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6 Increasing Returns to Scale and Imperfect Competition
Notes to Instructor
Chapter Summary
In the Ricardian and modified specific-factors model as well as in the Heckscher–Ohlin
model, we assumed perfectly competitive markets, where there are many firms, each
producing a homogeneous product, and where no firm is able to influence the market
price. In this chapter, we drop the assumption of perfectly competitive markets. We will
now assume imperfect competition, where firms are now able to influence the price of
their product.
There are many forms of imperfect competition that result from the breakdown of
assumption(s) of perfect competition. The market power that originates from the
Two new explanations for trade will be explored in this chapter that arise as a direct
result of the monopolistic competition model. Both of these additional reasons for trade
are a result of the two main characteristics of this model. The first characteristic is
product differentiation and the second feature is increasing returns to scale, where the
average costs for a firm fall as greater output is produced.
The second feature of monopolistic competition is increasing returns to scale. Here, firms
specialize in the product lines that are most successful, and by selling more of those
products, the average costs of production fall for them. Firms can lower their average
costs by selling not just in their own home markets but can achieve even lower costs by
selling in larger foreign markets, thereby increasing the size of the markets they reach.
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Comments
By now, students should have a good understanding of the concept of comparative
advantage as the basis for trade. To get them thinking about the monopolistic competition
model and product differentiation, find out how many prefer Coca Cola versus Pepsi
Lecture Notes
Introduction
Due to proximity, resources, and comparative advantage, the United States imported
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By contrast, the United States imported golf clubs valued at $399 million from 25
countries and exported $157 million of the product to about 66 countries in 2014. Panel
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(a) of Table 6-1 shows that China is the top-selling country of golf clubs to the United
States, with $340 million sold at an average price of $25 each. Taiwan comes in at a
distant second at $25 million; however, its average price is considerably higher at $62
To explain why the United States is both an importer and exporter of golf clubs, we
introduce a market structure called monopolistic competition, whereby countries trade
goods that are similar but not identical to each other. In other words, a firm is able to
maintain some monopoly power by differentiating its products from those of its
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1 Basics of Imperfect Competition
Monopoly Equilibrium We begin by reviewing the monopoly and duopoly market
cases. Understanding how demand is determined within these two types of markets will
help to explain how demand is determined in the monopolistic competitive market.
Recall from your principles course that as the sole producer in a market, the demand
curve faced by the monopolist is the industry demand curve. As shown in Figure 6-1, the
industry demand curve, D, is downward-sloping, which means that the monopolist must
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Demand with Duopoly By adding one additional firm to the industry, we have a
duopoly, where the industry demand curve, D (illustrated in Figure 6-2), is shared
between the two competitors. If they charge identical prices, each firm faces one half of
the industry demand, D/2. Namely, at the price of P1, the industry demand is at point A so
that each firm sells the quantity Q2, which is half of the total market demand Q1. If the
product is homogeneous, one of the firms will be able to capture the entire market simply
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the price to P2 if the first firm maintains its price at P1.
2 Trade Under Monopolistic Competition
We will now turn to the monopolistic competition model beginning with assumption 1.
Assumption 1: Each firm produces a good that is similar to but differentiated from the
goods that other firms in the industry produce.
Assumption 2: There are many firms in the industry.
Assumption 3: Firms produce using a technology with increasing returns to scale.
Increasing returns to scale technology means that the average cost of production
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Numerical Example For simplicity, let’s look at a numerical example with a firm that
has constant marginal costs similar to those depicted in Figure 6-3. Suppose the firm has
the following costs of production:
From the following table, we see that average cost for the first ten units of output is $20
each. Notice that marginal cost is lower at $10 per unit. Because MC is less than AC, the
firm would be able to lower its average costs by increasing the quantity produced. With
the next additional 10 units produced, the firm’s AC decreases to $15 per unit.
Quantity, Q
Variable costs
= Q • MC
Total Costs =
Variable Costs+
Fixed Costs (FC =
$100)
Average Costs =
Total Costs/Quantity
10
$100
$200
20
20
200
300
15
30
300
400
13.33
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Assumption 4: Firms can enter and exit the industry freely, so monopoly profits are zero
in the long run.
