Intra-Industry International Trade in an Imperfect Market Structure
The world is changing in many ways: the way we communicate has made possible that information can be shared instantly around the globe. The way countries have trade is changing. The world has become more interlinked specially within free-trade areas. Economists use economic and trade theory to try to predict and decided what is best for the world. However, the models that those economists use to understand the international market are based in a “fictional” situation called perfect competition.
In a perfect competition market none of the participants is large enough to have the market power to set the price of a specific product. So, every producer is a price taker. Some economists argue that this condition is very rare; there are very few markets for specific products that might be considered very close to the perfect competition.
Whatever the reality might be, economists are promoters that the ideal market is the perfect competition. Imperfect markets such monopoly should be fought so the market can work its way to perfect competition.
In this paper we will study different scenarios where the market has a behavior way different to the perfect competition; we will analyze Monopolistic Competition, Global Oligopoly, Agglomeration Economies etc. We will also analyze how these markets can be change to have perfect competition and we will use some real life examples. We will also analyze why is it that, against what the comparative advantage theory suggests, countries trade similar products.
Economies of Scale
My mother-in-law used to make tamales to sell while my wife was growing up. The average cost to make one tamale was $.50 each. She usually used to make 50 dozens or 600 tamales each time. She used to sell them one dollar each so she would spend $300 dollars including material and labor and she would make $300 profit. When people had parties or special occasions and ordered her 100 dozens she calculated that she just needed to double material and labor. This would mean that she make$600 profit. This is called Constant Returns to Scale.
To understand what an economy of scale is we need to suppose that my mother-in-law has developed production processes and acquire all the technology to maximize her production and minimize her costs. So, for each additional tamale she would produce, then the average cost of production of the tamale would decrease.
Of course, if my mother-in-law would hire excessive number of labor then the workers would crowd the kitchen and instead of helping the production would be the other way around. So, there is a key point where the average cost is in its minimum point. See the next graph:
If you see, Q2 is the optimum point where the average cost is at its minimum because if you increase production from that point on, the average cost would increase.
The text book explains it like this: “with constant returns to scale, input use and total cost rise in the same proportion as output increases… For constant returns to scale, total cost and output go up by the same proportion, so average cost (the ration between them) is constant (or steady)…Of course constant return to scale are not the only possibility. In fact, we believe that for many industries there is a range of output for which scale economies exist. With scale economies, output quantity goes up by a larger proportion than does total cost.”
A real life example of the benefits of economies of scale is related to the chain market Wal-Mart. The website Morningstar.com wrote this: “Wal-Mart WMT is perhaps the most salient example of a company benefiting from economies of scale, and for good reason. As a dominant player in retailing, the company's size provides it with enormous efficiencies that it uses to keep costs low. For example, its size allows Wal-Mart to do its own purchasing more efficiently since it has roughly 5,000 large stores worldwide. This gives the company tremendous bargaining power with its suppliers.”
Monopolistic Competition and the Gravity Model of Trade.
As we stated in the introduction, on perfect competition, no industry is big enough to have the power to set the price. All producers are price takers because competition allows consumers to have many options.
I like putting simple examples to understand the principles. So let consider this. My wife is from a tiny town in Wyoming. Worland Wyoming only has 5000 people. The closest Wal-Mart is one hour forty minutes away. The closest mall is three hours away. Let’s think in a fictional scenario that a huge flood leaves Worland, Wyoming inaccessible to receive help from outside. Then the few local grocery stores would become a monopoly, they would set the price they would want because consumers would have no other option. Those grocery stores won’t be a price taker. There would be a monopolistic competition. Even if Wal-Mart would be cheaper for those consumers wound not matter.
The gravity model of trade in international economics, like other gravity models in social science, predicts bilateral trade flows based on the economic sizes of and distance between two units. There are different versions of the but the “according to the generalized gravity model of trade, the volume of exports between pairs of countries, Xij , is a function of their incomes (GDPs), their populations, their geographical distance, and a set of dummies,
Xij = β0Y β1i Y β2j Nβ3i Nβ4j Dβ5ij Aβ6ij uij “
Going back to my example of Worland Wyoming: Once the roads are open, then of course consumers will go and buy to other towns. If they were countries, Worland can make a study called gravity model to see what is going to happen to them now that “exports” (products bought outside) will reduce their selling.
