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ECONOMICS
Richard Baldwin
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Richard Baldwin
Good 1
Good 2
Home
Good 2
Good 1
Good 3
Good 3
RoW
Partner
Economics
border price
internal price
XSR
MSMFN
XSP
MSPTA
P
P
P FT
MSFT
P
P FT
PT
PT
e
P T
MD
XR
RoW
exports
XP
71
Partner
exports
Home
exports
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Richard Baldwin
border price
XSP
D2
P
D1
C1
PT
B
P T
C2
MD
NB: C1 = D1
PTA
exports
XR XR
Home
imports
Economics
73
Figure 3.4. Effects of Preferential Frictional Barrier Liberalization on Prices and Imports
RoW
Partner
border price
Home
border price
domestic price
MSMFN
MSPTA
XSP
XSR
P
P
T
P T
P T
T
P*
MD
XR
XR
RoW
exports
XP XP
Partner
exports
Home
exports
Figure 3.5. Welfare Effects of Preferential TBT Liberalization: Viners Ambiguity Vanishes
euros
euros
XS
A
P
F
P
D
P T
MD
P T
XP
XP
exports
XR XP
imports
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Richard Baldwin
duo
BE (break-even) curve
COMP
curve
n=1 n=2
number
of firms
Economics
The competition (COMP) curve. It is easy to understand that imperfectly competitive firms charge a price
that exceeds their marginal cost; they do so in order to
maximize profit. But how wide is the gap between price
and marginal cost, and how does it vary with the number
of competitors? These questions are answered by the
COMP curve.
If there is only one firm, the price-cost gapthe markup
of price over marginal costwill equal the markup that a
monopolist would charge. If more firms are competing in
the market, competition will force each firm to charge a
lower markup. This competition-side relationship between
the markup and the number of firms is shown in figure 3.6
as the COMP curve. It is downward sloping because competition drives the markup down as the number of competitors rises, as explained above. We denote the markup by
the Greek letter , (mu, an abbreviation for markup). The
size of the markup is an indicator of how competitive the
market is.
The break-even (BE) curve. The markup and the number of firms are related in another way, summarized by the
BE curve.
When a sector exhibits increasing returns to scale, there
is only room for a certain number of firms in a market of a
given size. Intuitively, more firms will be able to survive if
the price is far above marginal cost, that is, if the markup is
high. The curve that captures this relationship is called the
zero-profit curve, or the break-even (BE) curve (figure
3.6). It has a positive slope because more firms can break
even when the markup is high. That is, taking the markup
as given, the BE curve shows the number of firms that can
earn enough to cover their fixed costsay, the cost of setting up a factory.
Equilibrium prices, output, and firm size. It is important
to note that firms are not always on the BE curve, since they
can earn above-normal or below-normal profits for a
while. In the long run, however, firms can enter or exit the
market, and so the number of firms rises or falls until the
typical firm earns just enough to cover its fixed cost. By
contrast, firms are always on the COMP curve, since firms
can change prices quickly in response to any change in the
number of firms.
With this in mind, we are ready to work out the equilibrium markup, number of firms, price, and firm size in a
closed economy, using figure 3.7. The right-hand panel
combines the BE curve with the COMP curve. The intersection of the two defines the equilibrium markup and the
long-run number of firms. More specifically, the COMP
curve tells us that firms would charge a markup of ' when
there are n' firms in the market, and the BE curve tells us
that n' firms could break even when the markup is '. The
equilibrium price is, by the definition of the markup, just
the equilibrium markup plus the marginal cost, MC. Using
the MC curve from the left-hand panel, we see that the
equilibrium price is p' (' plus MC). The middle panel
shows the demand curve, and this allows us to see that the
total level of consumption implied by the equilibrium
price is C'.
