Documenti di Didattica
Documenti di Professioni
Documenti di Cultura
PRODUCT DIFFERENTIATION
Introduction
We have seen earlier how pure external IRS can lead to intraindustry trade. Now we see how product dierentiation can
provide a basis for trade due to consumers valuing variety.
When trade occurs due to product dierentiation, even identical countries will trade by exchanging dierent varieties of the
same good. The value consumers place on variety generates
another source of gains from trade. IRS due to a xed cost
of producing each variety limits the number of varieties produced by a country. Two key versions of modeling preferences
for the dierentiated products are the love of variety approach
and the ideal variety (bliss point or spatial) approach. Both
provide a subutility function that increases in the number of
varieties available, but the love of variety approach is easier to
employ.
(5.1)
n
X
pi x i = I
(5.3)
i=1
(5.4)
pi x i = E
(5.5)
i=1
Love of Variety
Suppose the sub-utility function is a symmetrical CES function
!1
V =
n
X
xi
, <1
(5.6)
i=1
1
1
> 1 = 1
1
(5.7)
PRODUCT DIFFERENTIATION
V =
xi
"
E
= n
np
! # 1
!1
= (nx )
= n
(5.8)
1
E
E
= n 1
np
p
1
1 nV > 0
(5.9)
xi di
(5.10)
which can be more convenient. The goal is to maximize subutility V subject to the budget constraint
Z
(5.11)
pi xi di = E
xi di
+ E
pi xi di
(5.12)
1 1
xi di
x1
pi = 0
i
(5.13)
1 1
xi di
x1
pj = 0
j
(5.14)
xi
pj
=
xj
pi
PRODUCT DIFFERENTIATION
1
1
"
pj
=
pi
(5.15)
xj p1
p
di
=
x
p
p1
di
(5.17)
E=
j j
i
j
i
0
implies
Ep
Ep 1
j
xj = R n 1
= R j
n
1
di
0 pi
di
0 pi
(5.18)
An individual rm views 0n p1
di as xed and thus faces a
i
constant elasticity demand curve
xj = kp
j
(5.19)
where
E
(5.20)
1
di
0 pi
with demand elasticity equal to the elasticity of substitution
between a pair of the dierentiated goods.
Each rm chooses the price of its variety to maximize its
prots, taking as given the price charged by other rms. Assume that every variety is produced with the same production
function. Focus on a representative rm (producing a unique
variety), whose problem is to pick its price to maximize its
prots
= px C (x)
(5.21)
k Rn
Suppose the cost function takes the forms of a xed cost plus
a constant marginal cost
C (x) = b + cx
(5.22)
= (p c) x b = (p c) kp b
(5.23)
1
p 1
=c
(5.24)
(5.25)
PRODUCT DIFFERENTIATION
E
np
(5.26)
b b
b
(5.28)
Consumers
A large number of potential goods enter symmetrically into
utility according to the utility function
U=
n
X
ci , 0 < < 1
(5.29)
i=1
where ci is consumption of good i. Utility exhibits love of variety. Preferences exhibit a constant elasticity of substitution
between any two goods. Consumers choose their consumptions
PRODUCT DIFFERENTIATION
pi ci = I
i=1
!
n
n
X
X
max
ci + I
pi ci
c
i
i=1
i=1
where is the shadow price on the budget constraint (the marginal utility of income). The rst order conditions (FOC) are
c1
pi = 0, i = 1, . . . , n
i
(5.30)
1
c
i
(5.31)
xi
L
(5.32)
xi
pi =
L
(5.33)
1
Firms face a CES demand function with elasticity 1
. No
strategic interdependence among rms as the number of available varieties is assumed to be large. Each good i will be produced by only one rm: all rms dierentiate their product
from all products oered by other rms.
Producers
Suppose there is only one factor, labor. Let the cost function for each good be given by
li = + xi , > 0, > 0
(5.34)
PRODUCT DIFFERENTIATION
(5.35)
x 1 1
w( + xi )
i = i
L
The rst order conditions are
2!
