• Increasing returns ⟺ decreasing costs

• PPF is convex to origin

• Marginal rate of transformation (MRT) decreases as we produce more of a good

  • Again: “slope”, “relative price of x”, “opportunity cost of x”
  • Amount of y given up to get 1 more x

• To simplify our graph, assume Home and Foreign have identical preferences (same indifference curve), and identical endowments (both start at A)

• Countries open up trade, face same relative prices

• Each country exploits economies of scale, producing only one good

  • Home produces x, Foreign produces y
  • Points B and B'

• Countries open up trade, face same relative prices

• Each country exploits economies of scale, producing only one good

  • Home produces x, Foreign produces y
  • Points B and B'

• Trade and reach a higher indifference curve at C

• Countries open up trade, face same relative prices

• Each country exploits economies of scale, producing only one good

  • Home produces x, Foreign produces y
  • Points B and B'

• Trade and reach a higher indifference curve at C

• Countries open up trade, face same relative prices

• Each country exploits economies of scale, producing only one good

  • Home produces x, Foreign produces y
  • Points B and B'

• Trade and reach a higher indifference curve at C

U.S.

• Trade increases demand for China’s output

• Lowers AC and p even further, further outcompeting U.S.

• Suppose Vietnam actually has lower AC than China, once it gets up to scale (V1)

• Chinese economies of scale have world market price at C

• Current market price provides no profit to Vietnamese producers starting production at V0

• World is inefficiently “locked in” to Chinese production, sub-optimal path dependence

• Policy implication for Vietnam: shut out imports from China with tariffs, and subsidize this industry to get it up to scale

• In the long run, Vietnam can become the least-cost producer, increasing welfare

• Consumers are better off with more variety

• Two interpretations of why:

  1. Love of variety: consumers value variety for its own sake (directly enters utility function)
  2. Ideal variety: consumers have an ideal variety in mind, and having more varieties available increases probability that each consumer matches with their ideal variety

• Why can’t consumers each always have their favorite variety?

• Tradeoff between variety and (average) cost

• Why can’t consumers each always have their favorite variety?

• Tradeoff between variety and (average) cost

• If every consumer had their favorite variety: many varieties, each firm produces very few units at a very high price (QM,PM)

• Why can’t consumers each always have their favorite variety?

• Tradeoff between variety and (average) cost

• If every consumer had their favorite variety: many varieties, each firm produces very few units at a very high price (QM,PM)

• If there are only a few varieties, few firms produce many units at very low price (QF,PF)

• Suppose they trade 4 Harleys for 4 Kawasakis

• Globalization reduces geographic variation (more places look the same, have same amenities)

• But increases varieties available to individuals in each area

• Monopolistic competition: hybrid of monopoly and competition, where each firm has some market power

1. Goods are imperfect substitutes

   • consumers recognize non-price differences between sellers' goods

2. Free Entry and exit (no barriers)

3. Each firm is a price-searcher

   • faces own downward-sloping demand

• Keep it simply, assume MC(q)=0

• In autarky, long-run equilibrium for firm is p=AC, π=0 at q1,p1

• Firm opens up to international trade, has two effects on demand for firm:
  • greater demand for firm’s products
  • more competition from other countries’ firms
  • overall, demand becomes more elastic

• Firm opens up to international trade, has two effects on demand for firm:

  • greater demand for firm’s products
  • more competition from other countries’ firms
  • overall, demand becomes more elastic

• Allows firm to lower price, produce more at q2,p2 and earn some profit

• Firm opens up to international trade, has two effects on demand for firm:

  • greater demand for firm’s products
  • more competition from other countries’ firms
  • overall, demand becomes more elastic

• Allows firm to lower price, produce more at q2,p2 and earn some profit

• In reality, the size of the world market (Home+Foreign) has not changed

• Thus, not all firms can expand and survive in global market

• As all firms try to expand and compete, this lowers demand for each individual firm

• In reality, the size of the world market (Home+Foreign) has not changed

• Thus, not all firms can expand and survive in global market

• As all firms try to expand and compete, this lowers demand for each individual firm

• This continues until new equilibrium, where p=AC, π=0 again, at q3,p3

• In reality, the size of the world market (Home+Foreign) has not changed

• Thus, not all firms can expand and survive in global market

• As all firms try to expand and compete, this lowers demand for each individual firm

• This continues until new equilibrium, where p=AC, π=0 again, at q3,p3

• In autarky (before trade), suppose there were 2n firms (n in each country)

• When trade opens, each firm tries to gain larger share (but not all can)

• Some firms exit; firms that remain will produce more than before (q1→q3)

• With trade, and after the shakeout, there are n⋆ firms, n<n⋆<2n

• Price & AC fall, and product variety in each country rises from n→n∗

• With fewer firms, the remaining (low cost) firms can further increase their output

• Exploit economies of scale, moving down their average cost curves

• Implies lower costs, lower prices, and greater productivity for the incumbent firms remaining

• H-O theory vs. increasing returns

• Ex ante vs. ex post comparative advantage

• Emphasize different causes of trade

• Imply very different policies

  • free trade vs. industrial policy?

• Cultural/aesthetic views of the world? Difference vs. sameness?