Theorie und Politik der Europäischen Integration Prof. Dr. Herbert Brücker Lecture 6 Market Size and Scale Effects Theory and Politics of European Integration

Theorie und Politik der Europäischen Integration

Prof. Dr. Herbert Brücker

Lecture 6

Market Size and Scale Effects

Theory and Politics of European Integration

Theory and Politics of European Integration Lecture 5 Preferential Trade Liberalisation

Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker

Last Lecture

• Preferential Trade Liberalisation· The PTA Diagram

– Free Trade Equilibrium– MFN Tariff Equilbrium– Unilateral Trade Discrimination– Supply Switches– Welfare Effects

· Empiry: Is Trade Diversion an Issue?· Welfare Effects of a Customs Union· Customs Union vs. Free Trade Area· WTO Rules and Customs Union/Free Trade Areas

– Art. 24 WTO



Today's Lecture - Overview

• Market Size and Scale Effects



Today's Reading

• Market Size and Scale Effects· Baldwin & Wyplosz (2006) “The Economics of European

Integration”, McGraw-Hill, Ch 6.



Market Size Matters

• European leaders always viewed integration as compensating small size of European nations.• Implicit assumption: market size good for economic

performance.

• Facts: integration associated with mergers, acquisitions, etc.• In Europe and more generally, ‘globalisation.’



Facts

• M&A activity is high in EU.• much M&A is mergers within one member state

• about 55% ‘domestic’;• remaining 45% split between:

· one is non-EU firm (24%), · one firm was located in another EU nation (15%),· counterparty’s nationality was not identified (6%).



Facts

Distribution of M&A quite varied:• Big 4: share M&As much lower than share of the EU GDP.• I, F, D 36% of the M&As, 59% GDP.

· Except UK.• Small members have disproportionate share of M&A.



Facts

M&A activity by nation, 1991-2002

B, 2.8%

DK, 2.6%

EL, 1.1%

E, 5.0%F, 13.5%

IRL, 1.7%

I, 6.2%

L, 0.5%NL, 6.5%

A, 2.1%

P, 1.2%

FIN, 3.9%

S, 5.3%

UK, 31.4%

D, 16.3%



Facts

• Why M&A mostly within EU?• Why UK’s share so large?• Non harmonised takeovers rules.

· some members have very restrictive takeover practices, makes M&As very difficult.

· others, UK, very liberal rules.

• Lack of harmonisation means restructuring effects very impact by member states.



• Traditional Trade Theory I: Ricardo Model• Explains trade by comparative advantage in production, mainly

productivity differences• Each country exports goods where it has a comparative

advantage in production, i.e. where its relative productivity is below that of trading partner

• Each country imports goods where it has a comparative disadvantage, i.e. where its relative productivity is below that of trading partner

• Don’t confuse with absolute advantage!• Traditional Trade Theory II: Heckscher-Olin Model

• Explains trade by differences in relative factor endowments (land, capital labour)

• Each country exports goods which use relatively abundant factor intensively in production

• Each country imports goods which use relatively scarce factor intensively in production

New Trade Theory: A History of IdeasNew Trade Theory: A History of Ideas (I/V)



• Empirical knowledge• Limited until 1970s, no big data sets available, no computers• Boost in empirical research in 1970s• Two stylized facts:• (i) Net trade pattern supports factor abundance hypothesis• (ii) Overwhelming share of world trade is intra-industry trade, i.e.

trade in goods of same industries and which use same factors intensively (Grubel/Lloyd 1974)

• Heckscher-Olin model expects that mainly countries trade which differ in factor endowments

• Ricardo model expects that technology differences drive trade• Actually, the overwhelming share of world trade is between

countries which have same factor endowments and apply similar technologies

• Thus, traditional trade theories cannot explain intra-industy trade

New Trade Theory: A History of IdeasNew Trade Theory: A History of Ideas (II/V)



• Grubel & Lloyd expect that increasing returns to scale are main cause of intra-industry trade

• Basic idea is simple: • If you have increasing returns to scale, it makes sense to locate the

production of one variety of a good in one country, which is consumed by the domestic country and the trading partner. Another variety in produced in another country, such that two countries with similar factor endowments and technologies exchange goods if consumer preferences are similar.

New Trade Theory: A History of IdeasNew Trade Theory: A History of Ideas (III/V)



• Development of microeconomic tools: Dixit-Stiglitz and Lancaster explain develop methods to include increasing returns to scale in general equilibrium models in late 1970s

• Trade theorists demonstrate that increasing returns to scale and/or imperfect competition results necessarily in intra-industry trade in late 1970s and 1980s (Krugman, Brandner, Lancaster, Helpman)

• These models are called “New Trade Theory”: Idea was long around, but no tools available to demonstrate rigorously

• Thus, key difference to old theory is that assumption of constant returns to scale and perfect competition is replaces by increasing returns to scale and imperfect competition which enables us to explain intra-industry trade between countries

• Important for European integration: market size matters!

