Chapter 4: Krugman Salop Model Flashcards
What is intra industry trade
A large share of world trade consists of countries exporting and importing within the same product category =⇒ Intra-industry trade.
difference between intra -industry and inter-industry trade
increasing returns to scale vs constant returns to scale
differentiated vs homogenous products
What is increasing returns to scale?
Why is differentiated goods important
The general idea of increasing returns to scale is that when inputs increase at a certain rate, output increases at a faster rate: f (λK, λL) > λf (K, L) for all λ > 1.
⋆ Love-for-variety preferences: Consumers obtain a higher utility from eating different kinds of
food over eating the same calorie intake but only one type of food (at the same cost). =⇒ Utility increases with product variety.
⋆ “Salop preferences”: Within clothing, some consumers prefer suits, others jeans. In this class,
we will focus on the Krugman-Salop model, where consumers have preferred varieties and firms produce varieties tailored for particular segments of the market. =⇒ Utility increases with product variety since the larger the variety, the more likely a consumer is to be able to purchase (a variety closer to) their most preferred variety.
What is increasing returns to scale?
Why is differentiated goods important
The general idea of increasing returns to scale is that when inputs increase at a certain rate, output increases at a faster rate: f (λK, λL) > λf (K, L) for all λ > 1.
⋆ Love-for-variety preferences: Consumers obtain a higher utility from eating different kinds of
food over eating the same calorie intake but only one type of food (at the same cost). =⇒ Utility increases with product variety.
⋆ “Salop preferences”: Within clothing, some consumers prefer suits, others jeans. In this class,
we will focus on the Krugman-Salop model, where consumers have preferred varieties and firms produce varieties tailored for particular segments of the market. =⇒ Utility increases with product variety since the larger the variety, the more likely a consumer is to be able to purchase (a variety closer to) their most preferred variety.
What are external and internal economies of scale
External economies of scale occur when a firm’s cost per unit of output (average cost) depends on the size of the industry, not on the size of the firm.
An industry where economies of scale are purely external will typically consist of many small firms and be perfectly competitive.
Internal economies of scale occur when a firm’s cost per unit of output (average cost) depends on the size of the firm, not on the size of the industry.
Internal economies of scale result when large firms have a cost advantage over small firms, causing the industry to become imperfectly competitive.
Krugman models rely on internal economies of scale.
Why are Krugman Models considered as a form of imperfect competition
Krugman models rely on the second form of imperfect competition, where firms produce differentiated goods, i.e. different varieties of the same good.
What happens when there is imperfect competition?
What are the conditions for imperfect competition to hold
In imperfect competition, firms are aware that they can influence the prices of their products and that they can sell more only by reducing their price.
This situation occurs when
there are only a few major producers of a particular good, or,
when each firm produces a good that is differentiated from that of rival firms.
What is the calculation for intra-industry trade
I = min{exports, imports} / [ (exports + imports) /2}
different Krugman models assume that market structure is characterized by monopolistic competition.
what is monopolistic competition
Each firm has monopoly power in the sense that only one firm produces one particular product variety, but the firm faces competition from other varieties. In the long run, firms’ profits are driven down to zero.
Recap: What is average cost and marginal cost.
Why is the larger firm more efficient in this case?
Average cost is the cost of production C divided by the total quantity of production Q.
AC = C/Q = F/Q + c
where C is total cost of production, Q is the production volume, F is fixed cost of production, and c is the (constant) marginal cost.
Marginal cost: cost of producing an additional unit of output.
A larger firm is more efficient because average cost decreases as output Q increases: internal economies of scale.
How do monopolies make profits?
Profits come from: (Pm-AC) x Qm
Pm: Profit Maximising Price
AC: Average cost incurred per unit of output
Qm: profit maximising qty
What are some characteristics of monopolistic competition? What are some underlying assumptions as well
Characteristics:
can differentiate its product from the product of competitors;
takes the prices charged by its rivals as given
Assumptions:
There are a large number of firms in an industry so no firm can affect the average market price.
These firms produce differentiated products. Each firm is a local monopolist in the sense that it is the only firm producing a particular variety of the good. Each firm faces a downward sloping demand curve.
Entry and exit from the industry is relatively easy. In the long run, all firms make zero profits.
There are internal economies of scale.
Explain the Krugman-style model. What happens to the quanitity when there are
a. sales and prices charged by rivals increase
b. number of firms and individual firm’s price increase
We will assume a model with one good but many varieties of that good. There is one factor of production, labor. We assume that preferences are the same in both countries we will study and symmetric between varieties so that if all varieties have the same price, they will sell in the same quantity.
These concepts are represented by the
demand function of firm i Qi =S[1/n−b(Pi −P bar)]
Qi is quantity sold by firm i
S is the total quantity sold in the industry,
n is the number of firms in the industry,
b is a constant term representing the responsiveness of a firm’s sales to its price,
Pi is the price of variety i,
P bar is the average price charged by its competitors.
IfP =P bar ,thenQ =S/n. ii
S does not depend on P ̄ and we assume that each firm is small enough so that P does not
affect P ̄.
Q increase as total sales in the industry increase and as prices charged by rivals increase.
Q decrease as the number of firms in the industry increases and as the firm’s price increases.
How to set up MR=MC for the Krugman Model
Demand function of firm i: Q = S[1/n − b(P − P bar)]
Get inverse demand: Pi(Qi) = Pi(Qi) = 1/bn + P bar − 1/bS x Qi
Get total revenue: Pi (Qi) x Qi
Get Marginal revenue: MR = 1/bn + Pbar -[2/bS x Qi]
Total cost: Ci (Qi ) = F + cQi
Marginal cost = c
What happens to profits in the short run. As number of firms enter, what happens to profits in the LR
If there are positive profits in the short run, new firms will enter the market (the number of varieties or firms n increases). When that occurs, the inverse demand function and marginal revenue function shift downward.
Firm i now has to share consumer demand with more firms.
When n increases, profits fall because
- price falls
- average cost rises
- quantity produced declines
With monopolistic competition, free entry ensures all firms make zero profits in LR
