In Douglas Adams’s brilliant science fiction parody, The Hitchhiker’s Guide to the Galaxy, “a race of hyperintelligent pandimensional beings ... built themselves a super computer ... the size of a small city.” The single task assigned to this computer, which was named Deep Thought, was to provide “the Answer” to “the ultimate question of Life, the Universe, and Everything.” After 7.5 million years of work, it came up with the answer: 42.

I thought of this when the editors asked me to write about “my life philosophy ... interspersed with social philosophical issues, some perspective on the nature of life and of the universe, and the relationship between economics and other disciplines.” It took me less than 7.5 million years to come up with the answer: 23.

When the hyperintelligent beings complained, “Is that all you’ve got to show for seven and a half million years’ work?” Deep h ought replied, “I think the problem . . . is that you’ve never actually known what the question is.” My assignment is similarly vague. Deep thought told the hyperintelligent beings that they should construct an even larger computer to calculate “the Question to the Ultimate Answer.” I will not set the editors such a daunting task. I will merely make a few random remarks that may help sharpen the question. h ey may not, but what do you expect at er far less than 7.5 million years’ worth of shallow thought, coming from a far-from super computer who occupies barely two square feet of space?

Introduction

This chapter is an attempt to formalise a simple general equilibrium version of the Chamberlinian monopolistic competition model, in order to test whether there is any validity in the oft-quoted assertion that monopolistic competition leads to too much product diversification. Chamberlin (1950) himself was careful not to make any such assertion; as a matter of fact he saw the central issue very clearly, and expressed it succinctly as follows: ‘It is true that the same total resources … may be made to yield more units of product by being concentrated on fewer firms. The issue might be put as efficiency versus diversity.’ Kaldor (1935), too, saw that excess capacity did not mean excessive diversification. He said that if economies of scale were exploited to a greater extent, ‘the public would be offered finally larger amounts of a smaller number of commodities; and it is impossible to tell how far people prefer quantity to diversity and vice versa.’ What this really means is that a model must be specified in greater detail to determine conditions under which the one or the other might be expected. The one example which has been worked out in some detail, the Hotelling spatial location model, has led many economists to the presumption that there is in fact excessive diversity associated with monopolistic competition. The results of our analysis throw considerable doubt on this presumption.

Introduction

This chapter began as an attempt to formalise a simple general equilibrium version of the Chamberlinian monopolistic competition model, in order to see whether there is any validity in the common assertion that monopolistic competition leads to too much product diversification. Chamberlin (1950, p. 89) himself was careful not to make any such assertion; as a matter of fact, he saw the central issue very clearly, and expressed it succinctly as follows: ‘It is true that the same total resources … may be made to yield more units of product by being concentrated on fewer firms. The issue might be put as efficiency versus diversity’. Kaldor (1933, p. 50), too, saw that excess capacity was not the same as excessive diversity. He said that if economies of scale were exploited to a greater extent, ‘the public would be offered finally larger amounts of number of commodities; and it is impossible to tell how far people prefer quantity to diversity and vice versa’. What this really means is that a model must be specified in greater detail to determine conditions under which the one or the other might be expected. The one example which has been worked out in detail, the Hotelling spatial location model, has led many economists to the presumption that there is in fact excessive diversity associated with monopolistic competition. The results of our analysis throw considerable doubt on this presumption.

Introduction

Models of monopolistic competition are now well established as standard tools for the analysis of many economic issues. This is a relatively recent development. If we count the number of times the phrase ‘monopolistic competition’ appears in the entries (consisting of titles, and abstracts since 1989) for articles in the database Econ-Lit for the entire timespan it covers, we find the situation in table 5.1.

The rapid and continued increase in the numbers is impressive. Another fact is also noteworthy. During the 1990s, when abstracts have been available, the total number of appearances increased even while the number of appearances in titles fell. This suggests that this approach is becoming well established; users of the framework feel increasingly more assured about using it as a normal part of their toolkit without having to make a big deal about it.

