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Economies of Scale,
Imperfect Competition, and
International Trade
Chapter 6
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1 Introduction
we will examine
 The effect of relaxing the assumptions on
which the H-O theory rests.
 Int’l trade based on economies of scale
 Int’l trade based on imperfect competition
 Int’l trade based on differences in dynamic
changes in technology among nations
 The effects of transportation costs
 External economies and their importance for
international trade
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Key Terms
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Differentiated products
Externatal economies of scale
Footloose industry
Increasing returns to scale
Intr-iindustry trade
Monopoly
Nontraded goods and services
Oligopoly
Product cycle model
Resource-oriented industry
Technological gap model
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2 Limitations of H-O Model
Some of the assumptions are not valid. Some
of the international trade can not be explained
by the H-O theory.
H-O
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2.1 Relaxation of the
Assumptions in H-O Model
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2x2x2 Model
Both nations use the same technologies
X is L-intensive and Y is K-intensive
Constant returns to scale
Incomplete specialization
Equal tastes
Perfect competition
Internal factor mobility
No transportation costs.
All resources are fully utilized
Exports equal imports
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2.2 Summary of the
Relaxation
Which assumptions Which assumptions are
are invalid when we still good or basically
valid when we relax them?
relax them?
Constant
returns to
scale
Perfect competition
No differences in
technological change
among nations

2x2x2 model
 X is L-intensive and Y is
K-intensive
 Incomplete specialization
 Internal factor mobility
 Equal tastes
 No transportation costs
 All resources are fully
utilized
 Exports equal imports
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3 Increasing Returns to Scale
They mean that the output grows
proportionally more than the increase in inputs
or factor of production, e.g. a 10% increase in
input leads to more than 10% increase in output.
It occurs because at a large scale of
production a greater division of labor and
specialization becomes possible. Large scale of
operation may permit the introduction of more
specialized and productive machinery than
would be feasible at a smaller scale of operation.
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3.1 Trade Based on
Economies of Scale
Two nations are identical
in every respect.
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3.2 Important Conditions for
Economies of Scale
It is a matter of complete indifference which
nation specializes in the production of X or Y.
Specialization may result from historical
accident.
It should be clear that the two nations need
not be identical in every respect for mutually
beneficial trade to result from increasing returns
to scale.
If economies of scale exist for a long time on
the basis of a large amount of output, one or few
firms in the nation will capture the entire market
for a given product, leading to monopoly or
oligopoly. ANHUI UNIVERSITY OF FINANCE & ECONOMICS
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3.3 Internal and External
Economies of Scale
Internal economies of scale:
As the firm expands its output, the average
cost of production goes down. Increasing
returns to scale are internal to the firm.
External economies of scale:
It refers to the reduction in each firm's
average costs of production as the entire
industry output expands.
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3.4 Preference Similarity
Trade in manufactures is likely to take place
among countries that have similar tastes and
income levels.
If their incomes and
tastes are similar, they
would consume the same
kind of commodities. So
there would be some trade
between them.
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3.4 Preference Similarity
Product
Quality
Pw
b
Overlapping Demand
a
Similar
Income
O
Nation 1
Nation 2
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4 Intra-industry Trade
International trade can be classified
into two groups:

Inter-industry trade and Intra-industry trade;
 The former means the international trade takes
place between industries and the latter means
the trade in the same industry.
 Intra-industry trade involves the exchange of
differentiated products. They are produced in the
same industry but with different designs and
brands.
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4.1 Reasons for IIT
Reasons for Intra-industry trade
• To make use of economies of scale;
• To produce few varieties of the same products
to reduce the costs. With few varieties, more
specialized and faster machinery can be
developed for a continuous operation and a
longer production run.
Who will benefits from the trade?
• The producers will benefit because they can
produce at lower costs. The consumers will
have wider range of choices and will buy at
lower prices.
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4.2 Comparisons between H-O
Model & IIT
The
basis for trade
Prediction of trade patterns
Gains from trade
Trade contents
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4.3 Summary of the Comparison
Comparative advantage seems to determine
the pattern of inter-industry trade, while
economies of scale in differentiated products
give rise to intra-industry trade.
The more dissimilar are factor endowments,
the more important are comparative advantage
and inter-industry trade. On the other hand, intraindustry trade is likely to be dominant the more
similar are factor endowments.
Lancaster (1980): Inter-industry trade reflects
natural comparative advantage while intraindustry trade reflects acquired comparative
advantage.
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4.4 Measurement of IIT
X M
T  1
X M
What is the trend of
intra-industry trade?