New Trade Theory: A History of IdeasNew Trade Theory: A History of Ideas (IV/V)



New Trade Theory: A History of IdeasNew Trade Theory: A History of Ideas (V/V)

Main contributions:• Paul Krugman, 1979, 1980, 1981 articles.• Jim Brander, PhD thesis in late 1970s, 1982, 1984 articles

(with Krugman) & strategic trade policies (with Barbara Spencer) in 1980s.

• Elhanan Helpman, 1981 article and 1985, 1989 books (with Krugman). Further articles on multinational firms in 1980s and 1990s.

• Jim Markusen, 1980 article and article on multinationals in 1984.



New Trade Theory: A History of IdeasNew Trade theory: Outline of Krugman’s workhorse model

• Ricardo, Ricardo-Viner & HO models consider differences across countries as cause for trade

• Krugman model explains trade by geographical concentration of production of varieties of goods• trade = produce in one country and sale in another one• Internal IRS explain geographical concentration of production• Limited resources and imperfect competition explain why

different countries produce different variety of a good· One country cannot produce all varieties (resource constraint) · Every firm produces only one variety in order to avoid direct

competition

• Every country produces only one variety but buys all varieties, such that we have intra industry trade between similar countries



New Trade Theory: A History of IdeasFirst key element: Increasing returns to scale

• Internal returns to scale, i.e. average costs of production (AC) fall with increasing production within one firm

• External returns to scale, i.e. AC of production fall with increasing production of sector (or region), but own AC are assumed to be constant because own contri-bution to total production is small

• Internal and external returns to scale have different consequences, therefore different models. Here: internal returns to scale.



New Trade Theory: A History of IdeasSecond key element: imperfect competition

• External increasing returns to scale can be treated in perfect competition framework. Simple but covers only small part of real world phenomenon

• Internal increasing returns to scale need imperfect competition• What implies internal returns to scale:

• Average costs (AC) > marginal costs (MC)• If price (P) equals marginal costs, the firms makes losses:

P = MC < AC• Thus, we need P > MC to make non-negative profits• However, P > MC requires imperfect competition.



New Trade Theory: A History of IdeasSimple Imperfect Competition Theory

• Most simple framework: Monopolistic competition or Dixit-Stiglitz framework• Each firm is monopolistic supplier of one variety of a good• Faces fixed set-up costs, which result in declining average costs

if production increases• Product demand declines with price, since can substitute this

variety of a good by another one• Why simple?

• No strategic interaction between firms.• Main elements can be treated as in simple monopoly case.

• We start with closed economy setting to outline ideas.



Economic logic: Monopoly case (closed economy)

Sales

Price

MarginalCost

Marginal RevenueCurve

DemandCurve

Sales

Price

Q’+1

P”

MarginalCost Curve

C E

D

DemandCurve

A

B

Q*Q’

P*

P’




Sales

Price

MarginalCost


DemandCurve

Sales

Price

Q’+1

P”

MarginalCost Curve

C E

D

DemandCurve

A

B

Q*Q’

P*

P’What is the marginal revenue

curve?

price for first unit – Q times change in price




Sales

Price

MarginalCost


DemandCurve

Sales

Price

Q’+1

P”

MarginalCost Curve

C E

D

DemandCurve

A

B

Q*Q’

P*

P’

Marginal revenue curve is always below average cost curve!



MC

AC

Output, q

Price, p

Demand

Marginal Revenue (MC)

pMC

qMC




New Trade Theory: A History of IdeasMonopolistic Competition

• Monopolistic competition is a market form, where each firm is a monopolistic supplier of one variety of a good, which is a close substitute to another variety, but still different (“imperfect substitutes”)

• Every firm takes the price of all other firms as given. Its behavior can therefore described as one of a monopolist for the remaining demand

• Each firm faces fixed set-up costs, which result in declining average costs if production increases

• What happens if new firms entry market?• Residual demand of all other firms always declines• Residual demand curve becomes flatter, since the remaining

varieties become closer substitutes from the consumer’s perspective• Does not hold necessarily for all goods



• Profit-maximizing firms fix prices and production under monopolistic competition such that marginal revenues equal marginal costs, i.e. at point Q*.

• Note that marginal revenues depend on residual demand curve (RD).

• Differences between marginal costs and price is called as markup.

Sales

Price

MCMR

RD

RD’

MR’

Q’

P’

Q*

P*

The Residual Demand-Marginal Revenue Diagram



New Trade Theory: A History of IdeasWhat happens at market entry of new firms?

• Market entry shifts Residual Demand (RD) curve downward.• Consequently, Marginal Revenue (MR) Curve moves downward

and gets flatter.• As a result, firms have to reduces markup between prices and

marginal costs, i.e. prices and profits fall.• Two examples: Duopoly and Oligopoly.