Figure 3.7. Prices, Output, and Equilibrium Firm Size in a Closed Economy
Home market
euros
markup (P + MC)
price
demand curve
BE
E
p
'
AC
COMP
MC
n
x
Source: Authors elaboration.
sales
per firm
75
total
sales
number
of firms
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Richard Baldwin
Economics
77
Figure 3.8. Prices, Output, and Equilibrium Firm Size with Integration
Home market only
euros
markup
price
demand curve
BE
BE FT
E
E
'
E
A
pA
AC
COMP
MC
n
x
sales
per firm
C C
2n number
of firms
total
sales
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Richard Baldwin
price
markup
demand curve
BE
BEFT
p
p
p
E
E
E
AC
COMP
MC
x x
sales
per firm
n
C C
number
of firms
total
sales
activity, whereas dispersion forces discourage such concentration. The spatial distribution of economic activity at any
moment in time depends on the balance of the proconcentration (agglomeration) forces and the anticoncentration
(dispersion) forces.
The main question in this section is, how does trade
integration affect the equilibrium location of industry? To
set the stage for the equilibrium analysis, we first consider
dispersion and agglomeration forces in isolation. For better
understanding of how trade arrangements affect profitability, and thus industrialization, it is convenient to employ a
simple analytical framework, one constructed by Puga and
Venables (1998). It focuses on four forces: two dispersion
forces (factor-market competition and local-market competition), and two agglomeration forces (input-cost linkages and demand linkages).
Dispersion and Agglomeration Forces
Dispersion forces favor the geographic spreading out of
economic activity. Land prices are the classic example. The
price of land, and therefore the price of housing, office
space, and so on, is usually higher in built-up areas such as
central London than in rural areas such as northern Wales.
If everything else were equal, firms and workers would prefer to locate in less built-up areas. (Of course, we know that
other things are not equal.) The forces that make built-up
areas more attractive are called agglomeration forces; we set
them aside for the moment to concentrate on dispersion
Economics
79
require many intermediate inputsparts and components. When these parts and components are produced
locally, they tend to be cheaper and can be supplied in a
timelier manner. Demand linkages reflect the attractiveness of a country that has easy access to customers,
whether local or in a trading partner.
Demand-linked circular causality rests on market-size
issueshence its name. Firms want to locate where they
have good access to a large market such as Japan or the
United States. If a firm locates in the big market, it incurs
shipping costs to sell to other markets, but its costs of selling to big-market customers are low. (It is cheaper to sell to
nearby customers.) Since there are more customers in the
big market, firms can reduce their shipping by moving
there. This is where the circular causality of demand linkages starts. Other things being equal, firms want to be in
the big market.
The causality becomes circular because the movement
of firms from the small market to the big market makes the
big market bigger and the small market smaller. The reason
is that firms buy inputs from other firms. Thus, firms moving to the big market create more demand in the big market and less in the small one. We call this an agglomeration
force, since spatial concentration of economic activity creates forces that encourage further spatial concentration.
The basic idea is illustrated in figure 3.10. It is useful to
separate two things that are closely related: market size (big
market as a share of total market, or the spatial distribution
of demand), and firm location (share of firms in the big
market, or the spatial distribution of firms).
Starting from the left-hand arrow, we see that market
size affects the location of firms. The logic rests on firms
desire to minimize shipping costs. The right-hand arrow
shows that the location of firms affects relative market size.
The logic is simply that firms tend to buy inputs locally.
PRODUCTION
EXPENDITURE
SHIFTING
SHIFTING
Size of big
market as share
of world
Source: Authors elaboration.
When firms
move to big
market, local
purchases
makes the big
market bigger
and the small
market smaller.
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Richard Baldwin
PRODUCTION
COST
SHIFTING
SHIFTING
Cost of
producing in
the big market
Source: Authors elaboration.
When firms
move to the
big market,
the range of
intermediate
goods expands
while
contracting
in the small
market.
Economics
81
dispersion
force
All industry in
one nation
strength of the
agglomeration and
dispersion forces
D
E
A
agglomeration
force
1/2
share of
firms in
North
1/2
share of
firms in
North
the gap between the agglomeration force and the dispersion force narrows. The location equilibrium is where the
two forces just offset each other, that is, point E.
The example in the left-hand panel shows an equilibrium with some industry in both nations. The right-hand
panel shows the situation in which agglomeration forces
are so strong that all industry ends up in the North (full
agglomeration). This is not a bad approximation of the situation that confronts many developing countries today
(that is, they have essentially no competitive industry) and
that faced almost all developing countries before the emergence of the newly industrializing countries in the 1980s.
