Week 8 lesson 1 Flashcards
Long-Run Equilibrium in Monopolistic Competition
Definition:
- In the long run, firms enter and exit the market until economic profits are zero
Equilbrium conditions:
- Price = Average Cost: At equilibrium, the price charged by firms equals average cost
- If Price < Average Cost: Firms exit the market
- If Price > Average Cost: New firms enter the market
Adjustment Mechanism:
When the number of firms exceeds equilibrium
- Market share per firm decreases.
- Prices drop below average costs.
- Firms exit.
When the number of firms is below equilibrium:
- Market share per firm increases.
- Prices rise above average costs.
- New firms enter.
Monopolistic Competition: Core Concepts
Definition:
- Monopolistic competition is an imperfectly competitive market structure where firms differentiate their products and face some degree of market power
- Firms act as price setters rather than price takers, but still consider the prices of rivals
Key features:
- Product differentiation: Firms sell products that are similar but not identical (E.g., chocolate bars with different branding).
- Market Power: Firms can charge prices above marginal cost due to differentiation
- Free Entry and Exit: In the long run, profits attract new firms, and losses drive firms out
Behaviour of Firms:
Firms sell more when
- Total industry sales increase
- Rivals’ prices rise
Firms sell less when
- The number of competitors increases
- Their price is higher than rivals
Limitations:
- The version of the monopolistic model that is discussed here assumes that firms are symmetric (that they are the same)
- This assumption facilities the understanding and the resolution of the model, however it is not particularly realistic
Graphical Representation:
- Demand curve (Blue curve): Downward-sloping; price decreases as output rises
- Average Cost Curve (Red curve): U-shaped; costs fall initially with increased production but rise again due to diseconomies of scale
Key takeaway:
Monopolistic competition balances elements of perfect competition and monopoly, creating unique market dynamics driven by product differentiation and market entry
The effects of International Trade and Monopolistic Competition
Key Effects of Trade in Monopolistic Competition:
1. Market Expansion: Trade increases the size of the market, allowing firms to operate at lower average costs.
2. Product Variety: Consumers enjoy a wider variety of goods from international firms.
3. Lower Prices: Increased scale reduces costs, passing savings to consumers.
Graphical Impact:
Trade shifts the Average Cost Curve (CC1 to CC2) downward as firms produce at larger scales.
Key example:
Trade between two similar countries with no comparative advantage differences leads to intra-industry trade (e.g., cars traded between Germany and Japan).
Integrated markets: Monopolistic Competition and International Trade
Integrating markets through international trade therefore has the same effects as growth of a market within a signly country
Differences between Comparative Advantage and Intra-industry trade
Comparative advantage trade:
- Based on differences in factor endowments (e.g., labour, capital)
- Countries specialise in different goods
- Example: Brazil exports coffee, Germany exports machinery
Intra-Industry Trade:
- Happens between similar countries with no comparative advantage differences
- Driven by product differentiation and economies of scale
- Example: Germany and Japan both export cars to each other
Key insight:
Comparative advantage explains inter-industry trade, while product differentiation and economies of scale explain intra-industry trade
Key Takeaway:
Intra-industry trade highlights the importance of market size, variety, and product differentiation in global trade patterns
Heterogeneous Firms in International Trade
Key Differences Among Firms:
- Size: Larger firms dominate exports
- Experience: Older firms have established networks
- Technology: Advanced technologies drive competitiveness
- Productivity: Higher productivity enables lower costs
- Managerial Ability: Better management improves efficiency
Exceptional Trading Firms:
- Larger and more capital-intensive
- More technology-focused
- Pay higher wages due to higher human capital requirements
Key Takeaway:
Only exceptional firms can succeed in international markets due to high entry barriers
Self-Selection vs Learning-by-Exporting
Self-Selection:
Only highly productive firms can overcome trade costs (e.g., transportation, marketing, cultural barriers).
Learning-by-Exporting:
Firms become better performers through exposure to foreign competition and knowledge flows.
Key Insight:
Both mechanisms explain why only some firms succeed internationally while others fail.
Key Takeaway:
Successful exporting firms either start as exceptional or become exceptional through experience.
Winners and Losers in International Trade
Winners:
Highly productive firms expand output and profits.
Consumers benefit from lower prices and increased variety.
Losers:
Less productive firms exit the market.
Workers in these firms face temporary unemployment.
Key Adjustment Costs:
Increased unemployment during industry shifts.
Skills mismatch for displaced workers.
Key Takeaway:
Trade improves average productivity but creates short-term costs for weaker firms and workers.
Trade Costs and Export Decisions
Key Factors Influencing Trade Costs:
- Distance: Higher costs for remote markets.
- Market Size: Larger markets attract more firms.
- Competition Toughness: Intense competition raises costs.
- Openness: Regulatory barriers add to trade costs.