1
1
i
=
x1
w = 0, i = 1, . . . , n
i
xi
(5.36)
(5.37)
xi 1 w
(5.38)
=
L
1
i = (p w) xi w =
1 xi w
(5.41)
=
(5.42)
(1 )
Equilibrium output increases in the xed cost of variety and
but decreases in the marginal cost parameter
x
x
=
> 0,
=
= 2
> 0,
<0
2
(1 )
(1 )
(1 )
(5.43)
Equilibrium output is constant across goods and independent
of the resources in the economy. An increase in resources L
increases only the number of varieties n that are produced (see
below), not the output of each variety x.
x = xi =
p
w
PRODUCT DIFFERENTIATION
Full Employment
(5.44)
L(1 )
L
=
+ x
(5.45)
L = n( + x) =
The above equations provide a complete description of the autarkic equilibrium in an economy. As resources L increase, the
number of available varieties n increases.
dn
1
=
>0
dL
(5.46)
(5.47)
(5.48)
International
Trade
Assume two countries (alike in every way except size) engage in free trade (with zero transportation costs). What does
trade do? Fixed costs in the production of each good create an
incentive to concentrate production within a rm. Increasing
returns to scale imply that concentration is ecient so that two
identical countries will specialize in the production of dierent sets of goods and intraindustry trade will occur in similar
but dierentiated products. Gains from trade stem from the
increased diversity of goods available under free trade due to
market expansion. Full employment determines the varieties
produced in each country under free trade
n=
8
L
L(1 )
=
+ x
(5.49)
PRODUCT DIFFERENTIATION
n =
L (1 )
L
=
+ x
Results
1. Both countries gain from trade because of increased diversity of goods. To see the gains from trade, compare
(domestic) utility under autarky
"
w
w
=n
UA =
np
np
(1 )
=n
(5.50)
UT = (n + n )
(1 )
(5.51)
n + n
UT
UR
=
UA
n
n
= 1+
n
>1
(5.52)
n + n
dUR
=
d
n
ln
n + n
n
<0
(5.53)
n
n
(5.54)
Gains from trade vanish as goods become perfect substitutes (lose love of variety).
PRODUCT DIFFERENTIATION
2. Direction of trade is indeterminate, but nothing important depends on which country produces (and thus exports) which good as the goods are symmetric. Of the
n + n goods consumed, n are imported by the home
country. The value of home country imports measured
in wage units equals value of foreign country imports, so
trade is balanced. Thus, the volume of trade is determinate.
3. One peculiarity of the model is that the output of each
good remains the same even under trade. Krugman (JIE
1979) develops a more general (but more tedious) model
where the scale of production of each variety does increase
with trade.
4. When there are transportation costs, bigger country has
the higher wage. Iceberg type transportation costs are
assumed: when send one unit of any good abroad, only
g 1 arrives as the rest melts on the way. The higher
wage in the bigger country gives a production cost advantage in the smaller country to oset the higher total
transportation costs paid to reach consumers.
5. Transportation costs lead to the home market eect
countries export those products for which they have bigger markets at home.
