Feenstra and Taylor

Chapter 6 Increasing returns: Monopoly and Monopolistic Competition

Problems

See also the technical notes on monopoly and monopolistic competition

Problem 1. Increasing returns to scale as a basis for trade.

Assume two goods, one with production function Qx = 2 Kx Lx and one with production function
Qy = 4 Ky Ly. Note that both show increasing returns to scale: if you double both K and L in the production of
X, you quadruple output; if you double both K and L in the production of good Y, output increases by a factor of
eight.

In autarky, we have 600 units of both labor and capital. Assume we devote 300 units of labor and 300
of capital to good X, so producing 2 * 300 * 300 = 180,000 units of X; and we devote 200 units of labor and 200
units of capital to Y, producing 4 * 200 * 200 = 160,000 units of Y. So does the rest of the world.

World production of X and Y:

X = 360,000 and Y = 320,000.

In trade, the direction of specialization will depend on historical accident. Say we specialize in X and the
rest of the world in Y, and both areas have 600 units of both labor and capital. We have:

X = 2 (600) (600) = 720, 000 units for both countries together (an increase of 2 times)
Y = 4 (600) (600) = 1,440,000 units of Y for both countries together (an increase of 4.5 times)

It would be possible for both countries to become better off by specialization and trade.

Problem 2. Why is trade within countries greater than trade between countries?
The answer is NOT transportation costs Toronto is closer to New York city than Los Angeles is, yet
there is more trade between New York and Los Angeles. Note also that costs of sea transportation are much
lower than land transport. Border effects are quite important here, and are not limited to tariffs and quotas and
customs delays already existing patterns of trade are hard to change, and different legal systems make it harder
to settle disputes in another country. See the text treatment of trade between the US and Canada, and the two
gravity equations (p. 212 and 214):

Trade between US states and Canadian provinces = 93 * GDP.State * GDP.Province /dist 1.25
Trade between Canadian provinces = 1300 * GDP.Province1 * GDP.Province2 / dist 1.25

Other things equal, there is about 14 times (1300 / 93) more trade between Canadian provinces than between
equally distant US states. Tariffs between the two countries were very low even before NAFTA, and the
language barrier is non-existent which leaves pre-existing patterns of trade and different legal systems as the
probable major factors here.
Problem 3. From monopoly to duopoly to multi-opoly.
The treatment of reciprocal dumping should have convinced you that more firms mean lower prices
and can be extended beyond duopoly. There are two factors at work as trade is opened

1.The number of firms in any one country's market increase, putting downward pressure on price due to
increased competition.
2.The size of the market increases, allowing firms with constant marginal cost to produce more, and hence
allowing lower average costs of production.

The text treatment differentiates between industry demand and firm demand, with industry demand being
represented by D and firm demand by d. It may be less confusing to have a very specific form for the demand
curve, using Q for industry quantity demanded and q for firm quantity demand.

Q = 3000 / P

where the exponent is the elasticity of demand for the industry demand curve.
(Remember that the percent change in quantity will be equal to - times the percent change in P when we apply
our percentage change rules, so that - = % Q divided by % P the definition of elasticity)

Note also that the demand for any individual firm can be derived from the industry demand equation assuming
that there are N identical firms in the industry, total industry demand will be N q, so

Nq = 3000 / P

q= 3000 / N P

and our percentage change rules mean that % q = - N % P

So the elasticity of demand for an individual firm is -N = % Q divided by % P

And more elastic demand curves are flatter.

Hence after trade:

a. The industry demand curve shifts right.
b. Individual demand curves both shift up and pivot to become flatter the text stresses the pivoting, but
note that the industry demand curves will shift up with the market and (a point not stressed by the text) the total
number of firms at home and abroad will decline, despite the fact that in any individual market the total number
of active firms will increase.
c.The elasticity of demand facing an individual firm increases as N increases.
d.An illustration of long-run equilibrium will be provided in class, based on Krugman's analysis of
monopolistic competition.

