Increasing Returns to Scale

6
and Monopolistic Competition

1. Explain how increasing returns to scale in production can be a basis for trade.
Answer: With increasing returns to scale, countries benefit from trade due to the po-
tential to reduce their average costs by expanding their outputs through selling in a
larger market.
2. Why is trade within a country greater than trade between countries?
Answer: Border effects prevent trade between countries from being as large as within
countries. These factors include tariffs, quotas, administrative rules and regulations,
and whether the countries have a common border or language.
3. Starting from the long-run equilibrium without trade in the monopolistic competi-
tion model, as illustrated in Figure 6-5, consider what happens when the Home
country begins trading with two other identical countries. Because the countries are
all the same, the number of consumers in the world is three times larger than in a sin-
gle country, and the number of firms in the world is three times larger than in a sin-
gle country.
a. Compared with the no-trade equilibrium, how much does industry demand D
increase? How much does the number of firms (or product varieties) increase?
Therefore, does the demand curve D/N A still apply after the opening of trade?
Explain why or why not.
Answer: Industry demand increases by three times, and the number of firms also
increases by three times. Compared with the no-trade equilibrium, the demand
curve D/N A does not change because both total quantity demanded and the
number of firms tripled.
b. Does the d1 curve shift or pivot due to the opening of trade? Explain why or why
not.
Answer: Because D/N A is unchanged, point A is still on the short-run demand
curve facing each firm (d2 in Figure 6-6). However, the demand curve faced by

S-49
S-50 Solutions ■ Chapter 6 Increasing Returns to Scale and Monopolistic Competition

each firm becomes more elastic due to the increase in the number of firms: d1
pivots to become flatter.
c. Compare your answer to (b) with the case in which Home trades with only one
other identical country. Specifically, compare the elasticity of the demand curve
d1 in the two cases.
Answer: In the case with three countries, Home consumers have more varieties
to choose from compared with the two-country case. For that reason, the de-
mand curve facing each firm is flatter (more elastic) when there are more trad-
ing partners.
d. Illustrate the long-run equilibrium with trade and compare it with the long-run
equilibrium when Home trades with only one other identical country.
Answer: The long-run equilibrium with trade occurs where the demand curve
facing the firm is tangent to the average cost curve, to the right of the long-run
equilibrium without trade (due to the exit of firms from the industry). Because
the demand curve facing each firm with trade (d3) is flatter when there are three
countries compared with two, it will end up further down the average cost curve
in Figure 6-7. Therefore, firms will produce a greater quantity, at lower average
cost, than the in the two-country case.
4. Starting from the long-run trade equilibrium in the monopolistic competition
model, as illustrated in Figure 6-7, consider what happens when industry demand, D,
increases. For instance, suppose that this is the market for cars and lower gasoline
prices generate higher demand D.
a. Redraw Figure 6-7 for the Home market and show the shift in the D/N T curve
and the new short-run equilibrium.
Answer: The increase in demand shifts the D/N A curve to the right, dragging
along the curves d3 and mr3. Each firm produces Q4 at a price of P4 attempting
to earn monopoly profits at point D, and when all firms do so they move along
the new D/N T curve to point E.

Price

D/N T

D E
P4
C
PW
AC
d4
MC

mr4

Q3 Q4 Quantity
 Solutions ■ Chapter 6 Increasing Returns to Scale and Monopolistic Competition S-51

b. From the new short-run equilibrium, is there exit or entry of firms, and why?
Answer: In the short-run with trade, monopoly profits are positive because price
exceeds average cost. As a result, firms enter the industry and N T increases.
c. Describe where the new long-run equilibrium occurs, and explain what has hap-
pened to the number of firms and the prices they charge.
Answer: In the long-run with trade, firm entry shifts D/N T and d4 to the left
and makes d4 more elastic until it is tangent to the average cost curve. At that
point, monopoly profits are zero and firms no longer enter the industry. Rela-
tive to the short-run equilibrium in (b), the number of firms increases and price
decreases.
5. Our derivation of the gravity equation from the monopolistic competition model
used the following logic:
(1) Each country produces many products;
(2) Each country demands all of the products that every other country produces;
(3) Thus, large countries demand more imports from other countries.
The gravity equation relationship does not hold in the Heckscher-Ohlin model. Ex-
plain how the logic of the gravity equation breaks down in the Heckscher-Ohlin
model: that is, which of the above statements is no longer true in the Heckscher-
Ohlin model?
Answer: The Heckscher-Ohlin model assumes perfect competition. Therefore, each
country produces many products. However, in the Heckscher-Ohlin model not all
products produced in other countries (in autarky) are imported under trade. Rather,
because products are not differentiated, only those identical products with a lower rel-
ative price abroad are imported, and countries specialize in the good that uses their
abundant factor intensively. Hence larger countries do not necessarily demand more
imports from other countries.
6. The United States, France, and Italy are among the world’s largest producers. To an-
swer the following questions, assume that their markets are monopolistically compet-
itive, and use the gravity equation with B ⫽ 93 and n ⫽ 1. 25.

