.

8. Tariffs may encourage inefficiency

If an economy protects its domestic industry by increasing tariffs industries may not have any incentives to cut costs.

C) Even when a country has high levels of productivity in all goods, it can still benefit from trade. Gains from trade come about as a result of comparative advantage. By specializing in a good that it gives up the least to produce, a country can produce more and offer that additional output for sale. If other countries specialize in the area of their comparative advantage as well and trade, the highly productive country is able to benefit from a lower opportunity cost of production in other countries.