Question

Consider an industry that produces differentiated products with increasing returns to scale. The market structure is monopolistic competition. The firms in the industry have different productivities and different marginal cost.

 

1. How would trade liberalization affect demand curve facing a firm? Would the change have the same effects on firms with different marginal cost? Why?
2. Explain why international trade could improve the efficiency of the industry.
3. In many countries, the exporting firms are more productive than firms which serve only the domestic market. Why?

Answer 1

(a) The term trade liberalization means that an economy moves from a closed economy to open economy where international trade is allowed. This would mean that domestic producers can now sell its products all across the globe.

So the liberalization will affect the demand curve faced by the firms, as the demand for their products will increase substantially, given that their products are globally competitive. Here by word competitive, means being able to produce a good at a cheaper cost such that it can have competitive advantage over other countries products.

So the trade liberalization would mean that demand curve faced by domestic producers will shift to the right due to increased demand for their products.

The change would certainly have different effects on firms with different marginal cost of production. As we discussed above the demand for product will only increase for those firms who have low marginal cost of production which in turn means that they have competive advantage.

(b) The international trade improves the efficiency of domestic producers is absolutely true. As an economy opens up for international trade, the domestic producers are now competing with international firms. The international trade is purely based on the concept of competitive advantage.

The competitive advantage means that some producers can produce the same good at a much lower cost as compared to other producers in other country. As a result, countries with lower cost of production gains market share as it can provide the same good at much lower price.

So if countries really wish to take advantage of International trade they must improve their efficiency in terms of producing a good at lower cost. The international trade gives an incentive to domestic producers to invest in technology which can improve efficiency of domestic producers.

In long run international trade eventually eventually forces domestic producers across the globe to invest in technology which in turn improves the efficiency of firms.

(c) In many countries exporting firms are more productive than firms who serves only the domestic market due to the reasons we just discussed in part a and b.

The firms who engage in export of goods and services are more productive comes from the fact that international trade in purely based on competitive advantage, which in turn depends on productivity of firms. A firm with higher firms can produce a good at a low cost which gives them the competitive advantage.

Firms which have low productivity can't compete with those producers which can produce the same good a much lower cost, due to high efficiency. As a result firms with low productivity only serves domestic market.

Conclusion: The international trade is now days purely based on the competitive advantage. The firms with higher productivity or low cost of production leads the way in global exports, China for example. In this question we just need to relate few concept together, as I did.