GDP in 2009 ($bn) Distance from the United States (miles)

France $ 2,635 5,544

Italy 2,090 6,229
United States 14,270 —

a. Using the gravity equation, compare the expected level of trade between the
United States and France and between the United States and Italy.
Answer: The expected level of trade between the United States and France is
93(14,270 ⴢ 2,635) / 5,5441. 25 ⫽ $73,098 billion. The expected level of trade be-
tween the United States and Italy is 93(2,090 ⴢ 14,270) / 6,2291. 25 ⫽ $50,122
billion.
(Note: These numbers are larger than is realistic because we are using the gravity equation
estimated on the United States and Canada state/provincial trade, rather than the equa-
tion estimated on international trade.)
b. The distance between Paris and Rome is 694 miles. Would you expect more
French trade with Italy or with the United States? Explain what variable (i. e. ,
country size or distance) drives your result.
S-52 Solutions ■ Chapter 6 Increasing Returns to Scale and Monopolistic Competition

Answer: The expected level of trade between Italy and France is 93(2,635 ⴢ
2,090) / 6941. 25 ⫽ $143,784 billion. This number is so large because it reflects
the short distance between the two countries. In particular, this number is larger
than the predicted amount of trade between the United States and Italy, as cal-
culated in part (a).
7. What evidence is there that Canada is better off under the free-trade agreement with
the United States?
Answer: Economist Daniel Trefler found that between 1988 and 1996 the produc-
tivity of Canadian firms increased by as much as 15% in industries most affected by
the tariff cuts. The growth in productivity translates to an increase in real earnings of
3% over the 8-year period. Moreover, Canadian consumers gained from the fall in
prices and the rise in product variety.
8. In the section “Gains and Adjustment Costs for the United States under NAFTA,”
we calculated the lost wages of workers displaced due to NAFTA. Prior experience
in the manufacturing sector shows that about two thirds of these workers obtain new
jobs within 3 years. One way to think about that re-employment process is that one
third of workers find jobs in the first year, and another one third of remaining un-
employed workers find a job each subsequent year. Using this approach, in the table
that follows, we show that one third of workers get a job in the first year (column 2),
leaving two thirds of workers unemployed (column 4). In the second year, another
(1/3) ⴢ (2/3) ⫽ 2/9 of workers get a job (column 2), so that 1/3 ⫹ 2/9 ⫽ 5/9 of the
workers are employed (column 3). That leaves 4/9 of the workers unemployed (col-
umn 4) at the end of the second year.

Fraction Total Fraction Total Fraction

Year Finding Job Employed Unemployed

1 1/3 1/3 1 ⫺ 1/3 ⫽ 2/3

2 1/3 ⴢ 2/3 ⫽ 2/9 1/3 ⫹ 2/9 ⫽ 5/9 1 ⫺ 5/9 ⫽ 4/9
3 1/3 ⴢ 4/9 ⫽ 4/27
4
5
6 1/3(2/3)Year⫺1

a. Fill in two more rows of the table using the same approach as for the first two
rows.
Answer:

