Economies of Scale, Imperfect Competition, and International Trade

Chapter 6
Economies of
Scale, Imperfect
Competition, and
International Trade
Slides adapted from Bishop but modified by

Lim
Slides prepared by Thomas Bishop Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
Introduction
• When defining comparative advantage, the Ricardian
model (technology/productivity) and Heckscher-Ohlin
model (resources/factors of production) assume that
production processes have constant returns to
scale:
 When factors of production change at a certain rate, output
increases at the same rate.
 For example, if all factors of production are doubled then

output will also double.
• But a firm or industry may have increasing returns

to scale or economies of scale:
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-2

 When factors of production change at a certain rate, output
increases at a faster rate.
 For example, doubling the inputs to an industry will more

than double the industry’s production.
 A larger scale is more efficient: the cost per unit of output

falls as a firm or industry increases output.
• The presence of economies of scale may be seen

from Table 6-1.
 For example, when the input of labor doubles from 15 to 30,

output increases by a factor of 2.5.
 Equivalently, it is evidenced from the declining average labor

input (average amount of labor used to produce each unit of
output).

Table 6-1: Economies of Scale for a Hypothetical Industry

• The Ricardian and H-O models also rely on perfect
competition to predict that all income from production
is paid to owners of factors of production: no “excess”
or monopoly profits exist.
• But when economies of scale exist, large firms may be

more efficient than small firms, and the industry may
consist of a monopoly or a few large firms.
 Production may be imperfectly competitive in the sense that

excess or monopoly profits are captured by large firms.
• Moving away from comparative advantage, this chapter

turns to how economies of scale can give rise to
international trade: (1) monopolistic competition
model; (2) dumping model.
6-5
Types of Economies of Scale
• Economies of scale imply that the labor input per unit
of production is smaller the more units produced (or
unit costs tend to be lower with larger output).
• Economies of scale could mean either that larger firms

or a larger industry is more efficient.
• External economies of scale occur when cost per

unit of output depends on the size of the industry.
 Imagine an industry that initially consists of 10 firms, each

producing 100 widgets, for a total industry production of 1000
widgets.

 Suppose that the size of the industry doubles to 2000
widgets, with 20 firms each producing 100 widgets.
 It is possible that the costs of each firm will fall as a result of

the increased size of the industry (even though each firm is
the same size as before).
 An industry where economies of scale are purely external will

typically consist of many small firms, and hence consistent
with perfect competition.
• Internal economies of scale occur when the cost

per unit of output depends on the size of a firm.
 Imagine an industry that initially consists of 10 firms, each

producing 100 widgets, for a total industry production of 1000
widgets.

 Suppose that the size of the industry remains constant at
1000 widgets, but the number of firms was reduced to 5
firms, implying each producing 200 widgets.
 It is possible that the costs of each firm will fall as a result of

the increased output.
 An industry where economies of scale are internal will give

large firms a cost advantage over small firms, leading to an
imperfectly competitive market structure in the industry.

A Review of Monopoly
• A monopoly is an industry with only one firm.
• An oligopoly is an industry with only a few firms.
• In these industries, the marginal revenue (MR)

generated from selling more units is always less than
the price (MR < P).
 MR is the extra revenue the firm gains from selling an
additional unit.
 To sell an additional unit, a firm must lower the price of all

units (reflected in a downward sloping demand curve)
 The marginal revenue (MR) function therefore lies below the

demand (DD) function.

