International Trade Theory and Policy
by Steven M. Suranovic

Trade 80-5B

The Effects of Trade in a Monopolistically Competitive Industry

Assume that there are two countries, each with a monopolistically competitive industry producing a differentiated product. Suppose initially that the two countries are in autarky. For convenience we will assume that the firms in the industry are symmetric relative to the other firms in the industry. Symmetry implies that each firm has the same average and marginal cost functions and that the demand curves for every firm's product are identical, although we still imagine that each firm produces a product that is differentiated from all others. [Note: the assumptions about symmetry are made merely for tractability. It is much simpler to conceive of the model results when we assume that all firms are the same in their essential characteristics. However, it seems likely that these results would still obtain even if firms were not symmetric.]

In the adjoining diagram we depict a market equilibrium for a representative firm in the domestic industry. The firm faces a downward sloping demand curve (D1) for its product and maximizes profit by choosing that quantity of output such that marginal revenue (MR1) is equal to marginal cost (MC). This occurs at output level Q1 for the representative firm. The firm chooses the price for its product, P1, that will clear the market. Notice that the average cost curve (AC) is just tangent to the demand curve at output Q1. This means that the unit cost at Q1 is equal to the price per unit, i.e. P1 = AC(Q1) which implies that profit is zero. Thus the firm is in a long-run equilibrium since entry or exit has driven profits to zero.

Keep in mind that this is the equilibrium for just one of many similar firms producing in the industry. Also imagine that the foreign market (which is also closed to trade) has a collection of firms which are also in a long-run equilibrium initially.

Next suppose whatever barriers to trade that had previously existed are suddenly and immediately removed. That is, suppose the countries move from autarky to free trade. The changes that ultimately arise will be initiated by the behavior of consumers in the market. Recall that market demand can be described using a "love of variety" approach or an "ideal variety" approach.

In the love of variety approach the removal of trade barriers will increase the number of varieties consumers have to choose between. Since consumer welfare rises as the number of varieties increases, domestic consumers will shift some of their demand towards foreign varieties while foreign consumers will shift their demand towards domestic varieties.

In the ideal variety approach some domestic consumers will likely discover a more ideal variety produced by a foreign firm. Similarly some foreign consumers will find a more ideal variety produced by a domestic firm.

In either case domestic demand by domestic consumers will fall while domestic demand by foreign consumers will rise. Similarly foreign demand by foreign consumers will fall while foreign demand by domestic consumers will rise. Note that this is true even if all of the prices of all the goods in both countries are initially identical. In terms of the diagram, trade will cause the demand curve of a representative firm to shift out because of the increase in foreign demand, but, will cause the demand curve to shift back in because of the reduction in domestic demand. Since these two effects push the demand curve in opposite directions the final effect will depend upon the relative sizes of these effects.

Regardless of the size of these effects, the removal of trade barriers would cause intra-industry trade to arise. Each country would become an exporter and an importer of differentiated products which would be classified in the same industry. Thus the country would export and import automobiles, toothpaste, clothing etc. The main cause of this result is the assumption that consumers, in the aggregate at least, have a demand for variety.

However two effects can be used to isolate the final equilibrium after trade is opened. First, the increase in the number of varieties available to consumers implies that each firm's demand curve will become more elastic (or flatter). The reason is that consumers become more price sensitive. Since there are more varieties to choose between, a $1 increase in price of one variety will now lead more consumers to switch to an alternative brand (since there are more close substitutes available) and this will result in a larger decrease in demand for the original product. Second, free entry and exit of firms in response to profits will lead to a zero profit equilibrium for all remaining firms in the industry.

The final equilibrium for the representative firm is shown in the adjoining diagram. [Keep in mind that these same effects are occurring for every other firm in the industry, both domestically and in the foreign country.] The demand curve shifts from D1 to D2 and the marginal revenue from MR1 to MR2 as a result of trade. The firm's cost curves remain the same. Entry or exit of firms causes the final demand curve to be tangent to the firms average cost curve, but, since the demand curve is more elastic (flatter) the tangency occurs down and to the right of the autarky intersection. In the end, firm output rises from Q1 to Q2 and the price charged in the market falls from P1 to P2. Although individual firm output rises for each firm, we cannot tell in this model setup whether industry output has risen. In the adjustment to the long-run zero-profit equilibrium entry, or more likely exit of firms would occur. If some firms exit then it remains uncertain whether fewer firms, each producing more output, would raise or lower industry output.

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