- Imperfect competition is a competitive market situation where there are many sellers, but they are selling heterogeneous (dissimilar) goods as opposed to the perfect competitive market scenario. As the name suggests, competitive markets that are imperfect in nature.
- Imperfect competition is the real world competition. Today some of the industries and sellers follow it to earn surplus profits. In this market scenario, the seller enjoys the luxury of influencing the price in order to earn more profits.
- If a seller is selling a non identical good in the market, then he can raise the prices and earn profits. High profits attract other sellers to enter the market and sellers, who are incurring losses, can very easily exit the market.
- There are four types of imperfect markets:
a)Monopoly (only one seller) b) Oligopoly (few sellers of goods) c) Monopolistic competition (many sellers with highly differentiated product) d)Monopsony (only one buyer of a product).
Trade Based on Product Differentiation
- A large portion of the output of modern economies today involves differentiated rather than homogeneous products. Thus, a Chevrolet is not identical to a Toyota, a Volkswagen, a Volvo, or a Renault. As a result, a great deal of international trade can and does involve the exchange of differentiated products of the same industry or broad product group. That is, a great deal of international trade is intra-industry trade in differentiated products, as opposed to inter-industry trade in completely different products.
- Intra-industry trade arises in order to take advantage of important economies of scale in production. That is, international competition forces each firm or plant in industrial countries to produce only one or at most a few, varieties and styles of the same product rather than many different varieties and styles. This is crucial in keeping unit costs low. With few varieties and styles, more specialized and faster machinery can be developed for a continuous operation and a longer production run. The nation then imports other varieties and styles from other nations. Intra-industry trade benefits consumers because of the wider range of choices (i.e., the greater variety of differentiated products) available at the lower prices made possible by economies of scale in production.
- The importance of intra-industry trade became apparent when tariffs and other obstructions to the flow of trade among members of the European Union, or Common Market, were removed in 1958. Balassa found that the volume of trade surged, but most of the increase involved the exchange of differentiated products within each broad industrial classification. That is, German cars were exchanged for French and Italian cars, French washing machines were exchanged for German washing machines, Italian typewriters for German and French typewriters, and so on.
- Even before the formation of the European Union, plant size in most industries was about the same in Europe and the United States. However, unit costs were much higher in Europe, primarily because European plants produced many more varieties and styles of a product than did their American counterparts. As tariffs were reduced and finally eliminated and trade expanded within the European Union, each plant could specialize in the production of only a few varieties and styles of a product, and unit costs fell sharply as a result.
- Several other interesting considerations must be pointed out with respect to the intra-industry trade models developed by Helpman, Krugman, Lancaster, and others since 1979. First, although trade in the H–O model is based on comparative advantage or differences in factor endowments (labor, capital, natural resources, and technology) among nations, intra-industry trade is based on product differentiation and economies of scale. Thus, while trade based on comparative advantage is likely to be larger when the difference in factor endowments among nations is greater, intra-industry trade is likely to be larger among industrial economies of similar size and factor proportions (when factors of production are broadly defined).
- Second, with differentiated products produced under economies of scale, pretrade-relative commodity prices may no longer accurately predict the pattern of trade. Specifically, a large country may produce a commodity at lower cost than a smaller country in the absence of trade because of larger national economies of scale. With trade, however, all countries can take advantage of economies of scale to the same extent, and the smaller country could conceivably undersell the larger nation in the same commodity.
- Third, in contrast to the H–O model, which predicts that trade will lower the return of the nation’s scarce factor, with intra-industry trade based on economies of scale it is possible for all factors to gain. This may explain why the formation of the European Union and the great post-war trade liberalization in manufactured goods met little resistance from interest groups. This is to be contrasted to the strong objections raised by labor in industrial countries against liberalizing trade with some of the most advanced of the developing countries because this trade, being of the inter- rather than of the intra-industry trade type, could lead to the collapse of entire industries (such as the textile industry) and involve lower real wages and massive reallocations of labor to other industries in industrial nations.