• The functions can be written as:
Demand: Q = a – bP (negative slope) (6-1)

Marginal Revenue: MR = P – (1/b)Q (6-2)
On how to derive MR from demand function, see the

Appendix in your textbook (pp.152)
• As stated earlier, MR < P. But how much less?
Rearrange (6-2) yields: P - MR = (1/b)Q

 The gap between P and MR depends on (1) the initial sales of
the firm (Q, directly related); (2) the slope of the demand
function (b, inversely related).
6-10
Illustration
Assume that the demand function is:
Q = 120 – 0.5P
Recall that to sell an additional unit, a firm must lower the price of all
units.
(1) P- MR depends on initial sales Q
 Case 1: When the price is RM200, the firm can sell 20 units
(TR0 = RM200 x 20 = RM4000). If the firm wants to increase
its sales to 21 units in the following month, it must lower the
price to RM198 (TR1 = RM198 x 21 = RM4158).
 MR = RM4158 – RM4000 = RM158 (P – MR = RM40)

 Case 2: When the initial sales Q is at lower level, say Q0 = 5
units. The price will be RM230 (TR0 = RM230 x 5 = RM1150).
If the firm wants to increase its sales to 6 units in the following
month, it must lower the price to RM228 (TR1 = RM228 x 6 =
RM1368).
 MR = RM1368 – RM1150 = RM218 (P – MR = RM10)
 Summary: If the initial sales Q is at higher level (20 units vs 5

units), MR will be lower (RM158 vs RM218), and the gap will
be bigger (RM40 vs RM10).

(2) P- MR depends on the slope of the demand curve b
 Case 1: Q = 120 – 0.5P. When the price is RM200, the firm

can sell 20 units (TR0 = RM200 x 20 = RM4000). If the firm
wants to increase its sales to 21 units in the following month,
it must lower the price to RM198 (TR1 = RM198 x 21 =
RM4158).
 MR = RM4158 – RM4000 = RM158 (P – MR = RM40)
 Case 1: Q = 120 – 2P. When Q is 20 units, the price will be

RM50 (TR0 = RM50 x 20 = RM1000). If the firm wants to
increase its sales to 21 units in the following month, it must
lower the price to RM49.50 (TR1 = RM49.50 x 21 =
RM1039.50).
 MR = RM1039.50 – RM1000 = RM39.50 (P – MR = RM10)
 Summary: If the slope b is flatter (0.5 vs 2), MR will be lower

(RM158 vs RM39.50), and the gap will be bigger (RM40 vs
RM10).

• Average cost (AC) is the cost of production (C)
divided by the total quantity of production (Q).
AC = C/Q
• Marginal cost (MC) is the cost of producing an

additional unit of output.
• Suppose that costs are represented by C = F + cQ,

 where F represents fixed costs, those independent of the
level of output.
 c represents a constant marginal cost: a constant cost of

producing an additional quantity of production Q.

AC = C/Q = (F + cQ) / Q
= F/Q + c
• The fixed cost gives rise to internal economies of

scale, because the larger the firm’s output, the less is
the fixed cost per unit.
• AC is a decreasing function of output, because the

fixed cost is spread over a larger output.
• From microeconomics, we were shown:

(1) MC < AC
(2) Profit maximizing output: MR = MC

Fig. 6-1: Monopolistic Pricing and Production Decisions
Do note that our earlier demand

function is specified in terms of Q,
i.e. Q = a – bP.
In Figure 6-1, it is in terms of P.

For instance, Q = 120 – 0.5P can
be rewritten as P = 240 – 2Q.
The profit-maximizing output is

reached when MR = MC at (QM,
PM).

Monopolistic Competition
• Monopolistic competition is a model of an
imperfectly competitive industry which assumes
that:
 Each firm can differentiate its product from the product of
competitors.
 Each firm ignores the impact that changes in its price will
have on the prices that competitors set: even though each
firm faces competition it behaves as if it were a monopolist.
• Since 1980, monopolistic competition models have

been widely applied to international trade, showing
clearly how economies of scale can give rise to
mutually beneficial trade.
6-17
• A firm in a monopolistically competitive industry is
expected:
 to sell more as total sales in the industry increase and as
prices charged by competitors increase.
 to sell less as the number of firms in the industry increases

and as its own price increases

Demand Function
• The following demand function captures the stated
properties in slide 18:
Q = S[1/n – (P – P)] (6-3)
 Q is an individual firm’s sales

