The New Trade Model

Latest iteration

Gains from trade so far:
- different technology.
- different factor of endowment.
Today:
- product variety.
- productivity improvement from selection.

Internal economies of scale

We relax perfect market a bit: non-trivial fixed cost.
Consequently, average cost goes down with scale.
Meaning, a market can only host a limited number of firms.
In reality, fixed cost come in many firms: R&D, network, machines, etc.

Internal economies of scale

In reality, there are some industries where the global market only shared by small number of MNCs.
- semiconductor, aeroplane, software, soft drink.
In this context, trade brings more gain:
- the most efficient firms will dominate market and push cost down.
- inefficient firms exit.

example: mobile phone

Source: StatCounter Global Stats - Device Vendor Market Share

Monopolistic competition

In monopolistic competition, firms have some ability to control price.
Condition which enable this:
- Few number of players.
- DIfferentiated products.
Product differentiation may come from various aspect:
- Technology: smartphones, OS, recipe.
- Network effect: social media, apps store, Gojek/Grab.

Monopoly: a brief review

Assume an industry face demand \(Q=a-bP\)
\(P\) is not exogen (why?), thus rearrange:
- \(P=\frac{a}{b}-\frac{Q}{b}\)
Revenue in the industry \(R=Q\times P\), subs \(P\):
- \(R=Q \times \left(\frac{a}{b}-\frac{Q}{b}\right)\)
- \(MR=\frac{a}{b}-2\frac{Q}{b}=P-\frac{Q}{b}\)

Monopoly: a brief review

Total cost: \(C=F+cQ\)
Marginal cost: \(c\)
Average cost: \(\frac{F}{Q}+c\)
as \(Q \rightarrow \infty\), \(\frac{F}{Q} \rightarrow 0\)
The larger F, the larger Q is required.

The cost curve

AC2 has a higher fixed cost, thus requires more Q to reach “flat-ish” part of the cost curve.

Monopoly Q

monopolist akan memaksimalkan profit di MR=MC
pastinya akan ngecharge P>AC
profit \(=(P-AC)Q\)

Monopolistic competition

Characteristics of monopolistic competition industries:
- Firms can differentiate.
- Rival’s price is exogenous.
- free entry.
We also introduce high fixed cost!
- while entry is free, a firm must pay some fixed cost.
Can you mention some examples?

Karakteristik monopolistic

\[ Q=S\times\left[1/n-b(P-\bar{P})\right] \] - Q = total sales of individual firm - S = total sales of the industry - n = number of firms - b = elasticity of supply - P = firms’ price - \(\bar{P}\) = rival’s price index

Karakteristik monopolistic

\[ Q=S\times\left[1/n-b(P-\bar{P})\right] \]

A firm’s sales go up if total sales of the industry goes up and/or rivals’ price go up.
A firm’s sales goes down if the number of firms go up and its own price go up.
All firms are identic: \(P=\bar{P}\), all firms share the market equally \(S/n\)
\(AC=\frac{F}{Q}+c \Rightarrow AC=n\frac{F}{S}+c\)

Monopolistic characteristics

\(AC=n\frac{F}{S}+c\)

Average cost goes up as numbers of firm go up. This is because firms’ market share goes down. berkurang.
As the overall pie goes up, average cost go down: the fixed cost can be shared among more sales.
With a linear demand \(Q=a-bP\), firms produce at MR=MC
\(P-\frac{Q}{Sb}=c \rightarrow \frac{Q}{Sb}=P-c \rightarrow P-c=\frac{1}{nb}\)

Monopolistic Characteristics

\(P-c=\frac{1}{nb}\)

As the number of firms go up, \(P-c\) (markups) goes down.
- Since c is exogenous, reduction of markups is driven by \(P \Downarrow\)
- More firms, less market share, P must go up to avoid loss.
Firms will keep coming in as long as there’s profit.
In the long-run, number of firms settles at \(P=AC\)

Monopolistic

Any higher than \(n^*\), firms cost is too much.
Any lower than \(n^*\), mark-up will go up, incentives for new entrant to join.