Problem 4. Increase in industry demand.

An increase in industry demand will result in the entry of new firms and hence an increase in the
elasticity of demand facing any one firm.

Problem 5. Gravity equation and the Heckscher-Ohlin model.

The gravity equation is better suited to the monopolistic competition model in the Heckscher-Ohlin
model, factor endowment drives trade, not distance. In particular, the Heckscher-Ohlin model has no room for
inter-industry trade, and the gravity equation applies to both intra-and inter-industry trade.
Problem 6. Application of the Gravity Equation.

Trade = a * GDP1 * GDP2 / dist

We are given: a = 93 and b = 1.25, as well as the table:

GDP Distance to US
France 1830 5544
Italy 1668 6229
US 12,409 0

Hence the predicted values are:

Trade between US and France = 93 * 1830 * 12409 / 47838.66 = 44,146.04

Trade between US and Italy = 93 * 1668 * 12409 / 5537.9305 = 34,785.07

Both of these are MUCH too large to have come from observed data, (trade is predicted to exceed US
GDP) and have been a mechanical exercise in using the coefficients found in the Canadian case study in the
text. In reality, the parameters a and b would have been estimated from data that included France and Italy as
well as Canada and other trading partners. US-France trade in 2005 was under 24 billion dollars of exports to
France, and imports about 36 billion, so total trade was approximately 60 billion dollars. The gravity equation as
given overstates trade by a factor of 736 times ! Using a factor of 1/12 would be more appropriate than 93

Problem 7. Canadian gains from NAFTA

Besides the price effects stressed in Hecksher-Ohlin or the monopolistic competition model, there are
also dynamic effects. See pages 199-201 and Daniel Trefler's confirmation of the dynamic gains from trade
predicted by Richard Harris. Trefler, The Long and Short of the US-Canada Free Trade Agreement, American
Economic Review, 94:4 (Sept 2004), 870-985 and Richard G. Harris, whose work, Trade, Industrial Policy, and
Canadian Manufacturing was reviewed by John Whalley in the Canadian Journal of Economics, 17:2 (May,
1984) pages 386-398.

Problem 8. Unemployment costs.

Even if trade is beneficial to the average consumer, there will be unemployment costs. This problem
illustrates that the average length of unemployment may be quite long if the unemployment is due to plant
closings (other unemployment lasts an average of 3 months). The detailed calculation is tedious, but you should
note that the formula for the fraction finding a job in any year is p (1 p)z, where z is the year 1 from the plant
closure (in year 1). The formula for the total fraction unemployed in any year will be (1 p)n , where n is the
year from the plant closure.
The trickier part of the problem is the computation of the average length of unemployment, which as the
text correctly notes, is the sum of fractions N * p (1 p)z , since that is the fraction of workers who have been
unemployed for N years. The text on page 207 notes that the average spell of unemployment after plant closings
in the wake of NAFTA was 3 years. A computer simulation of the process with 1/3 finding a job each year found
an average unemployment of 2.5 years after 20 years.
Problem 9. Intra-industry trade index (IITI)

| X - M|
IITI = 1.0 - -------------- is easier to remember than the text version (which also works)
X + M

Note that if X = 0, we have IITI = 1.0 - M / M = 0.0 (one way trade = no intra-industry trade)
if X = M, we have IITI = 1.0 - 0 / 2 M = 1.0 (balanced trade = maximum possible IITI)
if X = 2 M, we have IITI = 1.0 - M / 3 M = 2/3

Some values of US trade in January, 2010:

Exports Imports IITI
Soybeans 1716 0 0
Wine and beer 105 680 0.2675
Tea 0 108 0

Steel mill products 762 882 0.9270

Cosmetics 764 582 0.8648
Organic chemicals 2589 1511 0.7371
Autos 8690 16816 0.6814
Pharmaceuticals 4355 6489 0.8032
Medical equipment 2354 2160 0.9570
Lab. Instruments 804 322 0.5719
Books 428 301 0.8258