 S is the total sales of the industry
 n is the number of firms in the industry
  is a constant term representing the responsiveness of a
firm’s sales to its price
 P is the price charged by the firm itself
 P is the average price charged by its competitors

• To understand the intuition of the model, (6-3) can
be rewritten as:
Q = S/n – S(P – P)
 Assume S = 10000 units, n = 10 firms,  = 0.5, P = RM3
 If P = P = RM3, then Q = S/n. Plugging numbers, Q =

10000/10 – 10000*0.5*0 = 1000. In other words, If all firms
charge the same price, each firm will have a similar market
share of 1/n, i.e., 10%.
 If P > P, then Q > S/n. Plugging numbers (assume P = 4), Q

= 10000/10 – 10000*0.5*1 = 500. In other words, a firm
charging more than the average of other firms will have a
smaller market share (i.e. 5%).
6-20
 If P < P, then Q > S/n. Plugging numbers (assume P = 2), Q
= 10000/10 – 10000*0.5*-1 = 1500. In other words, a firm
charging less than the average of other firms will have a
larger market share (i.e. 15%).
To model the behavior of this monopolistically

competitive industry, we assume that all firms face the
same demand functions (even though they sell
somewhat differentiated products).

Cost Functions
• The total and average cost functions of a typical firm

are similar to that of a monopoly firm:
C = F + cQ (see slide 14)

AC = F/Q + c (see slide 15)
• To model the behavior of this monopolistically

competitive industry, we assume that all firms face the
same cost functions

Market Equilibrium
• To analyze the effects of international trade, all we

need is to determine the number of firms in the
industry (n), and the average price these firms charge
(P).
• To determine n and P, we will proceed in 3 stages.
6-23
Step 1: Derive the relationship between n and AC
• Since we assume all firms in the industry are

symmetric (i.e. having identical demand and cost
functions), they will all charge the same price in
equilibrium (P = P).
• From equation 6-3 (see slides 19-20), Q = S/n when

P = P. Substitute this into the AC function:
AC = F/Q + c = F / (S/n) + c = F(n/S) + c
• Other things equal, if n , AC  (upward sloping).

This is because the more firms there are, the lower
the output of each firm, and thus the higher its cost
per unit of output.
6-24
Step 2: Derive the relationship between n and P
• If monopolistic firms have straight-line demand

functions,
 then the relationship between price and quantity may be
represented as:
Q = a – bP (6-1, see slide 10)
 and the marginal revenue may be represented as
MR = P – (1/b)Q (6-2, see slide 10)
• Profit maximizing output: MR = MC (see slide 15)

We can rewrite the demand curve 6-3 in the form of 6-1
(linear demand curve):
Q = S[1/n – (P – P)]

Q = S/n – S(P – P)
Q = (S/n + SP ) - SP
Now 6-3 is in the form of Q = a – bP,
 where a ≡ (S/n + SP) and b ≡ S
Since we assume all firms in the industry are

symmetric, they will all charge the same price in
equilibrium (P = P), and hence Q = S/n.
6-26
• Plug Q = S/n and b = S into the MR function (in slide
25):
MR = P – (1/b)Q
= P – (1/S)(S/n)
= P – 1/ n
• Profit maximizing output: MR = MC
P – 1/ n = c
P = c + 1/ n
• Other things equal, if n , P  (downward sloping).

This is because of increased competition.

Step 3: Determine the equilibrium point (n, P)
• The positive relationship between n and AC is

represented by the upward sloping CC curve in
Figure 6-3.
• The negative relationship between n and P is

represented by the downward sloping PP curve in
Figure 6-3.
• The equilibrium point (n, P) is reached when PP

intersects with CC. At this point E, P= AC implying
each firm will earn revenue that exactly offsets all
costs.