Fraction Total Fraction Total Fraction

Year Finding Job Employed Unemployed

1 1/3 1/3 1 ⫺ 1/3 ⫽ 2/3

2 1/3 ⴢ 2/3 ⫽ 2/9 1/3 ⫹ 2/9 ⫽ 5/9 1 ⫺ 5/9 ⫽ 4/9
3 1/3 ⴢ 4/9 ⫽ 4/27 5/9 ⫹ 4/27 ⫽ 19/27 1 ⫺ 19/27 ⫽ 8/27
4 1/3 ⴢ 8/27 ⫽ 8/81 19/27 ⫹ 8/81 ⫽ 65/81 1 ⫺ 65/81 ⫽ 16/81
5
6 1/3(2/3)Year⫺1

b. Notice that the fraction of workers finding a job each year (column 2) has the
formula:
1 2 Year⫺1
Fraction Finding Job ⫽ ᎏ ⴢ ᎏ
3 3 冢 冣
 Solutions ■ Chapter 6 Increasing Returns to Scale and Monopolistic Competition S-53

Using this formula, fill in six more values for the fraction of workers finding a
job (column 2), up to year 10.
Answer:

Fraction Total Fraction Total Fraction

Year Finding Job Employed Unemployed

1 1/3 1/3 1 ⴢ 1/3 ⫽ 2/3

2 1/3 ⴢ 2/3 ⫽ 2/9 1/3 ⫹ 2/9 ⫽ 5/9 1 ⫺ 5/9 ⫽ 4/9
3 1/3 ⭈ 4/9 ⫽ 0.15 5/9 ⫹ 0.15 ⫽ 0.7 1 ⫺ 0.7 ⫽ 0.30
4 1/3 ⭈ 8/27 ⫽ 0.10 0.80 0.20
5 0.07 0.87 0.13
6 0.04 0.91 0.09
7 0.03 0.94 0.06
8 0.02 0.96 0.04
9 0.01 0.97 0.03
10 0.01 0.98 0.02

c. To calculate the average spell of unemployment, we take the fraction of workers

finding jobs (column 2), multiply it by the years of unemployment (column 1),
and add up the result over all the rows. By adding up over 10 rows, calculate
what the average spell of unemployment is. What do you expect to get when
adding up over 20 rows?
Answer: We get 2. 77 over 10 years, and would expect ⬇3 over 20 years.

Total
Fraction Fraction Total Fraction Average
Year Finding Job Employed Unemployed Spell

1 0.33 0.33 0.67 0.33

2 0.22 0.56 0.44 0.44
3 0.15 0.70 0.30 0.44
4 0.10 0.80 0.20 0.40
5 0.07 0.87 0.13 0.33
6 0.04 0.91 0.09 0.26
7 0.03 0.94 0.06 0.20
8 0.02 0.96 0.04 0.16
9 0.01 0.97 0.03 0.12
10 0.01 0.98 0.02 0.09
Sum ⫽ 2.77

d. Compare your answer to (c) with the number used in the application for the av-
erage spell of unemployment: was that number accurate?
Answer: We had assumed that the average spell of unemployment was 3 years,
which is accurate!
9. Calculate the intra-industry trade index for rice (HS 1006) and paintings (HS 9701)
in 2005. To obtain the export and import values, access the U. S. TradeStats Express
Web site (http://tse. export. gov/). Click on “National Trade Data” then “Global Pat-
terns of U. S. Merchandise Trade. ” Under the “Product” section, change the item to
rice or paintings.
S-54 Solutions ■ Chapter 6 Increasing Returns to Scale and Monopolistic Competition

a. Of two products, rice and paintings, which product do you expect to have a
higher index of intra-industry trade? Why?
Answer: We would expect that paintings would have a higher index of intra-in-
dustry trade, because they are differentiated goods, unlike rice.
b. Access the U. S. TradeStats Express Web site at http://tse. export. gov/. Click on
“National Trade Data” then “Global Patterns of U. S. Merchandise Trade. ” Un-
der the “Product” section, change the item to rice (HS 1006) and obtain the ex-
port and import values. Do the same for paintings (HS 9701), and then calcu-
late the intra-industry trade index for rice and paintings in 2009. Do your
calculations confirm your expectation from part (a)? If your answers did not con-
firm your expectation, explain.
Answer:
Minimum of Imports and Exports
Index of intra-industry trade =
½ (Imports + Exports)
(HS 1006) – RICE
Export = 2,178,366,067
Imports = 588,181,227
588,181,227
Index of IITRice = = 43%
½ (588,181, 277 + 2,178,366, 067)

(HS 9701) – Paintings, drawings, and artwork done by hand

Export = 4,950,812,000
Imports = 3,285,991,000
3,285,991,000
Index of ITTPainting = = 79%
½ (3, 285,991,000 + 4,950,812,000)