Finally we come to the main subject of this section: how
does tighter economic integration affect the location of
industry across countries? Here, we view trade integration
as simply reducing trade barriers such as tariffs and other
restrictions. How do we show the trade-cost reduction in
the locational equilibrium diagram?
As the discussion above suggests, lower trade costs
between the two nations in our simple framework will
weaken both the agglomeration forces and the dispersion
forces. After all, at the extreme of costless trade, there is
no advantage to being in any particular market, with the
sole exception of that conferred by the factor-market
competition dispersion force. The other three forces rely
on differences that are created by costly trade. Factormarket competition, however, has nothing to do with
trade costs; all that matters is how much industry is in each
nation. The conclusion, then, is that if the world went to
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Richard Baldwin
share of
industry in South
strength of the
agglomeration and
dispersion forces
S1 = S2
E
A
A1
D
D1
A2
S1
S1
S2
freer
trade
freer
trade
1/2
share of
firms in
North
Economics
83
sufficiently high, industrialization will start in one southern nation. As before, the logic of cluster economics tells us
that the process begins in only one southern nation but
then shifts to the other.
Preferential Liberalization
If the two southern nations sign a PTA and lower tariffs
between themselves, something like multilateral liberalization occurs. As long as the two markets are not too small,
the liberalization will cause industry to become established
in the South, but the mechanism is completely different:
the driving force here is the effective market enlargement
caused by reducing intra-South barriers. This is, of course,
the classic argument made in the 1960s and 1970s for
South-South PTAs.
As in the multilateral case, the spread of industry to
developing countries is uneven, initially taking place in one
country and only spreading to the second when trade barriers are lower. Indeed, this sort of uneven development
did occur in some early South-South PTAs. For example, in
the East African Community, industry started to grow in
Kenya at the expense of Uganda and Tanzania. The key difference is that the countries do not benefit from better
access to northern markets or to North-produced intermediate inputs.
The impact of a North-South PTA is particularly interesting. Here, the southern nation obtains better access to
the big northern market and benefits from lower-cost
inputs, but in each case only with respect to the partner.
The liberalizing southern economy suffers from more
competition from northern firms, but because its wages are
lower, the balance of better reciprocal market access is in
favor of the South. This spread of industry is associated
with a large decline in the Norths share of industry. The
loser is the other southern economy, which does not attract
any industry and now has to contend with industrial clusters in both North and South. It is not difficult to see how a
single North-South PTA such as the U.S.Mexico agreement proposed in 1991 or the one between Japan and
Malaysia could trigger a spate of requests from other
southern nations.
Liberalization of Parts and Components
But not Final Goods
A very common liberalization strategy among developing
countries is to reduce tariffs unilaterally on inputs but
not, or to a lesser degree, on final goods. This evokes the
old measures of the effective rate of protection, whereby
the actual protection provided by a nominal tariff of, say,
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Richard Baldwin
10 percent on automobiles can be vastly larger than 10 percent if the tariff on imported intermediates is zero. A
numerical example will illustrate. Suppose a country can
buy autos at US$10,000 and adds a 10 percent tariff, so that
the auto sells for US$11,000 on the internal market. Furthermore, suppose the country charges no tariff on the
parts needed to assemble an auto and can buy these parts
for US$8,000. This implies that the cost of assembly, when
it is done most efficiently, is worth US$2,000. But now we
see that assembly of autos inside the country will be profitable as long as it costs less than US$3,000. Thus, in some
sense, the effective rate of protection on the assembly activity is 50 percent, not 10 percent as the tariff on autos suggests. This is an old story, and countries around the world
still keep up the fiction of having an automobile industry
by maintaining a high tariff on autos and a low tariff on
completely knocked down (CKD) autosbasically, kits
that are opened and assembled like IKEA furniture.
Recently, however, the situation has become far more
subtle. Many developing countries, especially in East Asia,
are industrializing on the basis of parts and components
manufacturing rather than final goods manufacturing. In
essence, they industrialize by becoming part of the global
supply chain. (Actually few of these supply chains are
global; apart from some electronics, they are regional, in
order to reduce transport cost and delays.)