Fig 6-3: Equilibrium in Monopolistically Competitive Market

• If P > AC (revenues exceed all costs), the PP curve is
above the CC curve. The industry will be making
profits and additional firms will enter the industry.
• If P < AC (revenues are less than all costs), the PP

curve is below the CC curve. The industry will be
incurring losses, and firms will leave the industry.
• When P = AC, firms have no incentive or tendency to

enter or exit the industry. Hence point E is the
industry’s long-run equilibrium.
With this monopolistic competitive model, we can

explore the role of economies of scale in international
trade.
Of course, there will be limitations of this model (see

textbook page 124-125).
6-30
Monopolistic Competition and Trade
• With international trade, market size , AC , P 

and n .
• Industry sales increase with trade leading to AC 

 CC curve is represented by AC = F(n/S) + c
 Other things equal, an increase in total sales (S) will cause
AC 
 Hence, CC curve will shift downward from CC1 to CC2 (see
Figure 6-4).
• What happens to PP curve?

 PP curve is represented by: P = c + 1/ n
 Market size does not enter into this equation, hence an

increase in S does not shift the PP curve (see Figure 6-4).
• From Figure 6-4, at the new equilibrium point 2,
 the number of firms (n)  from n1 to n2, and hence a greater

variety of products is available to consumers
 The price (P)  from P1 to P2

Fig. 6-4: Effects of a Larger Market

Gains from Trade: A Numerical Example
Assume that automobiles are produced by a

monopolistically competitive industry. There are two
countries, Home and Foreign, both have the same costs
of production.
F = $750 000 000

c = $5000
b = 1/30000
S (Home) = 900 000 units
S (Foreign) = 1 600 000 units
S (Integrated) = 900 000 + 1 600 000 = 2 500 000

(1) Home (Before Trade)
AC = F(n/S) + c (see slide 24)

P = c + 1/ n (see slide 27)
AC = (n*750000000) / 900000 + 5000

P = 5000 + 1/(n/30000)
At equilibrium, AC = P
7500n/9 + 5000 = 5000 + 30000/n
n2 = 36
n = 6
When n = 6, P = 5000 + 30000/6

= $10000

(2) Foreign (Before Trade)

P = c + 1/ n (see slide 27)
AC = (n*750000000) / 1600000 + 5000

P = 5000 + 1/(n/30000)
7500n/16 + 5000 = 5000 + 30000/n
n2 = 64
n = 8
When n = 8, P = 5000 + 30000/8

= $8750

(3) Integrated Market (After Trade)

P = c + 1/ n (see slide 27)
AC = (n*750000000) / 2500000 + 5000

P = 5000 + 1/(n/30000)
300n + 5000 = 5000 + 30000/n
n2 = 100
n = 10
When n = 8, P = 5000 + 30000/10

= $8000

Fig. 6-5: Equilibrium in the Automobile Market
6-38
Hypothetical example of gains from trade
in an industry with monopolistic competition
HOME FOREIGN INTEGRATED
before trade before trade after trade
Industry sales 900,000 1,600,000 2,500,000

Number of firms 6 8 10
Sales per firm 150,000 200,000 250,000
Average cost 10,000 8,750 8,000
Price 10,000 8,750 8,000
• As a result of international trade, the number of firms in a new

international industry is predicted to increase relative to each
national market, with each firm producing at a larger scale, and
selling at a lower price.
6-39
Monopolistic Competition & Comparative
Advantage
• Despite the gains from international trade, the model

says little about the pattern of trade that results from
economies of scale.
 For instance, it is unclear where the 10 firms will be located:
4H, 6F OR 0H 10F, …
 To determine the pattern of international trade, we need to

consider the interaction between economies of scale and
comparative advantage.

(1) Inter-industry Trade (Comparative Advantage)
• According to the Heckscher-Ohlin model or Ricardian

model, countries specialize in production due to
comparative advantage.
• In a Heckscher-Ohlin model suppose that:

 The capital-abundant Home specializes in the production of
capital-intensive cloth, and hence export cloth and import
food.
 The labor-abundant Foreign specializes in the production of

labor-intensive food, and hence export food and import
cloth.
 The exchange of cloth for food by both countries is called

inter-industry trade.
6-41
Fig. 6-6: Trade in a World Without Economies of Scale
Without economies of scale, international trade is an exchange of

cloth for food called inter-industry trade.

