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

INTERNATIONAL ECONOMICS ...Evaluate the significance of imperfect competition models for explaining the pattern of international trade Contents Imperfect Competition and Assumptions 3 Intra Industry Trade 3 Dumping 6 Reciprocal Dumping 7 Infant Industry Policy 9 Strategic Trade Policy 10 Issues concerning Trade policies 11 Aspects of International Trade 12 Reference 12 Imperfect Competition and Assumptions The word “competitive” means ‘not monopolies’. A market structure that does not satisfy the assumptions of perfect competition is regarded as the market of imperfect competition. 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 characterized by increased size of the market which enters the AC equation as S. This results in downward shifting of the ATC curve. The number of variable firms increases and price of the good gets reduced. Consumers are offered with more variety along with low prices because of international trade. The concept of intra industry trade makes a distinction between gross trade flows and net trade flows. If food is a homogeneous commodity, the import of the country represents the net balance between net consumption and total production. But, if food is heterogeneous, with the type of food product available in each country somewhat different, even a balance in aggregate consumption and production in each country could mask substantial trade flows. Net trade in food is close to zero, but gross trade could be large as consumers in each country partake of the fare available abroad as well as at home and this type of trade adds to the gains from trade (Caves, Frankel and Jones, p. 23). Dumping Dumping is regarded as the situation where a firm changes the price of its goods which is lower than the price charged in the domestic market or the cost of production. It is special case of price discrimination. A firm may involve itself in dumping due to variety of reasons namely price discrimination, predatory pricing (reduction of prices to an extent which will drive out the competitors), and disposal of surplus stock and economies of large scale production (Loehr, 1997, p. 1). There are three identified forms of dumping namely sporadic dumping, short run and continuous dumping. An occasional or casual dumping that takes place only in scattered instances and is not the manifestation of a definitely established price-policy on the part of the dumping concerned is called sporadic dumping. The motivation behind such dumping is disposal of goods in the short run to get rid of surplus stock. Short run dumping refers to a situation that lasts for a limited period. Exporters, in order to compete in foreign markets sell goods at a price which is less than the cost of production. In absence of competitors, exporters would have increased the price and gain the highest profits. When a company possesses monopoly power domestically, but faces foreign competition, it may participate in long run dumping. Absence of competition allows the company to sell the products domestically at a high price. This type of dumping is generally associated with maintaining a long run position in foreign market. The significance of dumping to the importing country may be considered from the divergent views of consumers and producers. Consumers may enjoy short term benefits from dumped imports because of low prices but condition may not be favourable in the long run. In situation where domestic producers are forced to either cease or reduce their production, competition is reduced and this type of situation is not likely to serve the interests of the consumers in the long run. It must be presumed that a producer who dumps benefits from doing so, although in the case of promotional and predatory dumping, there is an element of risk in that the ultimate benefits on which the loss‐making export sales are premised, may not materialize. Provided its home market is shielded against arbitrage or retaliation, and consequent price drop (which would neutralize the discrimination), dumping can have clear advantages for the individual exporter. A profitable home market provides a platform which may be used to operate in export markets at prices much lower than could have been possible without market segregation (University of Fort Hare, n.d. p.40). Reciprocal Dumping Suppose a good is consumed in each country and each country has one firm. The countries and the firm are considered to be identical. The countries will not engage themselves in trade if transportation costs exist and markets are competitive. Consider first the situation in absence of international trade. (Desmet, 2005, p.4). Then each firms acts like a monopoly and price is greater than marginal cost. Now, consider the situation where international trade is present. The assumption is that price is greater than the sum of marginal cost and transportation cost. This will provide the incentive for foreign firms to sell in the domestic market. Similarly the domestic firm will involve itself in selling in the foreign market. The foreign firm will continue to sell in the domestic market until MR=MC+TC, TC=transportation cost. This situation will reduce the marginal revenue of the domestic firm as the price of the good gets lowered by the entry of foreign firms. The domestic firm will react to this situation by reducing domestic sales. Thus we witness a costly trade because of transportation costs between two countries in an identical good. Monopoly power has also been reduced. (Desmet, 2005, p.5). The above figure resembles the home market before opening up of trade. (Desmet, 2005, p.5). The above figure resembles the situation after trade opened up for the same country. Infant Industry Policy The infant industry