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4.5 Shares of IIT in Some Nations
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4.7 Production and Pricing Under
Monopolistic Competition
What is AC, MC and MR? Why do they look like that?
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4.8 Monopolistic Competition & IIT
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4.9 Relationship between Interand Intra-industry Trade
Nation 1 is labor abundant and X is Lintensive, nation 2 has a relative abundance of
capital and Y is K intensive. If X and Y are
homogeneous, nation 1 will export X and import
Y, while nation 2 will export Y and import X as
postulated by the H-O theory.
If X and Y are differentiated, nation 1 will still
be net exporter of X (inter-industry trade and
based on comparative advantage), but it will also
import some varieties of X and export some
varieties of Y (IIT and base on economies of
scale).
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4.10 Conclusion
When products are homogeneous, we have
only inter-industry trade. But when products are
differentiated, we have both inter- and intraindustry trade.The more alike nations are in
factor endowments and technology, the smaller
is the importance of inter-industry trade relative
to intra-industry trade.
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5 The Product Cycle Model
When a new product is introduced, it requires
highly skilled labor. As the product matures and
acquires highly mass acceptance, it becomes
standardized, it then can be produced by mass
production techniques and less skilled labor.
The comparative advantage in the product
shifts from the advanced nation that originally
introduced it to less advanced nations, where
labor is relatively cheaper. It is accompanied by
FDI from the innovating nation to nations with
cheaper labor.
Skill-intensive
Capital-intensive
Labor-intensive product.
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5 The Product Cycle Model
High-income and L-saving
products are to be introduced.
The opportunities to make
new products are greatest in
rich nations.
The new products need to
be close to markets so as to
get feedback from consumers
and modify the products.
It is easier to provide
services
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5 The Product Cycle Model
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5.1 The Technological Gap Model
A great deal of international trade is based on
the introduction of new products and production
process. As the most technologically advanced
nation, the United States exports a large number
of new products.
However, as foreign producers acquire the
new technology, they eventually are able to
conquer markets abroad, and even the U.S.
market for the product, because of their lower
costs. This model was sketched by Posner in
1961.
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5.1 The Technological Gap Model
Nation A’s Production
and Consumption
Nation A’s
Production
To
T1
T2
Nation B’s
Productio
n
Nation B’s Production
and Consumption
T3
T4
Nation B’s
Export
Time
Nation A’s
Imports
To---T1: Demand lag;
To---T2: Response lag;
T2---T3: Control lag in technology;
To---T3: Imitation lag;
T1---T3:Trade period
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5.2 Difference between Technological
Gap Model and Product Cycle Model
Technological gap model emphasizes the time
lag in the imitation process.
The product cycle model stresses the
standardization process.
According to these models, the most highly
industrialized nations are expected to export
nonstandardized products embodying new and
more advanced technologies and import
products embodying old and less advanced
technologies. On the other hand, developing
nations import non-standardized products and
export standardized products.
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5.3 Conclusions of Trade Theories
The more different countries are in factor
endowments, the more likely it is that they may
have inter-industry trade. The more alike
countries are in factor endowments, the more
likely they may have intra-industry trade.
So H-O model is most appropriate to explain
trade in raw materials, agricultural products and
labor intensive manufactured products, while the
new trade theories based on economies of scale
and differentiated products are most appropriate
to explain intra-industry trade.
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6 Transportation Costs
They refer to all the costs of transferring
goods from one location to another, such as
freight charges, costs for loading and unloading
and insurance premiums while goods in transit.
A homogeneous good will be trade
internationally only if the pretrade price
difference in the two nations exceeds the costs
of transporting the goods from one nation to the
other.
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6.1 Nontraded Goods
Nontraded goods and
services refer to the
goods and services that
can not be traded
because the
transportation costs
exceed price differences
across nations, such as
haircut.
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6.2 Illustration of Transportation
Costs
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6.3 Transportation Costs &
Location of Industry
Transportation costs also affect international
trade by influencing the location of production
and industry. Industries can be classified as
resource oriented, market oriented and
footloose industries.
 Resource-oriented industries
 Market-oriented industries
 Footloose industries
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7 Questions for Discussion
• What is meant by economies of scale? How
can they be the basis for international trade?
• What is product differenciation? How can
international trade be based on product
differenciation?
• How can intra-industry trade be measured?
What are the shortcomings of such a
measure?
• What do we mean by monopolistic
competition? Why do we use this to examine
intra-industry trade?
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THANK YOU!
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