(2) Intra-industry Trade (Economies of Scale)
• Suppose now that the global cloth industry is

described by the monopolistic competition model.
• Because of product differentiation, suppose that each

country produces different types of cloth.
• Because of economies of scale, large markets are

desirable: Foreign exports some cloth and Home
exports some cloth (relate with the numerical example
on integrated market in slides 34-39).
• International trade occurs within the cloth industry

(though between 2 countries) is called intra-industry
trade.
6-43
(3) Inter-industry and Intra-industry Trade
• If cloth is a monopolistically competitive industry,

 Home and Foreign will produce different types of cloth, hence
giving rise to intra-industry trade (due to economies of
scale).
 If domestic country is capital-abundant, it still has a

comparative advantage in cloth. It should therefore export
more cloth than it imports (hence more firms located in
Home)
• Suppose that the trade in the food industry continues

to be determined by comparative advantage,
 The labor-abundant Foreign specializes in the production of
labor-intensive food to be imported by Home, giving rise to
inter-industry trade.
6-44
Fig. 6-7: Trade with Economies of Scale and Comparative
Advantage

Key Points (Summary)
1. Gains from inter-industry trade reflect comparative

advantage.
2. Gains from intra-industry trade reflect economies of

scale (lower costs) and wider consumer choices.
3. The monopolistic competition model does not predict

in which country firms locate, but a comparative
advantage in producing the differentiated good will
likely cause a country to export more of that good
than it imports.

4. The relative importance of intra-industry trade
depends on how similar countries are.
 For countries with similar capital-labor ratios, intra-industry

trade (due to economies of scale) will be dominant.
 For countries with different capital-labor ratios, inter-

industry trade (based on comparative advantage) will be
dominant.
5. Unlike inter-industry trade in the Heckscher-Ohlin

model, income distribution effects are not predicted
to occur with intra-industry trade.

Dumping Model
• Dumping is the practice of charging a lower price for
exported goods than for goods sold domestically.
• Dumping is an example of price discrimination:

the practice of charging different customers different
prices.
• Price discrimination and dumping may occur only if
 imperfect competition exists: firms are able to influence

market prices (firms are price setters and not price takers).
 markets are segmented so that goods are not easily bought

in one market and resold in another.
6-48
• Dumping may be a profit maximizing strategy
because of differences in foreign and domestic
markets.
• One difference is that domestic firms usually have a

larger share of the domestic market than they do of
foreign markets.
 Because of less market dominance and more competition in

foreign markets, foreign sales are usually more responsive to
price changes than domestic sales.
 Domestic firms may be able to charge a high price in the

domestic market but must charge a low price on exports if
foreign consumers are more responsive to price changes.

• We draw a diagram of how dumping occurs when a
firm is a monopolist in the domestic market but
must compete in foreign markets.
 Because the firm is a monopolist in the domestic market, the

demand function that it faces in the domestic market is
downward sloping, and marginal revenue from additional
output is always less than a uniform price for all units of
output (MR < P, see slide 9).
 Because the firm competes in foreign markets, the demand

function that it faces in foreign markets is horizontal,
representing the fact that exports are very responsive to
small price changes (MR = P, perfect competition).
 A horizontal demand curve also implies that the firm can sell as
much as it wants at the given price.
See Figure 6-8!

6-50
Fig. 6-8: Dumping
MC=MRFOR
MRDOM=PFOR
6-51
• To maximize profits, the firm must set MR = MC in
each market.
 Since the firm can sell as much as it wants in Foreign, it

should set MRFOR = MC (Point 1).
 The total output to be produced is QMONOPOLY, regardless the

unit is destined for Home or Foreign market.
 The MC at point 1 is PFOR, and this is the actual cost of

producing one additional unit.
 Hence, for Home, the MRDOM should be set equal to this