The textbook explains it like this: “The gravity model of international trade posits that trade flows between two countries will be larger as:
1. The economic sizes of the two countries are larger
2. The geographic distance between them is smaller and
3. Other impediments to trade are smaller.
I think this just make a lot of sense. NAFTA is the best example. Even though Mexico is not as large or wealthy as the US or Canada, the benefits that the US and Canada would receive from NAFTA are evident. The US has a new market to sell its products, the distance is very short and being in a free-trade area tariffs are not a problem. Regarding an example of monopolistic competition would be: Books, CDs, movies, computer software, restaurants, cars etc.
One example is the companies of books like Barnes and Noble. These companies have their headquarters in the US. For example if the US was to consider a free-trade agreement with India (which has plenty of English readers, then using a gravity model of trade, this company could predict what the trade will be for them.
Global Oligopoly (Strategic Trade policy).
The text book says: “Our second case is a stronger form of imperfect competition. Some important industries in the world are dominated by a few large firms. Two firms, Boeing and Airbus, account for nearly all the world’s production of large commercial aircraft. Sony, Nintendo and Microsoft design and sell most of the world’s video game consoles. “
To understand what the difference between monopolic competition and oligopoly is, we have to remember that the example for monopolic competition is the car industry. Large number of relatively small companies, whereas the oligopoly contains a small number of very large firms.
So, analyzing the example of the aircraft industries where two firms dominate the global market. We have to consider the repercussions of this. First in the price, if both firms can have some sort of agreements then they can decide on a price that would benefit both companies. This agreement would cause that the firms may act as one and act as a monopoly. If, on the other hand they want to compete with each other then is very likely that the prices will be low (trying to gain customers) and the profits will low as well.
To understand better how the market behaves, we need to show two graphics.
1. If a firm raises prices, other firms won’t follow and the firm loses a lot of business.
So demand is very responsive or elastic to price increases.
2. If a firm lowers prices, other firms follow and the firm doesn’t gain much business.
So demand is fairly unresponsive or inelastic to price decreases.
Since oligopoly is very close to monopoly, especially when they collude and act like one, the optimization in its profit will be reach when the Marginal Cost is equal to the Marginal Revenue. MR=MC
So, when a very small number of very large firms dominate the majority of the market is more profitable convenient for them to collude and act as a monopoly. Then can decide on the highest price so they can have more profits. Because the danger with the price war is that they will lower the price more and more to sell (otherwise the competitor will sell and win the consumers) and they eventually reach the point where they are not making any profit but just breaking even. Let say for example that Microsoft will lower the price of their video game consoles, then Nintendo and Sony won’t sell almost anything unless they will lower their prices too. If they continue to do this they will reach the point of no profiting.
Agglomeration Economies (External Economies of Scale).
I know very close a case of external economies of scale or agglomeration economy because a live in an area where this happened. Let’s give the definition first. The book says: “Now let’s turn to our third case, an industry that benefits from substantial external scale economies. External scale economies exist when the expansion of the entire industry’s production within a geographic area lowers the long-run average cost for each firm in the industry in the area. External scale economies are also called agglomeration economies, indicating the cost advantages to firms that locate close to each other.”
I lived for a period of time in the border of Mexico and the US in the Mexican side. Almost all the TV produces, such as Sony, Phillips etc. set up TV factories in the Mexican border which represent an Economy of Scale in the Mexican side because reduce the cost (wages in Mexico are very low) and increase the production and profits. To the US market represent an external economies of scale. The benefits are for both countries, the US can have cheaper TVs and Mexico can have more jobs. Now, I think the tendency is moving those plants to China.
The graphs are the same as the economies of scale. So I won’t repeat it.
Case of Study and Conclusions
Nintendo is a video game company that I grew up with. The first video game was developed in 1974. The company has the factories in China but the distribution center in Australia. So, this company is one of the three largest companies of video games. According to the information in this paper we can assume that if they collude with the other two companies they will get the highest price possible. If not then the future will lead these companies to almost zero profit. So, if they have not gone out of business I would assume they have some kind of agreement. In my personal opinion now in these days that the markets are opening we can conclude that companies will face less and less barriers to trade with other countries. This can be bad or good for them depend on the production costs. For the consumer is always good. Because the lower price will always attract. The danger is that oligopolies would become or act as a monopoly and then the consumer will suffer.
Pugel, Thomas; International Economics (14th edition) Chicago, IL: Irwin, 2009
History of Nintendo