International Trade the World Economy Charles van Marrewijk

International Trade & the World Economy; Charles van Marrewijk CHAPTER 10; INTRA - INDUSTRY TRADE Introduction Measuring intra-industry trade Dixit-Stiglitz demand Demand effects; income, price elasticity , and price index Increasing returns to scale Optimal pricing and zero profits Explaining intra-industry trade An alternative interpretation: intermediate goods Conclusions

International Trade & the World Economy; Charles van Marrewijk CHAPTER 10; INTRA - INDUSTRY TRADE Introduction Measuring intra-industry trade Dixit-Stiglitz demand Demand effects; income, price elasticity , and price index Increasing returns to scale Optimal pricing and zero profits Explaining intra-industry trade An alternative interpretation: intermediate goods Conclusions

International Trade & the World Economy; Charles van Marrewijk Introduction Avinash Dixit (1944 - )

International Trade & the World Economy; Charles van Marrewijk CHAPTER 10; INTRA - INDUSTRY TRADE Introduction Measuring intra-industry trade Dixit-Stiglitz demand Demand effects; income, price elasticity , and price index Increasing returns to scale Optimal pricing and zero profits Explaining intra-industry trade An alternative interpretation: intermediate goods Conclusions

International Trade & the World Economy; Charles van Marrewijk Measuring intra-industry trade (= two-way trade in similar goods) Use the Grubel-Lloyd (GL) index to measure intra-industry trade:

International Trade & the World Economy; Charles van Marrewijk Measuring intra-industry trade Variations in extent of intra-industry trade

International Trade & the World Economy; Charles van Marrewijk Measuring intra-industry trade Increasing importance of intra-industry trade

International Trade & the World Economy; Charles van Marrewijk CHAPTER 10; INTRA - INDUSTRY TRADE Introduction Measuring intra-industry trade Dixit-Stiglitz demand Demand effects; income, price elasticity , and price index Increasing returns to scale Optimal pricing and zero profits Explaining intra-industry trade An alternative interpretation: intermediate goods Conclusions

International Trade & the World Economy; Charles van Marrewijk Dixit-Stiglitz demand If there are N (= ‘large’) different varieties of manufactures And the utility function is: Then, subject to the budget constraint; the demand for a variety, say j, is: (discussed below) Characteristic is the love-of-variety effect, e. g. if ci = c for all i:

International Trade & the World Economy; Charles van Marrewijk CHAPTER 10; INTRA - INDUSTRY TRADE Introduction Measuring intra-industry trade Dixit-Stiglitz demand Demand effects; income, price elasticity , and price index Increasing returns to scale Optimal pricing and zero profits Explaining intra-industry trade An alternative interpretation: intermediate goods Conclusions

International Trade & the World Economy; Charles van Marrewijk Demand effects; income, price elasticity , and price index Dixit-Stiglitz demand depends on: • The income level I equiproportionally • The price charged by the producer negatively • A parameter > 1 = price elasticity of demand • The price index P positively Demand for a variety rises if the general price level P increases; Each producer ignores his own impact on this price level, which is reasonable if N is ‘large’ but not if N is ‘small’ (see next slide)

International Trade & the World Economy; Charles van Marrewijk Demand effects; income, price elasticity , and price index

International Trade & the World Economy; Charles van Marrewijk CHAPTER 10; INTRA - INDUSTRY TRADE Introduction Measuring intra-industry trade Dixit-Stiglitz demand Demand effects; income, price elasticity , and price index Increasing returns to scale Optimal pricing and zero profits Explaining intra-industry trade An alternative interpretation: intermediate goods Conclusions

International Trade & the World Economy; Charles van Marrewijk Increasing returns to scale (IRS) If the production function requires a fixed labor cost f before production starts at variable labor cost m there are IRS:

International Trade & the World Economy; Charles van Marrewijk CHAPTER 10; INTRA - INDUSTRY TRADE Introduction Measuring intra-industry trade Dixit-Stiglitz demand Demand effects; income, price elasticity , and price index Increasing returns to scale Optimal pricing and zero profits Explaining intra-industry trade An alternative interpretation: intermediate goods Conclusions

International Trade & the World Economy; Charles van Marrewijk Optimal pricing and zero profits • As a result of IRS each variety is produced by single producer. • This producer has market power and charges a monopolistically competitive price (determines the optimal price by MR = MC, taking the prices charged by the other firms [the price index P] as given). • Because the price elasticity of demand is constant (equal to the parameter ) the mark-up over marginal costs charged by the producer is also constant. • Firms will enter the market (producing new varieties) if profits are positive; they will exit if profits are negative. • The number of varieties N produced is therefore determined by the zero-profit condition. • In the Dixit-Stiglitz model the number of varieties N produced is proportional to the size of the economy as measured by the labor force

International Trade & the World Economy; Charles van Marrewijk CHAPTER 10; INTRA - INDUSTRY TRADE Introduction Measuring intra-industry trade Dixit-Stiglitz demand Demand effects; income, price elasticity , and price index Increasing returns to scale Optimal pricing and zero profits Explaining intra-industry trade An alternative interpretation: intermediate goods Conclusions

International Trade & the World Economy; Charles van Marrewijk Explaining intra-industry trade

International Trade & the World Economy; Charles van Marrewijk CHAPTER 10; INTRA - INDUSTRY TRADE Introduction Measuring intra-industry trade Dixit-Stiglitz demand Demand effects; income, price elasticity , and price index Increasing returns to scale Optimal pricing and zero profits Explaining intra-industry trade An alternative interpretation: intermediate goods Conclusions

International Trade & the World Economy; Charles van Marrewijk An alternative interpretation: intermediate goods; Krugman

International Trade & the World Economy; Charles van Marrewijk An alternative interpretation: intermediate goods; Ethier

International Trade & the World Economy; Charles van Marrewijk CHAPTER 10; INTRA - INDUSTRY TRADE Introduction Measuring intra-industry trade Dixit-Stiglitz demand Demand effects; income, price elasticity , and price index Increasing returns to scale Optimal pricing and zero profits Explaining intra-industry trade An alternative interpretation: intermediate goods Conclusions

International Trade & the World Economy; Charles van Marrewijk Conclusions • Empirically observed prevalence of intra-industry trade (two-way trade in similar products) puzzled theorists. • Intra-industry trade is measured using the Grubel-Lloyd index. • Krugman uses Dixit-Stiglitz variety approach with monopolistic competition and IRS to explain intra-industry trade. • Trade extends the market and raises welfare through an increases of the number of varieties available (love-of-variety). • Alternative interpretation (Ethier) explains intra-industry trade through exchange of intermediate goods; increased specialization leads to positive production externalities.