actual cost of producing one more unit (PFOR). Point 2 is
where MRDOM=PFOR. At this intersection point, Home should
produce QDOM and sell at a price of PDOM.
 The intersection MC = MRDOM is where the firm would produce if

it did not have the option of exporting. But this is irrelevant
here!
6-52
 For Foreign market, the firm will export QMONOPOLY – QDOM
there, and sell at a price of PFOR.
The firm is charging a lower price for exported goods than for goods
sold domestically. This is known as dumping.
In general, firms will charge lower prices in markets in which they

face a higher elasticity of demand, i.e. a 1% increase in price will
result in a big drops in sales.
The analysis of dumping suggests that price discrimination can

actually give rise to international trade.

• Dumping (as well as price discrimination in domestic
markets) is widely regarded as unfair.
• A US firm may appeal to the Commerce Department

to investigate if dumping by foreign firms has injured
the US firm.
 The Commerce Department may impose an “anti-dumping

duty,” or tax, as a precaution against possible injury.
 This tax equals the difference between the actual and “fair”
price of imports, where “fair” means “price the product is
normally sold at in the manufacturer's domestic market.”
• Next the International Trade Commission (ITC)

determines if injury to the U.S. firm has occurred or is
likely to occur.
6-54
• If the ITC determines that injury has occurred
or is likely to occur, the anti-dumping duty
remains in place (for details, click here).
For Case Study on Anti-dumping,

see textbook page 138-139.

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Chapter 6

Slides adapted from Bishop but modified by

 For example, if all factors of production are doubled then

• But a firm or industry may have increasing returns

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-2

 For example, doubling the inputs to an industry will more

 A larger scale is more efficient: the cost per unit of output

• The presence of economies of scale may be seen

 For example, when the input of labor doubles from 15 to 30,

 Equivalently, it is evidenced from the declining average labor

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-3

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-4

• But when economies of scale exist, large firms may be

 Production may be imperfectly competitive in the sense that

• Moving away from comparative advantage, this chapter

• Economies of scale could mean either that larger firms

• External economies of scale occur when cost per

 Imagine an industry that initially consists of 10 firms, each

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-6

 It is possible that the costs of each firm will fall as a result of

 An industry where economies of scale are purely external will

• Internal economies of scale occur when the cost

 Imagine an industry that initially consists of 10 firms, each

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-7

 It is possible that the costs of each firm will fall as a result of

 An industry where economies of scale are internal will give

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-8

• An oligopoly is an industry with only a few firms.

• In these industries, the marginal revenue (MR)

 To sell an additional unit, a firm must lower the price of all

 The marginal revenue (MR) function therefore lies below the

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-9

Demand: Q = a – bP (negative slope) (6-1)

On how to derive MR from demand function, see the

• As stated earlier, MR < P. But how much less?

Rearrange (6-2) yields: P - MR = (1/b)Q

(1) P- MR depends on initial sales Q

 MR = RM4158 – RM4000 = RM158 (P – MR = RM40)

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-11

 MR = RM1368 – RM1150 = RM218 (P – MR = RM10)

 Summary: If the initial sales Q is at higher level (20 units vs 5

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-12

 Case 1: Q = 120 – 0.5P. When the price is RM200, the firm

 MR = RM4158 – RM4000 = RM158 (P – MR = RM40)

 Case 1: Q = 120 – 2P. When Q is 20 units, the price will be

 MR = RM1039.50 – RM1000 = RM39.50 (P – MR = RM10)

 Summary: If the slope b is flatter (0.5 vs 2), MR will be lower

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-13

• Marginal cost (MC) is the cost of producing an

• Suppose that costs are represented by C = F + cQ,

 c represents a constant marginal cost: a constant cost of

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-14

• The fixed cost gives rise to internal economies of

• AC is a decreasing function of output, because the

• From microeconomics, we were shown:

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-15

Do note that our earlier demand

In Figure 6-1, it is in terms of P.

The profit-maximizing output is

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-16

• Since 1980, monopolistic competition models have

 to sell less as the number of firms in the industry increases

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-18