Today, we explain the model of monopolistic competition
and we apply it to international trade.
The monopolistic competition model is in a way in between
"perfect" competition and monopoly.
In particular from "perfect" competition we're going to have lots of firms -
so many that
each firm will take the actions of all the other firms as given.
So there will be no strategic interaction in this model
but each firm is going to have some market power as with monopoly.
The market power will be driven here not by restrictions on entry
but by differentiated goods.
So each firm will be producing a product for which there are close
but no perfect substitutes.
Because there are no perfect substitutes a firm that raises its prices a little bit
it won't lose all of its customers.
In other words, each firm faces a downward-sloping demand curve
as with monopoly.
The difference for monopoly is that there will be free entry in the long run
and that free entry will drive prices and profits down,
perhaps to 0 if all the firms are homogeneous
or down a lot if the firms are heterogeneous -
they have different costs that may not drive them all the way to 0.
Each firm will have some economies of scale,
but not enough to create a natural monopoly.
Enough however so that each firm will continue to produce
a differentiated good even in the long run,
so those fixed costs, which generate the economies of scale,
will be such that it never pays to produce a perfect substitute for every good.
So even in the long run,
each firm will produce a differentiated good
and won't face a downward-sloping demand curve.
Classic example here is restaurants.
Tyler and I like to eat at a local Chinese restaurant,
China Star.
Even if China Star raised its prices a little bit,
we would probably continue to eat there
because although there are many other Chinese restaurants in the area,
there's none which produces food which is quite like that at China Star.
It produces a differentiated good for which there is no perfect substitute.
If you think about this,
a monopolistic competition model differentiated goods
for which there is no perfect substitute
it applies very very widely.
And not just to consumer goods,
but also to many intermediate goods as well.
So the model has become --
a workhorse model in industrial organization,
in trade, and in other fields as well.
Okay, here's the model monopolistic competition in a nutshell,
the simple version.
Here's our demand curve,
marginal revenue curve,
marginal cost, and average cost.
So the model begins just as does monopoly.
And, as with monopoly, the profit-maximizing point is found
where marginal revenue is equal to marginal cost.
That is, the firm will expand production
so long as the revenue from selling an additional unit
exceeds the cost of selling an additional unit.
It will expand production, therefore, until this point.
That gets us the short-run quantity and a short-run price.
The difference now between price and average cost,
that will give us our profit.
Price minus average cost times quantity gives us profit.
So far, exactly the same as with monopoly.
The difference with monopoly is this:
in the long run,
these profits will attract entry,
and as new firms enter into this industry,
profits will be driven to 0, will be driven down.
So let's get rid of some
superfluous stuff and see what happens as these profits attract entry,
the demand curve shifts back,
it will continue to shift back until profits are driven to 0,
which happens at this point here.
That is the new profit-maximizing point.
We can also show that with the marginal revenue equal to marginal cost, as before
our new-long run quantity is here,
new price is here,
and again, that is found where the demand curve is just tangent
to the average cost curve,
and that's when profits have been driven to 0.
So, that's a monopolistic competition model in a nutshell.
Profits in the short run, just as with monopoly,
but those profits attract entry,
the entry shifts back the demand curve until profits have been driven down to 0.
Okay, now let's now apply this model to international trade
where there will be one more important twist.
We begin with a representative firm in long-run equilibrium in the home country.
So profits are 0,
here's the price,
here's the quantity as we just showed.
Now think about this as a Canadian firm,
a free trade agreement with the United States has just been implemented.
There are 2 effects:
first, the firm will find that it faces much more competition
as all those US firms can now compete in its market.
At the same time, however,
the firm realizes that it now has access to a much larger market than it did before.
The firm may perceive for example that by setting a lower price
the potential increase in the quantity demanded has now gone up.
By setting a lower price,
it can now sell to a much larger audience than it did before.
What these 2 factors mean is that the demand curve twists -
it becomes more flatter.
The demand curve becomes more elastic.
So each firm perceives that by expanding it can increase its profits.
Here, for example, is a price greater than average cost
so the firm by expanding in the short run will be able to make profits.
And I haven't drawn in all the details here because I don't want to clutter the diagram.
But each firm perceives that by expanding
it can increase profits.
However,
not all firms can sell more -
after all,
the actual size of the market has not gone up.
Canadian firms perceive that they can now sell in a larger market,
US firms perceive that they can sell in a larger market,
but the total size of the Canada plus US market has not gone up,
so all firms will not be able to expand.
Instead,
by trying to expand,
these firms are going to push down the price,
and as they push down prices,
profits will decrease
until we get to a new long-run equilibrium
much as we did before
here and here with 0 profits.
Now notice that in this new long-run equilibrium,
the representative firm is selling more
and it is selling at a lower price
because it has moved down its average cost curve.
But again, all firms can't be selling more.
So what must have happened?
What must have happened is that some firms have exited the industry.
So let's sort of sum this up.
Before trade,
suppose there are 2N firms with N firms in each country.
With trade,
each firm tries to gain a larger share of the market,
but not all of them can.
As a result, some firms exit,
but the firms that remain produce more.
In fact, you can show by working it out mathematically
that with free trade there will be N* firms
where N* is bigger than N
so each country has more firms that it did before
but it's smaller than 2N.
In other words, another way of saying this
is that price and average cost falls
and product variety in each country increases from N to N*.
Now I haven't proven that, but I can give you the intuition.
The intuition is that consumers care about 2 things.
