Evaluate the Significance of Imperfect Competition Models for Explaining the Pattern of International Trade - Essay Example

Download file to see previous pages... This type of market does not operate under the rules of perfect competition. In this type of market structure, a firm has the ability to affect the prices. In spite of being close substitutes, the products can be differentiated and advertising and branding plays a major role in this type of market. A large number of sellers exist in the market. The market structure is characterized by freedom of entry and exit. Monopolistic competition and oligopoly constitute the structure of imperfect competition. Firms that are imperfectly competitive offer many products. The products are offered at administered prices. The price changes are costly and slower. The prime prediction of the theory of monopolistic competition is that firms will produce at the level where marginal cost equals marginal revenue in the short run. However in the long run, the firms will operate at zero profit levels and the demand curve will be tangential to the average total cost curve. Intra Industry Trade Situation where there is exchange of similar products between similar industries is referred to as intra industry trade. This is a very common term in international trade where imports and exports of similar product take place. The three types of intra industry trade include trade between goods that are homogeneous, trade between horizontally and vertically differentiated goods. Consider the Krugman’s model of monopolistic competition. This model helps to explain intra industry trade by using economies of scale as experienced by production, products that can be differentiated and heterogeneous preferences between and within countries. The sum of fixed cost and variable cost is the total cost of the firm. Therefore, C= F+cX, where F is the fixed cost, c is the constant marginal cost and cx is the variable cost. So, average cost, AC= F/X+c The demand curve faced by the monopolistically competitive firms is downward sloping. Profit is maximized at the level where marginal revenue equals marginal cost. The equation of the demand curve faced by a monopolistically competitive firm is X= S[1/n-b(P-Pavg)] Where X= sales of the firm, S= total sales of the industry, n= number of firms participating in the industry, P=price charged by each firm, Pavg=average price charged by each firm, b=parameter of MR. A typical firm that charges the price greater than Pavg, is likely to enjoy smaller share of the market. Another assumption is that S is not affected by P. This refers to the situation where competition in price will simply redistribute the share of the market without increasing the total sales. To determine the market equilibrium, firms are assumed to be symmetric. The demand and cost functions are the same for all firms. An upward sloping relationship is said to exist between the number of firms and average cost of any firm. A downward sloping relationship is said to exist between the number of firms and price charged by each firm. In equilibrium, P=Pavg as all firms are assumed to be symmetric. The demand curve is X=S/n, and AC=nF/S+c. The demand curve can be rewritten as X=(S/n+SbPavg)-SbP where the bracketed term is the intercept and Sb is the slope. Then the marginal revenue is P-X/Sb. MR=MC, therefore, P-X/Sb=c or, P=c+X/Sb. But each firm charges the same price, then, P=v+1/bn. (Cashel, n.d., p. 1). The long run equilibrium takes place where P=AC. This model can be used now to derive the implications of international trade. International trade is ...Download file to see next pagesRead More