- Finally, intra-industry trade is related to the sharp increase in international trade in parts and components of a product, or outsourcing. International corporations often produce or import various parts of a product in different nations in order to minimize their costs of production (international economies of scale). The utilization of each nation’s comparative advantage to minimize total production costs can be regarded as an extension of the basic H–O model to modern production conditions. This pattern also provides greatly needed employment opportunities in some developing nations.
- The tentative conclusion that can be reached, therefore, is that comparative advantage seems to determine the pattern of inter-industry trade, while economies of scale in differentiated products give rise to intra-industry trade. Both types of international trade occur in today’s world. The more dissimilar are factor endowments (as between developed and developing countries), the more important are comparative advantage and inter-industry trade. On the other hand, intra-industry trade is likely to be dominant the more similar are factor endowments broadly defined (as among developed countries). As Lancaster (1980) pointed out, however, even in the case of intra-industry trade, “comparative advantage is somewhere in the background.” One could say that inter-industry trade reflects natural comparative advantage while intra-industry trade reflects acquired comparative advantage.
- More importantly, the more recent empirical tests of the H–O theory showed that by allowing for differences in technology and factor prices across countries, for the existence of non-traded goods and transportation costs, and by utilizing more disaggregated factor endowments and trade data, a great deal of intra-industry trade is in fact based on international differences in factor endowments and comparative costs.
- Thus, there seems to be much less conflict between intra-industry and the H–O theories than might appear at first sight. That is, a great deal of intra-industry trade is in fact consistent with trade based on differences in factor endowments and comparative costs. For example, the importation of a computer from Mexico by the United States may in fact involve the re-export of U.S. computer chips produced with highly skilled U.S. labor, as well as the export of other less-skilled Mexican labor embodied into the computer.
Measuring Intra-Industry Trade
The level of intra-industry trade can be measured by the intra-industry trade index (T)
Where X and M represent, respectively, the value of exports and imports of a particular industry or commodity group and the vertical bars in the numerator of Equation denote the absolute value. The value of T ranges from 0 to 1. T = 0 when a country only exports or only imports the good in question (i.e., there is no intra-industry trade). On the other hand, if the exports and imports of a good are equal, T = 1 (i.e., intra-industry trade is maximum).
Formal Model of Intra-Industry Trade
- Figure 1 presents a formal model of intra-industry trade. In Figure 1, D represents the demand curve faced by the firm for the differentiated products that it sells. Since many other firms sell similar products, the demand curve faced by the firm is fairly elastic (i.e., D has a small inclination). This means that a small price change leads to a large change in the firm’s sales.
- The form or market organization where (as in this case) there are many firms selling a differentiated product and entry into or exit from the industry is easy is called monopolistic competition. Because the firm must lower the price (P) on all units of the commodity if it wants to increase sales, the marginal revenue curve of the firm (MR) is below the demand curve (D), so that MR < P. For example, D shows that the firm can sell 2 units at P = $4.50 and have a total revenue of $9 or sell 3 units at P = $4 and have a total revenue of $12. Thus, the change in total revenue or MR = $3, compared with P = $4 for the third unit of the commodity sold.
By producing only one of a few varieties of the product, the firm also faces increasing returns to scale in production, so that its average cost curve (AC) is also downward sloping (i.e., AC declines as output increases). As a result, the firm’s marginal cost curve (MC) is below the AC curve. The reason for this is that for AC to decline, MC must be smaller than AC. The best level of output for the firm is 3 units and is given by point E, where the MR and MC curves intersect. At a smaller level of output, MR (i.e., the extra revenue) exceeds MC (i.e., the extra cost) and it pays for the firm to expand output.
- On the other hand, at an output greater than 3 units, MR < MC and it pays for the firm to reduce output. Thus, the best level of output (Q) is 3 units. The firm will then charge the price of $4, shown by point A on the D curve. Furthermore, since more firms are attracted to the industry in the long run whenever firms in the industry earn profits, the demand curve facing this firm (D) is tangent to its AC curve, so that P = AC = $4 at Q = 3. This means that the firm breaks even (i.e., it earns only a normal return on investment in the long run).