For a wide range of countries, the import and export of
parts and components are much more important than the
export of final goods (Fukunari and Ando 2005). For the
Philippines, for instance, 60 percent of the countrys
machinery exports consists of parts, as does 45 percent of
its imports in this category. Plainly, the Philippines industry is in the business of importing parts, adding some
value, and then exporting the parts.
In terms of the Puga-Venables analysis, this uneven liberalization of parts and final goods fosters southern
industry in that it reduces the cost of inputs without
increasing the competition from northern industry in the
Table 3.1. ASEAN Tariffs on Engines and Automobiles, Most Favored Nation (MFN) Tariffs and Common Effective Preference
Tariffs (CEPTs), 2008
(percent)
Malaysia
Item
Small-auto engines
Medium-size-auto engines
Automobiles
Indonesia
Philippines
Thailand
MFN
CEPT
MFN
CEPT
MFN
CEPT
MFN
CEPT
25
30
30
0
0
5
0
0
55
0
0
5
0
0
30
0
0
5
10
10
80
0
0
5
85
Economics
500
400
300
200
100
0
1975
1980
1985
1990
1995
China
Thailand
Indonesia
Vietnam
2000
2004
Malaysia
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Richard Baldwin
EU-15
CEMAC
WAEMU
EAC
SACU
Internal
External
46.6
1.2
0.9
0.3
0.3
24.8
0.1
0.4
0.4
9.0
Economics
euros
PB + T
XSB + T
XSA + T
PA + T
B+D
PB
PA
XSB
XSA
MD
M
imports
87
quantity
Source: For right-hand panel, Johnson (1960b); for left-hand panel, authors elaboration.
Note: The right-hand panel is the standard open-economy supply-and-demand diagram in price-quantity space for an infinitely small nation (Home).
The left-hand panel transcribes the analysis into a more compact diagram in price-import space.
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Richard Baldwin
euros
trade
price
gain
PARTNER
euros
HOME
trade
volume
gain
trade
price
loss
PR + T H
PR + TP
PR
XSRoW
D
MH
Source: Authors modification of a diagram in Pomfret (1997).
quantity
MH
quantity
Economics
89
90
Richard Baldwin
price
P*
P
A
P
B
demand
curve
marginal
revenue
curve
marginal
cost curve
C
E
Q
Q + 1
sales
Q*
sales
Economics
91
price
firm 1s expectation of
sales by firm 2, Q2
firm 2s expectation of
sales by firm 1, Q1
demand
curve (D)
p1
demand
curve (D)
p2
residual demand
curve, firm 1 (RD1)
A1
x 1
residual demand
curve, firm 2 (RD2)
MC
MC
A2
x2
firm 1 sales
firm 2 sales
price
OLIGOPOLY
p*
price
D
D
p**
RD
RD
MC
MC
RMR
x*
RMR
2x* sales
sales
x**
3x**
to note are that (a) the optimal output for a typical firm is
x*, given by the intersection of RMR and MC; (b) total
sales to the market are 2x*, and at this level of sales the
overall market price (given by the demand curve D) is consistent with the price each firm expects to receive, given the
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Richard Baldwin
the market equilibrium. Modeling TBTs in such sexy industries will certainly be the subject of much future work, but in this chapter we focus on
mundane industries in which TBTs act by raising the costs of foreign
firms more than the costs of local firms.
9. The left-hand panel of figure 3A.1 translates the effects into
Meades two-part framework: B + D is the trade volume effect (related to
the change in the volume of imports), and E is the trade price effect
(related to the change in the border price).
10. This contrast is the source of the rule of thumb that a PTA with
your main trading partners is more likely to be welfare improving, since
you are giving preferences to the partners that have demonstrated themselves to be the low-cost suppliers by winning the largest market share in
an even competition with other suppliers.
11. The early 1980s saw a number of widely read studies that sought
to reverse the Johnson-Cooper-Massell (JCM) proposition while retaining the small-country framework. These efforts (e.g., Wonnacott and
Wonnacott 1981; Berglas 1983) strike the modern reader as awkward
because of the small-nation assumption and the intricate diagrammatic
analysis.
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