Trade & monopolistic

\[ AC=n\frac{F}{S}+c \\ P=\frac{1}{nb}+c \]

Opening to trade increases the market size.
- \(S \uparrow\) increase AC (less share per firm), but pricing is unaffected.
- New equilibrium is lower price and more firms in the market.
More firms->more varieties.

Nummeric examples

Let an automotive industries as follows:

\[ Q=S\times[(1/n)-(1/30000)\times(P-\bar{P})] \\ \]

with this cost structures:

\[ AC=750000000/Q+5000 \]

Let home sells 900k vehicles a year while foreign produces 1,600k.

Numeric examples

Contoh numerik

	Home, no trade	Foreign, no trade	Integrated market
Output	900,000	1,600,000	2,500,000
n	6	8	10
Output per firm	150,000	200,000	250,000
AC=P	10,000	8,750	8,000

Highlighted feature

Even when both countries have the same technology (identical cost structure), trade brings positive impact.
Monopolistic competition is benefited from intra-industry trade.
- Export car but also import car.
- Think of Toyota and Ford.
more car variety: from 6 & 8 brands to 10 brands for both countries.

Highlighted feature

Note that intra-industry trade is more beneficial for Home
- price reduces by 2k, foreign only by 750.
This is because home country have a smaller market.
- The smaller the market, the less fixed cost is shared.
- This is why small countries like Singapore, Malaysia, Vietnam and Thailand pursue FTAs vigorously.

Firms response to trade

From 14 brands of car, only 10 survives.
These 10 brands get more market share, hence able to reduce cost.
Since all firms are identical in our analysis, we do not care who out and who’re staying.
However, in the real world, firms are not identical: 4 firms who exit must be the worst performers.

Firms response to trade

Market integration forced firms with worse cost structure to exit.
If the fixed cost to enter the industry is the same, cost variation will come from variable cost.
Then there’s a threshold \(c^*\) where all firms with \(c>c^*\) exit.

More gain from trade

This, in turn, adds to the gain from trade:
- worst firms will exit, only firms with \(c<c^*\) stays.
- meaning, price index further even more from lower average variable cost.
- If 5 worst students drop out, average GPA will go up.
Firms who exit will be absorbed by the stayers: either naturally or through acquisition/joint-venture.

Export cost

We can associate a fixed cost with export cost:
- establish presence, market research, finding partners.
- Only the most productive firms join the global market.
Opposite argument is also true:
- Learning by doing: As the firm keeps on exporting, they learn from the global market and become much more productive.

Multinationals and FDI

In general, FDI is considered more costly than ekspor.
Greenfield FDI: Brand new investment.
Brownfield FDI: purchasing someone else’s asset.
Horizontal FDI: Replicating domestic success.
Vertical FDI: global value chain.

Multinationals and FDI

Horizontal FDI is done under high trade cost.
- the goal is market access. Usually will not export to other countries.
Vertical FDI: the goal is to supress cost.
- Low-tech countries can export high-tech goods.
- Requires low trade cost, and possible large intermediate imports.
- leads to intrafirm trade.

Intrafirm Trade

Analyzing between-country trade is getting less relevant as the importance of intrafirm trade improves.
Half of total imports of US are intrafirm. However, around 10% of US trade with Indonesia is intrafirm.
The difference between exporters and non-exporters is mostly driven by firms that both import and export. This is true also in Indonesia.
Amiti and Konings (2007) show that a reduction of import tariff by half improves productivity of an importing firm by 12%, which is larger than the reduction of output tariff by destination countries.
Channels: foreign technology embeded in the inputs, variety of inputs, cheaper and higher quality inputs.
Others try to find more evidence for Indonesia (e,g., Pane and Patunru 2019, Gupta 2020), but data availability in firm level remains a huge challenge.