New Trade Theory: Explaining Intraindustry Trade
The basicmodel (Krugman 1979) assumes that consumers value variety, but it is also possible to set up themodel so that each consumer has a preferred variety that differs across consumers (Helpman and Krugman 1985). Each variety is produced by a single firm using labor. The cost function of the firm consists of fixed and variable costs; marginal cost is constant, and average cost is decreasing (internal economies of scale). The consumers’ utility function is such that the price elasticity of demand for any variety is finite and exceeds one, so that the profit-maximizing price exceeds marginal cost by a positive markup. The number of firms is limited by the zero profit condition.
When the domestic country opens up to trade with an otherwise similar economy, foreign consumers create additional demand for domestic varieties. In equilibrium, individual consumption per variety and the price-wage ratio both fall. The tradeinduced increase in demand allows firms to move down their average cost curve and increase production. At the same time, the full employment condition still holds. Hence, since firm-level production increases, the number of domestic firms goes down. Yet the number of varieties, domestic plus foreign, available to domestic consumers increases.
Gains fromtrade arise for two reasons. First, trade allows firms to better exploit economies of scale; as a result, the domestic real wage rises. Second, domestic consumers have access to a larger number of varieties.
To analyze the impact of transportation costs and home market effects, consider two differentiated industries A and B and two groups of consumers in countries 1 and 2 (Krugman 1980). The first group consumes only products from industry A and the second group only products fromindustry B.Type A consumers have a higher population share in country 1 and type B consumers in country 2, while country population levels are the same. Due to positive transportation costs, the consumption ratio of foreign to domestic goods is below one in both coun- tries. In this case, each countrywill produce relatively more of the product for which it has the larger home market. If countries’ tastes are sufficiently dissimilar (i.e., if the population shares ofA-consumers in 1 and B-consumers in 2 are high), specialization will be complete: industryAwill be located only in country 1 and industry B only in country 2. The model thus explains how a bigger home market can give an industry a comparative advantage.
To investigate the determinants of intraindustry trade shares, consider two differentiated-goods industries and two sector-specific inputs (Krugman 1981). To keep things simple, let the two countries have equalpopulationsize, but country 1 has a share z < 50 percent of industry B specific labor and country 2 has a share z of industry A specific labor. Whereas the trade volume is constant and does not depend on z, the share of intraindustry trade becomes maximal as z approaches 50 percent. Thismodel can thus explain why we see more intraindustry trade between countries that are more similar in terms of factor endowments.
Intraindustry trade also arises in amodel with one domestic and one foreign market and two firms, domestic and foreign, who produce a homogeneous good and compete Cournot style (i.e., each firm treats the output level of its competitor as fixed) in both markets (Brander 1981). The markets are segmented, and shipping goods fromone country to the other is costly. In this case, as long as the per unit transportation cost does not exceed the monopoly price markup over marginal cost, both firms will sell goods in both markets, so intraindustry trade arises.