Equilibrium Without Trade
Short-Run Equilibrium As shown in Figure 6-4, a firm in a monopolistic competition
faces a downward-sloping demand curve, d0. This is because consumers view its product
to be different from that of other firms in the industry. In the short run, a monopolistically
Long-Run Equilibrium Attracted by the monopoly profits and given the assumption of
free entry into the industry, new firms will provide similar, albeit not identical, products
to existing consumers. With the availability of new product varieties, some consumers
will switch their purchases to the new firms, causing the demand curve, d0, for the
established firm to shift to the left. In addition to losing some consumers who opt to try
the new varieties, the firm faces a more elastic demand curve as consumers become more
price-sensitive given the increasing number of close substitutes.
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and price, PA, the firm is making zero profits because price equals average costs.
We now introduce another demand curve, D/NA, to Figure 6-5 before examining trade
under monopolistic competition. This demand curve, derived from dividing the total
market demand, D, by the number of firms in autarky, NA, reflects the quantity that
demanded that is faced by each firm when all competitors charge the same price. The
Equilibrium with Free Trade
Suppose firms in both Home and Foreign are monopolistically competitive. For
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simplicity, further assume that the two countries are identical in terms of size, number of
consumers and firms, and technology and cost curves. Note that without the assumption
of increasing returns to scale, the two countries would not engage in trade given their
Short-Run Equilibrium with Trade We begin with the no-trade equilibrium given by
point A in Figure 6-5, which is reproduced in Figure 6-6. As the two countries engage in
trade, the number of consumers each firm can serve doubles. Likewise, there are twice as
many firms available to consumers in each country so that the demand curve, D/NA,
remains the same (i.e., 2D/2NA = D/NA). However, with the doubling of the number of
However, motivated by the same incentive to attract consumers from other firms by
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lowering prices, every firm in the industry will make the same decision. This collective
Long-Run Equilibrium with Trade The losses will cause some firms to leave the
industry, reducing the product varieties available to consumers and increasing demand for
surviving firms. The number of firms remaining in each country after trade, NT, is less
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greater product variety with trade, the demand curve, d3, facing each firm is more elastic
than with absence of trade. The intersection of the marginal revenue curve, mr3, with the
Gains from Trade In general, consumers gain as a result of trade under monopolistic
competition. In particular, consumers benefit because of the reduction in the price, as
reflected by the increasing returns to scale the firms remaining in the industry receive.
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Adjustment Costs from Trade Nevertheless, to fully examine the overall effect of trade
when firms compete under imperfect competition, we need to also analyze the short-run
3 The North American Free Trade Agreement
Although the notion that trade could lead to an increase in product varieties was
discussed earlier by David Ricardo, the introduction of the monopolistic competition
Gains and Adjustment Costs for Canada Under NAFTA
The gains and losses for Canada after joining the Canada–U. S. Free Trade Agreement
(CUSFTA) were examined by economist Daniel Trefler at the University of Toronto.
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However, real earnings in Canada rose by a modest 2.4% for production workers or .3%
per year in spite of the 0.7% per year in productivity growth in manufacturing, suggesting
that perhaps manufacturing workers did not entirely share in the gains from productivity.
Gains and Adjustment Costs for Mexico Under NAFTA
As part of its economic reforms, Mexico joined NAFTA along with the United States and
Canada in 1994. Under NAFTA, Mexican tariffs on U.S. goods declined from 14% in
H E A D L I N E S
Nearly 20 Years After NAFTA, First Mexican Truck Arrives in U.S. Interior
On October 21, 2011, the first big-rig truck from Mexico crossed the border into Laredo,
Texas, under a trucking program that was agreed to in NAFTA, but took nearly 20 years
to implement. The Obama administration finally signed an agreement with Mexico to end
the long dispute over the NAFTA provisions that Mexican trucks be permitted into the
Productivity in Mexico We can examine the growth in labor productivity in Mexico, as
shown in panel (a) of Figure 6-8 for maquiladora plants—those near the U.S. border,
producing mostly for export to United States—and for all other non-maquiladora
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Real Wages and Incomes Panel (b) of Figure 6-8 shows the real wages in the
maquiladora and non-maquiladora plants. Between 1994 and 1997, the real wages for
Mexican workers fell by over 20% in both non-maquiladora and maquiladora plants. The