policy is dynamic in nature. It does not support the fact that the government’s acting as a protectionist would remain over the domestic firms only for a limited period of time and would fade out after the period. After the regime of protectionism is over, the government would allow the industries to compete in the international market. The argument is applied on economies for the sake of correcting the disturbances that are short lived. According to the argument, the government’s role in the protecting the domestic firms is good for a certain period but market forces are allowed to take its place after the time period is over. The aim behind such argument is to produce a level playing field between an advanced industry and a traditional one both producing similar goods. The policy is implemented frequently in the developing economies. If the traditional ones are exposed to compete in the international market they are probable to lose out because of the already existing advanced industries who can offer better products at lower prices. In such cases the industries in the disadvantaged position will require government’s support to survive in the industry by either through tariff protection on a temporary basis or through subsidy (Ederington and McCalman, 2011, p. 1). Strategic Trade Policy The policy of the government that attempts to shift the excess profits accrued in international oligopolistic firm towards the domestic firms is defined as strategic trade policy. The policies can be implemented in the form of subsidies like outright grants, loans at a rate which is lower the prevailing market rate and commitments to purchase large volumes of production. In a market characterized by several players and positive profit, each will like to increase the share of the market at the expense of the other (Brander, 1995). But if the competitor produces more, the other firm will like to produce less otherwise the price would get lowered along with profits. The reaction function can help to describe the relationship between the domestic (H) and foreign (F) firm. The reaction function will slope downwards. (University of California, n.d. p.1). The equilibrium occurs at the point where the two curves intersect. A domestic firm will like the equilibrium at the point B as here the foreign firm produces less. But given the cost structure, it may not be a credible threat. The strategic trade policy can be implemented to force the foreign firm to produce at the point B. The implemented subsidy will allow the domestic firm to move to H2 at the new equilibrium B. International oligopolies, first move advantages, lack of retaliation and enough information to target the correct industry are some of the preliminaries for this strategy to work. A strategic trade policy can be used to shift profits and as a ‘tit for tat’ strategy. Issues concerning Trade policies Some selected issues in trade policies are non-reciprocal preferences and the multidimensional trading system, economics and politics of non-reciprocal preferences, the pattern of reciprocal preferences, enhancement of market access, limits to market access, implications of multilateral trading system (World Trade Report, 2004, p. 2). Aspects of International Trade There are positive and negative aspects in international trade. The U.S. is held responsible for the existing trade policies in the world’s economy. A country can use the trade policy to reduce the expense of producing a good with scarce resources. If trade was absent it would have been difficult for a country to meet the expense of producing a particular good. The resultant would have been higher prices for the consumers. Decision makers will choose the most efficient and economical way to produce a particular product. Thus it can be assumed that the country will decide upon the amount of trade that will benefit the country as a whole. Economic actions often generate secondary effects in addition to their immediate effects (McMasters, Pitts, Prien and Kamery, 2003, p. 43). Reference Cashel-Cordo, P. n.d. Krugman Model-Monopolistic Competition. [pdf].Available at: http://business.usi.edu/cashel/341/krugman.pdf. [Accessed: 26th March, 2012]. Caves, R., Frankel, J. and Jones, R. 2006. World Trade and Payments. Ninth Edition. India. Pearson Education. Loehr, W., 1997. Dumping and Anti dumping policy with Applications in Lithuania. [pdf]. Available at: http://pdf.usaid.gov/pdf_docs/PNACB763.pdf. [Accessed:26th March, 2012]. Desmet. K., 2005. Dumping. [pdf].Available at: http://lsb.scu.edu/~mkevane/intlecon/432summer2005/dumping.pdf. [Accessed:26th March, 2012]. Ederington, J. and Mccalman, P., 2011. Infant industry protection and industrial dynamics. [pdf]. Available: http://people.ucsc.edu/~mccalman/Publications/JIE2011.pdf. [Accessed:26th March, 2012]. University of California, n.d. Introduction to Strategic trade policy. [pdf]. Available at: http://emlab.berkeley.edu/users/webfac/harrison/e181_s04/181s04lect28nts.pdf. [Accessed:26th March, 2012]. World Trade Report, 2004. Selected Issues in Trade and Trade Policy. [pdf]. Available at: http://www.wto.org/english/res_e/booksp_e/anrep_e/wtr04_1b_e.pdf. [Accessed:26th March, 2012]. McMasters, M., Pitts, S., Prien, K. and Kamery, R. 2003. Positive and Negative aspects of International Trade on the U.S. Economy and Labor. [pdf].Available at: http://www.sbaer.uca.edu/research/allied/2003/IntlBusiness/new/10.pdf. [Accessed:26th March, 2012]. University of Fort Hare, n.d. Dumping as an economic phenomenon. [pdf]. Available at: http://ufh.netd.ac.za/bitstream/10353/100/5/Zvidza%20thesis%20ch3.pdf. [Accessed:26th March, 2012]. Brander, J., 1995. Strategic Trade Policy. Available at: http://ideas.repec.org/p/nbr/nberwo/5020.html. [Accessed:26th March, 2012]. Read More