Consumers
Assume a general utility function
u=
v(ci )
10
PRODUCT DIFFERENTIATION
v0
i
and assume that
<0
00
v ci
ci
(5.55)
dci 1
dpi 1
=
ci pi
pi ci
which gives
dci /ci
pi
v 0 (ci )
= 00
= 00
dpi /pi
v (ci )ci
v (ci )ci
Since all consumers are identical, cL = xi . This along with
(5.55) gives
1 xi
pi = v 0 ( )
L
Producers
Cost function for a producer
li = + xi
A producer solves
max pi xi wli =
1 0 xi
v ( )xi w( + xi )
L
1
p 1
= w
w
1
Note that depends upon ci so in the above equation price still
depends upon an endogenous variable. Therefore, we need to
use the free entry zero prot condition in conjunction with the
p=
PRODUCT DIFFERENTIATION
11
=+ =+
w
x
cL
This denes the ZZ curve. Equilibrium price and quantity are
determined by the intersection of the two curves. Finally, the
equilibrium number of products is given by
n=
L
L
=
+ x
+ cL
Results
1. Eects of an increase in L: As L increases, the PP curve
is unaected but the ZZ curve shifts to the left. Thus,
both p/w and c fall. This implies n increases. Also, since
p/w falls, x also increases. Thus, with an increase in the
labor force, price to wage ratio falls (real wage increases),
output of each good increases, and the number of goods
produced increases. Conceptually, some of the increased
labor goes to increased output while some of it goes to
the production of more varieties, this is why per capita
consumption of each good falls not all of the increase
in L goes toward increasing x.
2. Trade: Very much like the rst model. Expansion in
the number of varieties for each consumer, also increased
output and lower prices. Welfare gains.
3. Factor Mobility: The bigger country will have a higher
real wage. Incentive to migrate from the small country
to the big.
PRODUCT DIFFERENTIATION
an industry as well as cross industries (intra- and inter- industry). In addition, it gives the realistic prediction that the
degree of intra-industry trade increases with the similarity of
the two countries factor endowments. The model also makes it
feasible to assess the distributional eects of the two types of
trade.
Model
Two sectors with dierentiated goods
N1
N2
X
X
u = ln
c1i
+ ln
c2j
i
and
l1i = L1 = 2 z
L2 = z
Equilibrium
As before, we have
p1 =
w1 and p2 = w2
and
PRODUCT DIFFERENTIATION
13
n1 =
2z
z
and n2 =
+ x1
+ x2
|Xk Mk |
I = 1 P
Xk + Mk
L1 = 2 z; L2 = z
L1 = z; L2 = 2 z
If z = 1, resources are identical in the two countries. As z
increases, factor proportions diverge: when z = 0, each country
has only one factor.
Under free trade, prices and wages are equalized (note that
w1 = w2 in each country). The zero prot condition gives the
output of each good in terms of parameters. We have
xi = x =
(1 )
As always, full employment condition gives the number of equilibrium products in each country. What can we say about the
volume of trade? Let Y denote the national income in both
countries (Y = wi Li ). Equal factor prices imply equal income.
14
PRODUCT DIFFERENTIATION
Y 2z
Y z
and X2 =
2 z
22
Similarly,
Y (2 z)
z
and M1 = Y
2
2
Substitute the above exports and imports into the Grubel-Loyd
measure of intra-industry trade and we get
M2 =
I =z
This is a striking result! The degree of intra-industry trade
exactly equals the degree of similarity between the factor endowment of the two countries. What can we say about the
welfare consequences of such trade? The basic message is that
distributional consequences are not serious if the countries are
similar enough intra-industry trade is politically more palatable since everyone benets from it.
Individuals split their income equally into the two sectors
and within each sector, consumers buy all goods. Thus we have
U = ln n1
w
2n1 p1
! 1
+ ln n2
w
2n2 p2
! 1
w
1
1
w
ln n1 +
ln n2
+ ln +
p1
p2
2z
z
1
2 2
2 1
ln z ln 2 z +
ln 2
=
U T U A = ln
From the above we can conclude the following. First if < 0.5,
scarce factor also gains. When is small, diversity matters a lot
to the consumer. Second, if > 0.5 and if z > z, both factors
still gain z above a threshold implies sucient similarity in
factor endowments.
PRODUCT DIFFERENTIATION
15
Model
Two goods: wheat W and manufactures M
Two factors: capital K and labor L
Wheat has CRS technology
Manufactures has IRS. Dene M = km where k is an
index of scale economies and m is the size of operation
in the M industry (how much of the economys K and
L is in M . You can think of m as the output from a
neoclassical production function).
