International Trade Theory and Policy
by Steven M. Suranovic

Trade 80-5C

Benefits of Free Trade under Monopolistic Competition

Welfare of individual consumers who purchase this product will be enhanced for three main reasons. First, trade increases the number of varieties of products for consumers to choose. Second, free trade reduces the price of every variety sold in the market. Third, free trade may increase the supply of products in other markets and result in lower prices for those products.

1) If the product is such that an individual consumer seeks to purchase a product closest to her ideal variety, then presumably with more varieties available, more consumers will be able to purchase more products closer to their ideal. For these consumers welfare will be improved. Other consumers however may not be affected by the increase in varieties. If, for example, the new varieties that become available are all more distant from one's ideal than the product purchased in autarky, then one would continue to purchase the same product in free trade. In this case the increase in variety does not benefit the consumer.

If the product is one in which consumers purchase many different varieties over time (love of variety) then because trade will increase the number of varieties available to each consumer, trade will improve every consumer's welfare. Of course, this is based on the assumption that every consumer prefers more varieties to less.

Thus regardless of whether the product is characterized with the ideal variety or the love of variety approach, free trade, by increasing the number of varieties, will increase aggregate consumer welfare.

2) The second effect of trade for consumers is that the price of all varieties of the product will fall. The prices fall because trade allows firm to produce further down along its average cost curve which means that it lowers it per unit cost of production. This implies that each product is being produced more efficiently. Competition in the industry, in turn, forces profit to zero for each firm which implies that the efficiency improvements are passed along to consumers in the form of lower prices.

3) Finally, the improvement in productive efficiency for each firm may lead to a reduction in the use of resources in the industry. This effect would occur if industry output falls or if output does not rise too much. Although the use of resources per unit produced falls, total output by each firm rises. Thus it is uncertain whether an individual firm would have to layoff workers and capital or whether they would need to hire more. Even if they hired more though, the possibility that some firms would drop out of business in the adjustment to the long-run equilibrium may mean that as an industry resource usage falls. If resource usage does fall and capital and labor are laid off, then in a general equilibrium system (which has not been explicitly modeled here) these resources would be moved into other industries. Production in those industries would rise leading to a reduction in the prices of those products. Thus free trade in the monopolistically competitive industry can lead to the reduction in prices of completely unrelated industries.

International Trade Theory and Policy - Chapter 80-5C: Last Updated on 2/15/07