They care about lower prices,
but also about more variety.
And what free trade does is it allows them a better trade-off
and they end up taking more of both goods.
So they end up taking lower prices,
but they don't just take lower prices,
they use some of the gains from free trade
to take some of that in higher variety.
So after free-trade
people in each country now have access to N* products or firms,
which is bigger than the number they had before.
So they get more variety,
but prices have also fallen so they get lower costs as well.
A little bit of the best of both worlds.
Now I said in the previous slide that some firms will exit the industry
when we have a free trade agreement,
but I didn't say which ones and when all the firms are the same
we don't know which ones and it doesn't really matter.
But with a little bit more structure to the model,
we can say some interesting things about which firms will exit the industry.
So here's the demand curve, marginal revenue curve,
and let's begin with MCH, a high marginal cost,
H for high.
Well, then we know that profit maximizing point
where marginal revenue is equal to marginal cost,
that will give us an operating profit given by this area.
I'm not going to clutter the diagram with an average cost curve,
so this is our operating profit before we take into account fixed costs.
Now here's the point: suppose we have another firm
which has lower marginal cost,
MCL, L for low.
Well for the same reasons we can then find it's operating profit
which is this much larger area.
Notice also
that the firm with lower costs,
it produces more and it sells at a lower price.
So a firm with lower costs has got higher profits,
it produces more, it sells at a lower price.
Also, notice that the markup of price above marginal cost
is bigger for the firm with lower costs.
That's one of the reasons of course why it's making a higher profit.
It's producing more
and its markup of price over marginal cost is bigger
than for the high-cost firm who has the smaller markup.
Now, let's go back and think about free trade.
There are going to be 2 effects of opening the market.
First, greater competition, as I said before,
and second, the bigger potential market.
Now all else being equal greater competition reduces profit.
However,
firms with lower costs are in the best position
to take advantage of the bigger market.
So think about that opportunity now
of the Canadian firm to sell in the US market.
This firm, the one with high costs,
it can't do very much with that opportunity.
Its costs are high
so it really can't expand very much at all
because it already has a low markup
so to expand it's got to lower the price
but since it's costs are high it can't expand that much.
On the other hand, the firm with low costs
it has lots of room to expand.
It has a high markup already,
it's costs are low,
so there's a big opportunity for it to lower price
to expand and to increase profit.
So the bottom line here
is that when we have free trade
it's the firms with the higher costs that are going to exit the market.
And as the firms with the lower costs,
which are going to expand and potentially begin to export.
Now what this means is that with a free trade agreement
you have changes in the composition of the industry.
In particular, industry costs are going to fall
or productivity is going to rise.
That is,
a larger share of the output of the industry
will be determined by the firms with the lower costs.
The firms with the lower costs are going to expand
these guys are going to contract and exit.
That means that overall industry costs are going to be closer to these guys.
So overall industry costs are going to decline.
That is a potentially huge effect,
a massive way of increasing productivity
by driving production to those firms with the lowest cost.
Let's take a look at the empirics.
Okay, here's some data on productivity in Canadian manufacturing firms
in 1988 just before the Free Trade Agreement in 1989
and in 1996
after the Free Trade Agreement had taken place
and after the transition to the new economy.
Now I want to focus first of all on the 1988 picture
just to explain how to interpret some of the things in this graph.
This is a log graph
and 0 is sort of an average productivity level.
A firm with a productivity level of 1
has a productivity which is almost 3 times higher
than a firm with a productivity level of 0.
And a firm with a productivity level of 4
has a productivity which is about 50 times higher
than one with the average productivity level of 0.
So even small changes in this graph can mean big differences in productivity.
Moreover,
this kind of distribution has been shown actually
to be typical across the world.
That's quite remarkable.
What that says is that even for firms in the same industry
producing a similar product,
some firms in those industry can be not twice, not three times,
not four times, but ten times,
twenty times more productive
than the average firm in that industry.
Because of these massive differences in productivity between firms
if there were a way to shift production from the low productivity firms
to the high productivity firms
we could have overall a massive increase in productivity.
And what we just showed in theory in the previous slides
was that free trade does exactly this.
Expanding the size of the market does exactly this.
And in fact, by 1996
after the Free Trade Agreement had been put in place
the entire productivity curve
for Canadian manufacturers shifted to the right.
So we had not firms which were 50 times
but firms which were more than 100 times more productive
than the average firm in 1988 had been.
So we had a reduction
in the number of low productivity firms,
these firms go away,
and we had an increase over here in the number of high productivity firms.
And what free trade did is it shifted production
from the low productivity firms to the high productivity firms
which expanded with free trade
and because the high productivity firms expanded
overall productivity increased.
In fact, the shift to higher productivity firms
created by the Free Trade Agreement increased Canadian productivity overall
by 8.4%.
That is a huge increase in productivity in just a short period of time.
Okay, we've covered a lot of meaty material,
here's some further reading.
The Melitz and Trefler which I have drawn from
is an excellent piece in the Journal of Economic Perspectives,
"Gains from Trade When Firms Matter" you can find that free in the web.
Once again Paul Krugman's 1979 piece was a seminal article.
The model of monopolistic competition with firms with different
levels of costs and the effect on trade,
that's worked out in detail in Melitz and Ottaviano.
And finally, Daniel Trefler's 2004 piece
looks in more detail at the empirical results
what happened with the Canada-US Free Trade Agreement.
Thanks!