Problem 10. Demand, Price, Total Revenue and Marginal Revenue

If demand is P = 100 Q,
total revenue is TR = 100 Q - Q2
marginal revenue is MR = 100 2 Q Note that MR = 0 only when Q = 50.
Problem 11. Profits from dumping
This is a simple calculation exercise:
FC = 140, MC = 10, so AC = 140 / Q + 10
At home: P = $ 25, Q = 20, so revenue = $ 500
Variable cost = $ 10 * 20 = $ 200
Operating profit = PQ VC = $ 300
Fixed cost = $ 140
Total profit from home market = $ 160
Foreign market (note that no new fixed cost is required):
P = $ 15, Q = 10, so revenue = $ 150
Variable cost = $ 10 * 10 = $ 100
Operating profit = $ 50
Total profit from operating in both = $ 160 + $ 50 = $ 210
Note that the firm is dumping, since price in the foreign market exceeds home market price.

Problem 12. Monopoly

The demand function in both Home and Foreign markets is 50 - Q. MC = $ 10 for both producers.
Considering just the Home market, MR = 50 Q, so a Home monopolist would produce 40 units and
charge $ 30 --
MR = MC
50 Q = 10
Q* = 40 and use the demand equation to find P* = 50 - (40) = 50 20 = $ 30
Revenue = $ 40 * 30 = $ 1200, and VC = MC*Q = $ 10 * 40 = $ 400, leaving $ 800 as operating profit.
As an exercise, choose another quantity arbitrarily:If Q = 41, P = 50 - (41) = $ 29.50
Revenue = $ 29.50 * 41 = $ 1209.50 up by 9.50
Unfortunately, the marginal cost of the 41st unit is still $ 10, so you lose $ 0.50
Revenue VC = $ 1209.50 410 = $ 799.50
Problem 13. Dueling Duopolies

Assume both Home and Foreign monopolists faced the same demand and costs as in the previous problem.
After trade opens, what will be the effect on prices and quantities?
(for reference, monopoly price = $ 30 and monopoly Q = 40 in both markets, with profits of $ 800 )

Consider the Foreign market (the Home market will be identical, with only the names of the firms changing):

P = 50 - Q = 50 - Qh - Qf where Qh = quantity of goods exported by Home to Foreign

Qf = quantity of Foreign produced goods sold in Foreign

Note that there will be two marginal revenues and two marginal costs
(Home will pay a transport cost of $ 8)

MR.h = 50 Qh - Qf
so Home will maximize profit by setting MR.h = MC.h or 50 Qh - Qf = 18,
from which we can derive Home's reaction function Qh = 32 - Qf

MR.f = 50 - Qh Qf and setting MR.f = MC.f = $ 10, we will get the foreign reaction function,
Qf = 40 - Qh

Substitute the foreign reaction function into the Home reaction function to get:

Qh = 32 - [ 40 - Qh]

Qh = 32 20 + 1/4 Qh

Qh = 12

Qh = 48 / 3 = 16

Likewise, substitute the Home reaction function into the Foreign reaction function to get:

Qf = 32.

The Foreign market will have a total quantity supplied of 48, which implies a price of
P = 50 - 48 = $ 26.

Home will collect a revenue of $ 26 * 16 = $ 416 from the Foreign market, and will incur
variable costs of $ 18 * 16 = $ 288, leaving a profit of $ 128 from the Foreign market.

Foreign's revenue will be $ 26 * 32 = $ 832, and VC = $ 10 * 32 = $ 320, leaving Foreign an

operating profit of $ 512 from Home market operations.

Note that the total monopoly profit from the Foreign market is $ 512 + $ 128 = $ 640, down from $ 800.
Price has fallen from $ 30 to $ 26, and the quantity sold is now 48, not 40.