Krugman Model

Question 1

What do we focus on in the Krugman Model?

Answer 1

Intra-industry trade between similar countries:
Homogeneous firms (‘New trade theory’, Krugman)

Question 2

Model setup

Answer 2

Economic environment:
Country populated by L households
Increasing returns to scale (IRS) production technology using labor as the only input
Monopolistic competition
Each firm possesses a distinct variety of a good and has a monopoly (e.g., through patent) over its variety (varieties are imperfect substitutes)
In their pricing decision, firms take price-setting by all other firms and all aggregate outcomes as given
Free entry into new varieties

Question 3

What does sigma determine?

Answer 3

sigma determines how much substitutable the products are, the larger it is the closer we are to perfect substitution

Question 4

what is the only factor of production?

Answer 4

Labor

Question 5

talk about production in the model

Answer 5

Production involves fixed cost and constant marginal cost, both in terms of labor:
f units of labor needed to set-up the firm / production process
in addition: 1/ units of labor needed per unit of output (→ unit labor requirement)

Question 6

what is that letter i don’t know?

Answer 6

is the constant productivity of workers (same for all firms ↔ Melitz)
⇒ After covering the fixed cost f, one unit of labor yields units of output

Question 7

explain the constant markup

Answer 7

page 30

Question 8

equilibrium under autarky conditions

Answer 8

Two equilibrium conditions: (1) zero profits due to free entry and (2) full employment
Free entry into new varieties

Question 9

explain equilibrium under autarky

Answer 9

page 31

Question 10

explain welfare under autarky

Answer 10

page 31

Question 11

explain free trade between symmetric countries

Answer 11

page 32 - welfare increases with free trade
consumers can also purchase foreign varieties

Question 12

explain Home Market Effect

Answer 12

With costly trade of the differentiated good, the larger country is a net exporter of the differentiated good:
larger market attracts more firms
with trade costs (and IRS), it matters where production takes place!

Question 13

what’s different in the 1979 model?

Answer 13

Same setup as Krugman (1980), but elasticity of demand, (q), is decreasing in q i.e., with higher q consumers become less responsive to the price

Question 14

what happens in the 1979 model?

Answer 14

Welfare rises:
More varieties for consumption (love of variety)
Pro-competitive / efficiency effect (scale economies)
Intuition: More firms ⇒ lower consumption per variety (q ↓)
⇒ lower mark-ups (because demand is more elastic)
⇒ some firms exit (otherwise negative profits if all firms survived)
⇒ more total output per firm (y ↑, via zero-profit condition)
⇒ better use of increasing returns to scale (efficiency gain)

Question 15

Linder hypotesis

Answer 15

Countries trade more if they have similar demand stuctures because demand also drives domestic industrial development
⇒ with non-homothetic preferences, these are countries with similar incomes

Question 16

Brander hypotesis

Answer 16

Reciprocal dumping can be yet another reason for trade between perfectly symmetric countries, even without increasing returns and without product differentiation.
Consider two firms that:
are located in different countries (home and foreign)
produce the exact same good with constant returns to scale using only labor and same productivities