T5: New Explanations for International Trade

Question 1

What are the assumptions of the Krugman, Dixit and Stiglitz model?

Answer 1

1. Increasing returns to scale
2. Love of variety <= horizontal demand curve

Question 2

Where do firms produce in a monopolistically competitive market?

Answer 2

Where MC=MR because this is the profit maximising production

Question 3

What are the key factors to trade in imperfect competition?

Answer 3

1. Each firm produces a similar but differentiated good (downward sloping D)
2. Many firms
3. Firms produce using tech (increasing RTS)
4. Because firms can freely enter and exit the industry, monopoly profits are 0 in the LR

Question 4

What happen to imperfect competition when we open it up to free trade?

Answer 4

1. number of consumers doubles, but the ratio of consumers to firms remains the same
2. Product varieties doubles
3. Greater number of varieties available, the D for each individual variety will be more elastic

Question 5

What is the difference between SR and LR trade?

Answer 5

in the SR we produce where MC=MR, but in doing so P<AC so all firms take losses and some exit the industry

in the LR, firms produce where MR=MC and where P=MC meaning no monopoly profits are made so no firms enter the industry

Question 6

What is the gravity equation?

Answer 6

B * (GDP1*GDP2)/Distance

B = all the factors, other than size, that influences whether countries trade

Gravity equation shows that physical distance explains whether firms trade together