Duopoly case, example of non-equilibrium

Residual Demand Curve firm 2 (RD2)

Firm 2’s expectation of sales by firm 1, Q1

DemandCurve (D)

MC

Residual Marginal Revenue Curve firm 2 (RMR2)

x2’

p2’

Firm 2 sales

Residual Demand Curve firm 1 (RD1)

Firm 1’s expectation of sales by firm 2, Q2

DemandCurve (D)

price

MC

Residual Marginal Revenue Curve firm 1 (RMR1)

x1’

p1’

Firm 1 sales

A1 A2

price



Duopoly and oligopoly case, equilibrium outcome

RD’

D

MC

x**

p**

sales

A

price

RMR’

3x**Oligopoly

RD

Typical firm’s expectation of the other firm’s sales

D

MC

x*

p*

sales

A

price

RMR

2x*

Duopoly

Typical firm’s expectation of other the other firms’ sales



• In his book, Krugman (1984) uses maths to make these basic points about increasing returns to scale and imperfect competition

• You can skip the math and just read it for ideas• Rely on the previous diagram to motivate why more firms leads to

lower prices – this is, after all, a very intuitive outcome (more competition, lower prices).

• To determines the equilibrium number of firms we introduce two curves: The PP or COMP curve and the CC or Break even curve.

The PP-CC or the BE-COMP Diagram



BE

COMP

Krugman’s CC-PP Diagram



Breakeven-Competition (BE-COMP) Diagram

Mark-up ()

COMPcurve

BE (break-even) curve

’

n’

mono

duo

n=1 n=2 Number of firms



• CC- or breakeven (BE) curve gives number of firms which breakeven, i.e. make zero or higher profits at given number of firms in market

• Sales of firm fall with increasing n, such that firms need higher price on product market to breakeven

• While CC- or BE-curve shows which price is requested to breakeven, the PP or COMP curve presents price maximum at given competition of firms

• At cut-off point of PP/BE and CC/BE curves, firms request profit-maximizing prices and just breakeven, i.e. price equals average costs (P=AC)

Determination of equilibrium number of firms



Details of COMP curve

Marginal cost curve

Typical firm’s sales

price

p"

Monopoly mark-up

Duopoly mark-up

D

R-D (duopoly)

xmonoxduo

MR (monopoly)R-MR

MC

p'

AB

A’

B’

COMPcurve

n=1 n=2

mono

duo



Details of BE curve

Sales per firm

AC

price

Totalsales

Co

Demand curve

Mark-up (i.e., p-MC)

o

xo= Co/no

MC

euros

BE

no

poo+MC

x’= Co/n’ x”= Co/n”

A

B

B Apo

ACo=po

n” n’

Home market



• In the models we have two-way trade between identical countries• “Krugman model of trade” (Krugman JIE 1979, AER 1980, JPE

1981)• We have only intra-industry trade

• Domestic countries exports varieties of an industrial good to foreign country and vice versa

• Two sources of gains from trade: scale effects and pro-competitive effects

Implications of monopolistic competition for trade (Krugman’s model)



Sketch of economic logic

• liberalisation • de-fragmentation • pro-competitive effect • industrial restructuring (M&A, etc.) • RESULT: fewer, bigger, more efficient firms

facing more effective competition from each other.



Recall: autarky equilibrium

Sales per firm

AC

price

Totalsales

Demand curve

Mark-upeuros

x’

BE

n’

E’

C’

E’

MC

p’ '

A

p’

Home market

E’

C



No-trade-to-free-trade integration

Sales per firm

AC

price

Totalsales

Demand curve

Mark-upeuros

x’

BE

2n’

x”

n” n’

E’

E”

C’ C”

E’

A

1

E”

A

MC

p”

p’

pA

'

A

p”

p’

Home market

E”

E’

C



Economic logic

• Integration: no-trade-to-free-trade: BE curve shifts out (to point 1).

• Defragmentation:• PRE typical firm has 100% sales at home, 0% abroad;

POST: 50-50 ,• Can’t see in diagram.

• Pro-competitive effect: • equilibrium moves from E’ to A: Firms losing money (below BE).• pro-competitive effect = markup falls.• short-run price impact p’ to pA.



Economic logic (cont.)

Industrial Restructuring:

• A to E”,• number of firms, 2n’ to n”. • firms enlarge market shares and output, • more efficient firms, AC falls from p’ to p”, • mark-up rises, • profitability is restored.

Result:

• bigger, fewer, more efficient firms facing more effective competition.

Welfare: gain is “C”.



• Existence of internal returns to scale is the key to falling prices

• Each of the n2 firms sales more than under autarky

• Therefore, AC are lower than under autarky

• This implies, they can request (and will request) lower prices to break-even

• Constraint: zero profits under monopolistic competition imply that prices equal average costs (P=AC).

AC

euros

x’

p’E’

MC

x”

p”

Firm-level output

Why do prices fall under zero profit condition?

E”



Competition and subsidies

Two immediate questions:

• “As the number of firms falls, isn’t there a tendency for the remaining firms to collude in order to keep prices high?”

• “Since industrial restructuring can be politically painful, isn’t there a danger that governments will try to keep money-losing firms in business via subsidies and other policies?”

The answer to both questions is “Yes”. • See Chapter 11, 2nd Edition.



NEXT LECTURE

• November 27

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Theorie und Politik der Europäischen Integration Prof. Dr. Herbert Brücker Lecture 6 Market Size and Scale Effects Theory and Politics of European Integration