- We can now examine the relationship between inter-industry and intra-industry trade. To do this, suppose that Nation 1 has a relative abundance of labor and commodity X is labor intensive, while Nation 2 has a relative abundance of capital and commodity Y is capital intensive. If commodities X and Y are homogeneous, Nation 1 will export commodity X and import commodity Y, while Nation 2 will export commodity Y and import commodity X, as postulated by the Heckscher–Ohlin theory. This is inter-industry trade and reflects comparative advantage only.
- On the other hand, if there are different varieties of commodities X and Y (i.e., commodities X and Y are differentiated), Nation 1 will still be a net exporter of commodity X (this is inter-industry trade, which is based on comparative advantage), but it will also import some varieties of commodity X and export some varieties of commodity Y (this is intra-industry trade, which is based on product differentiation and economies of scale).
- Similarly, while Nation 2 will still be a net exporter of commodity Y, it will also import some varieties of commodity Y and export some varieties of commodity X. The net exports of X and Y by Nations 1 and 2, respectively, reflect inter-industry trade, which is based on comparative advantage. On the other hand, the fact that Nation 1 also imports some varieties of commodity X and exports some varieties of commodity Y, while Nation 2 also imports some varieties of commodity Y and exports some varieties of commodity X (i.e., the fact that there is an interpenetration of each other’s market in each product) reflects intra-industry trade, which is based on product differentiation and economies of scale. Thus, when products are homogeneous, we have only inter-industry trade.
- On the other hand, when products are differentiated, we have both inter- and intra-industry trade. The more similar nations are in factor endowments and technology, the smaller is the importance of inter-relative to intra-industry trade, and vice versa. Since industrial nations have become more similar in factor endowments and technology over time, the importance of intra-relative to inter-industry trade has increased.
Another Version of the Intra-Industry Trade Model
- We now examine intra-industry trade from a different perspective with the aid of Figure 2. The horizontal axis in Figure2 measures the number of firms (N) in a monopolistically competitive industry, while the vertical axis measures the product price (P) and the average or per unit cost of production (AC).
- All firms sell at the same price even though their product is somewhat differentiated. This will be true if all firms in the monopolistically competitive industry are symmetric or face identical demand and cost functions or conditions.
- In Figure 2, curve P shows the relationship between the number of firms in the industry and the product price. Curve P is negatively sloped, showing that the larger the number of firms in the industry the lower is the product price because competition is greater or more intense with more firms in the industry. For example, P = $4 when N = 200 (see point F in the figure), P = $3 when N = 300 (point E), and P = $2 when N = 400 (point E’).
- Curve C, on the other hand, shows the relationship between the number of firms in the industry and their average cost of production for a given level of industry output. Curve C is positively sloped, showing that the larger N is, the greater their AC is. The reason is that when more firms produce a given industry output, each firm’s share of the industry output will be smaller, and so each firm will incur higher average costs of production. For example, AC = $2 when N = 200 (point G in the figure), AC = $3 when N = 300 (point E), and AC = $4 when N = 400 (point H).
- The intersection of curve P and curve C defines equilibrium point E, at which P = AC = $3 and N = 300 and each firm breaks even (i.e., makes zero profits). With 200 firms, P = $4 (point F), while AC = $2 (point G). Since firms will then be earning profits, more firms will enter the industry until long-run equilibrium point E is reached.
- On the other hand, with N = 400, P = $2 (point E’), while AC = $4 (point H ). Since now all firms incur losses, some firms will leave the industry until long-run equilibrium point E is reached. By opening up or expanding international trade and thus becoming part of a much larger integrated world market, firms in each nation can specialize in the production of a smaller range of products and face lower average costs of production. Mutually beneficial trade can then take place even if nations are identical in factor endowments and technology.
- Consumers in each nation would benefit both from lower product prices and from the larger range of commodities. This is shown by the downward shift of curve C to curve C in Figure 2. Curve C shifts down to curve C because an increase in market size or total industry sales increases the sales of each firm, for any given number of firms in the industry and lowers the average production cost of each firm. The downward shift in curve C to curve C leads to new long-run equilibrium point E’, P = AC = $2 and N = 400, as compared with original equilibrium point E (with P = $3 and AC = $3).