Key Takeaway:
Trade costs determine which firms export and which markets they target
Essay for this topic
📝 Introduction
Monopolistic competition, international trade, and firm heterogeneity are three interconnected pillars that explain the complexities of modern global markets. Monopolistic competition captures the behavior of firms in imperfectly competitive markets characterized by product differentiation and price-setting power. International trade expands market size, reduces costs, and increases consumer welfare, while heterogeneous firm models highlight how firms differ in productivity, size, and ability to compete internationally. Together, these concepts provide valuable insights into trade patterns, firm behavior, and economic adjustments in a globalized world. This essay will explore monopolistic competition’s equilibrium dynamics, the impact of international trade on industry outcomes, and the role of firm heterogeneity in determining winners and losers from economic integration.
Sub-Question 1: Monopolistic Competition – Key Characteristics and Equilibrium
Key Characteristics of Monopolistic Competition
Monopolistic competition is a market structure where firms produce differentiated products, face some degree of market power, and have free entry and exit in the long run. Firms in this setting act as price setters, adjusting their prices based on demand and the pricing behavior of rivals.
- Product Differentiation: Each firm offers a unique product, creating brand loyalty and allowing price markups.
- Market Power: Firms can set prices above marginal cost but are still constrained by competitors’ pricing.
- Free Entry and Exit: In the long run, economic profits attract new firms, while losses drive inefficient firms out.
Short-Run vs. Long-Run Equilibrium
- In the short run, firms can earn economic profits if demand exceeds costs.
- In the long run, profits are eroded as new firms enter the market.
At the long-run equilibrium, the following condition holds:
[
P = AC
]
Where:
- P: Price charged by firms
- AC: Average cost
If P > AC, firms have an incentive to enter the market. If P < AC, firms exit until equilibrium is restored.
Graphical Representation:
- The Demand Curve (Blue Curve): Downward-sloping, representing reduced demand at higher prices.
- The Average Cost Curve (Red Curve): U-shaped, showing cost efficiency at optimal production levels.
- Point E: Equilibrium where price equals average cost.
📝 Graph Required: Include the graph showing equilibrium, with key points labeled.
Key Insight: Monopolistic competition represents a dynamic market structure where firms balance product differentiation with competitive pressures, reaching a stable long-run equilibrium where economic profits are zero.
Sub-Question 2: Impact of International Trade on Monopolistically Competitive Industries
How Trade Expands Market Size
International trade integrates domestic markets into a larger global market, increasing industry sales and enabling firms to produce at larger scales. This results in:
1. Lower Average Costs: Firms achieve greater economies of scale.
2. Increased Product Variety: Consumers benefit from more choices.
3. Lower Prices: Firms can pass on cost savings to consumers.
Graphical Impact of Trade
Trade shifts the average cost curve (CC1 → CC2) downward as firms benefit from larger markets.
📝 Graph Required: Include the shift in average cost curves due to increased market size from trade.
Intra-Industry Trade vs. Comparative Advantage Trade
- Comparative Advantage Trade: Driven by differences in factor endowments (e.g., Brazil exporting coffee, Germany exporting machinery).
- Intra-Industry Trade: Happens between similar countries, driven by product differentiation and economies of scale (e.g., Germany and Japan trading cars).
Real-World Example:
The European automobile industry benefits from intra-industry trade, with Germany and France exporting cars to each other despite similar production capabilities.
Key Insight: Trade under monopolistic competition enhances efficiency, product variety, and welfare, while fostering unique trade patterns distinct from comparative advantage.
Sub-Question 3: Firm Heterogeneity and Trade Outcomes
Heterogeneous Firms in Trade
Firms differ significantly within the same industry in terms of:
1. Size: Larger firms dominate export markets.
2. Technology: Technologically advanced firms are more productive.
3. Productivity: High-productivity firms outperform competitors.
4. Human Capital: Exporting firms pay higher wages due to skilled labor.
Self-Selection vs. Learning-by-Exporting
1. Self-Selection: Only highly productive firms can overcome international trade costs (e.g., transport, marketing).
2. Learning-by-Exporting: Firms become more productive through exposure to foreign competition and knowledge transfer.
Winners and Losers from Trade
- Winners:
- High-productivity firms expand and increase profits.
- Consumers benefit from lower prices and product variety.
- Losers:
- Low-productivity firms are forced to exit the market.
- Workers in these firms may face temporary unemployment.
Adjustment Costs:
- Increased competition eliminates inefficient firms.
- Workers face short-term unemployment but are expected to find better jobs in higher-productivity firms over time.
Key Example:
Increased competition from international trade in the textile industry caused low-productivity firms to shut down while high-productivity firms expanded.
Key Insight: Trade favors high-productivity firms and leads to industry-wide improvements in average productivity, but at the cost of temporary adjustment hardships.
Conclusion
Monopolistic competition, international trade, and firm heterogeneity collectively shape global trade patterns and industry performance. Monopolistic competition balances product differentiation and competitive pressures, while international trade expands markets and drives efficiency. Heterogeneous firm models reveal how only the most productive firms thrive in global markets, creating winners and losers. Policymakers must address the adjustment costs from trade to ensure inclusive benefits across the economies.
