36 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Ninth Edition
and describes, for example, the trading of one type of manufactured good for another type of manufactured
good. It is shown that trade can occur when there are no technological or endowment differences, but when
there are economies of scale or increasing returns in production.
Economies of scale can either take the form of (1) external economies, whereby the cost per unit depends
on the size of the industry but not necessarily on the size of the firm; or as (2) internal economies, whereby
the production cost per unit of output depends on the size of the individual firm but not necessarily on the
size of the industry. Whereas Chapter 7 looked at external economies of scale, this chapter focuses on internal
economies of scale. Internal economies of scale give rise to imperfectly competitive markets, unlike the
perfectly competitive market structures that were assumed to exist in earlier chapters. This motivates
the review of models of imperfect competition, including monopoly and monopolistic competition.
The instructor should spend some time making certain that students understand the equilibrium concepts
of these models since they are important for the justification of intraindustry trade.
In markets described by monopolistic competition, there are a number of firms in an industry, each of which
produces a differentiated product. Demand for its good depends on the number of other similar products
available and their prices. This type of model is useful for illustrating that trade improves the trade-off
between scale and variety available to a country. In an industry described by monopolistic competition, a
larger market—such as that which arises through international trade—lowers average price (by increasing
production and lowering average costs) and makes available for consumption a greater range of goods.
While an integrated market also supports the existence of a larger number of firms in an industry, the
model presented in the text does not make predictions about where these industries will be located.
It is also interesting to compare the distributional effects of trade when motivated by comparative advantage
with those when trade is motivated by increasing returns to scale in production. When countries are similar
in their factor endowments, and when scale economies and product differentiation are important, the income
distributional effects of trade will be small. You should make clear to the students the sharp contrast between
the predictions of the models of monopolistic competition and the specific factors and Heckscher-Ohlin
theories of international trade. Without clarification, some students may find the contrasting predictions
of these models confusing. The chapter presents the case study of the 1964 North American Auto Pact
which lowered trade barriers in trade of automotive products between Canada and the United States.
With trade driven by internal economies of scale, the smaller country tends to gain more from trade.
This is supported by the increase in exports of automotive products from Canada to the United States,
rising from $16 million in 1962 to $2.4 billion in 1968.
Another important issue related to imperfectly competitive markets is the practice of price discrimination,
namely charging different customers different prices. One particularly controversial form of price
discrimination is dumping, whereby a firm charges lower prices for exported goods than for goods sold
domestically. This can occur only when domestic and foreign markets are segmented. The economics
of dumping are illustrated in the text using the example of an industry which contains a single monopolistic
firm selling in the domestic and foreign markets. While there is no good economic justification for the view
that dumping is harmful, it is often viewed as an unfair trade practice. The chapter concludes with a
discussion of foreign direct investment (FDI). FDI may be horizontal or vertical. With horizontal FDI, a firm
replicates its production process in multiple locations. With vertical FDI, a firm breaks up its production
chain across multiple locations. The decision by a multinational to engage
in FDI is driven by a proximity-concentration trade-off. Internal economies of scale give an advantage to
locating all production in one location. However, trade costs increase the cost of exporting from a single
location. Thus, FDI is more likely when trade costs are high and internal economies of scale are low. Finally,
a multinational must decide whether to engage in direct foreign production through a foreign affiliate or
to engage in outsourcing. The former is more likely when the multinational has a proprietary technology
that it is concerned about losing control over or if foreign firms cannot produce as efficiently as direct
production through a foreign affiliate.
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