16
PRODUCT DIFFERENTIATION
mi
xi
Final Good
All components are assembled through a symmetric CES
production function
M =n
xi
!1
M = n (
x ) = n (nx ) = n x = n1 [nx]
17
qi xi such that n (
x ) = 1
"
n
1 X
xi
i=1
# 1 1
x1
pi = 0
i
"
n
1 X
x
i=1 i
# 1 1
xj1 pj = 0
xi
qj
=
xj
qi
1
1
Components
We know
xi = xj
"
qj
qi
1
1
i = qx + T (m)(b + ax)
18
PRODUCT DIFFERENTIATION
x=
T (m)b
q + T 0 (m)a
x=
T (m)b
T (m)a
+ T 0 (m)a
b
a(1 )
m(1 )
b
(1 )
b
!1
1
m
a
Autarky
Set PW = 1 and let P =
of M requires that
PM
PW
PS M = qnx PS n x = qnx
which gives
PS = qn1
which can be rewritten using values of q and k and n as
0
T (m)
T (m)m
PS =
=
M
k(m)
Note that due to IRS, the supply function is downward sloping.
On the demand side we assume homothetic preferences
U (M, W ) = M W 1
PRODUCT DIFFERENTIATION
19
T (m)
1 k(m)m
International
Two economies that dier only in terms of factor endowTrade
(opments. Denote foreign country by asterisks. If both countries
tional)
continue to make both goods, they will specialize in dierent
components. Let nH and nF denote their numbers.
n = nH + nF =
(m + m )(1 )
b
M +M = k(m+m )(m+m ) =
k(m+m )
(1 )
b
}|
!1
(m + m )1 (m+m )
1
M +M
1
b
(1 )
!1
T (m) + S(m )
(m + m )
aT (m)
T (m)
= [(1 )(m + m )/b]1
=
k(m + m )
PRODUCT DIFFERENTIATION
The HAC indicates for each m the foreign allocation of resources for which the home economy is in equilibrium in world
markets: m and m are on the HAC if the demand price that
clears the world market for the two goods is equal to home
supply price for which the domestic producers are willing to
supply W = T (m) and M = k(m + m )m: their share of
the world output that is required to clear the market for both
goods, given that the foreigners are supplying the rest (S(m )
and M ). Simple calculations show that it is downward sloping. Furthermore, PD < PSH above the curve and vice versa
below it. mo denotes complete specialization points. Similarly,
the Foreign Allocation Curve (FAC) is dened by
0
T (m) + S(m )
S (m )
=
k(m + m )
1 M + M
International equilibrium is given by the intersection of the two
curves.
Intraindustry
Intraindustry trade has a factor endowments basis and it is
Trade
and
complimentary to international factor mobility similarity of
Complemenendowments leads to more intraindustry trade.
tarity
First, both countries specialize in dierent types of components, if they both produce M. Home countrys import and
export of components are given by
MC = nF gx and XC = nH x(1 g)
where g equals domestic national income as a fraction of world
income, i.e.,
g=
PM + W
P (M + M ) + W + W
|XC MC |
XC + MC
which gives
=
2gnF
if nH nF
(1 g)nH + gnF
2(1 g)nH
if nH nF
(1 g)nH + gnF
and
PRODUCT DIFFERENTIATION
21
Fate of the
HOS Theory
PRODUCT DIFFERENTIATION
3. Stolper Samuelson: The standard result holds with respect to the change in price of components relative to
wheat. But what we care about is manufactures since
thats whats consumed the essence of the StolperSamuelson theorem is its prediction about changes in real
rewards. So what can we say about that? Things are
more complicated here. There are two competing eects
and results depend upon which of the two dominates.
First dene the nominal price of a component
PC = qPW
Note that
PM = n1 PC
which gives
b
PbM = PbC ( 1)n
PRODUCT DIFFERENTIATION
23