This is noteworthy because the starting date of 1969 for this data was immediately after George Stigler published his important book, The Organization of Industry, which included a chapter on monopolistic competition. Reviewing the work of Robinson and Chamberlin through the lens of Triffin's general equilibrium formulation, Stigler reached a basically negative conclusion about the theory. Triffin had argued that in principle all products in a general equilibrium system formed a continuum with degrees of greater or smaller substitution. Abstract principles did not tell us where to break this chain in order to define a group or an industry.

Introduction

Of all the important contributions Ron Jones has made to international trade theory, probably the most outstanding is his analysis of the equilibrium effects of changes in the prices of tradable goods on the returns to non-tradeable factors. In Jones (1965), he elucidated the Stolper–Samuelson magnification effect in the Heckscher–Ohlin model. In the process, Jones replaced earlier intricate geometric techniques with the delightfully simple and elegant λ–θ algebra. Jones (1971), together with Samuelson (1971), gave us a general equilibrium formulation of the Ricardo–Viner model, where the relationship between the prices of goods and factors is different from, and perhaps more realistic than, that of the Heckscher–Ohlin model. Jones (1977) and Jones and Scheinkman (1977) were insightful studies of whether and how such relationships extend to models with more goods and factors.

The progress of trade theory in the last two decades has led to formal models of uncertainty and adjustment in a trading economy. Jones' birthday celebration seems a particularly suitable occasion for developing this line of research to examine the relationship between the prices of goods and factors in a dynamic economy with uncertainty.

Comparative statics has been the basic technique for analyzing the effect of changes in the prices of tradeable goods on the returns to non-tradable factors. Goods' prices are exogenous parameters in specifying the general equilibrium of a small open economy. When such exogenous parameters change, the whole equilibrium shifts. Total differentiation, or some other comparative static argument such as revealed preference, allows us to determine the resulting changes in the endogenous variables, including the factor prices.

Introduction

To most non-economists, and to some economists, the word “strategic” in the title will have either military connotations (securing our supplies of essential materials, denying such materials or sensitive technology to our adversaries) or industrial policy connotations (identification and promotion of sectors that are of special importance to our economy). The role of trade policy in such situations is indeed an interesting question; for recent analyses see Cooper (1987, pp. 305-15) and Krugman (1987), respectively.

However, it has become customary in international trade theory to use the word “strategic” in a different sense - namely, that of game theory. In the working of trade and trade policy, there is the usual structural interaction among the firms and governments: The outcome for each depends on the actions of all. The added element of strategic interaction arises when each decision maker is aware that he faces an environment that is not passive, but composed of other rational decision makers, who in turn are similarly aware, and so forth.

One expects such strategic interactions to arise when there is a small number of large buyers, sellers, or policy makers. During the last four decades, such conditions have arisen due to the growth of large and multinational firms, of public enterprises in major industries, and of large countries and blocks with considerable economic power. Until recently, trade theory neglected these developments. The standard model assumed perfect competition among firms, and allowed only one government to be active in policy making.

We have looked at some questions of welfare in previous chapters. In Chapter 3 we established the gains from trade in single- and manyconsumer economies. In Chapter 5 we looked at the welfare effects of income transfers, changes in technology, growth in factor endowments, and international factor movements–all in the context of one-consumer countries. We also saw how such a country could gain from the imposition of trade taxes if the world excess supply function facing it was less than perfectly elastic. Thus, we have already looked at a number of welfare implications of trade, and at some issues relating to trade policies. When we now turn to general questions of welfare and trade policy, therefore, it is merely a change in emphasis as compared to the previous chapters.

In particular, this chapter looks explicitly at the optimum formulation of trade policy from the point of view of a single country. By trade policy we shall mean the imposition of positive or negative trade taxes, i.e. specific departures from a policy of free trade. Such a departure could be rationalized on four grounds: (i) trade taxes could be used to affect world market prices, and thereby to achieve better terms of trade, (ii) trade taxes could be used to achieve an optimum domestic distribution of income, (iii) trade taxes could be used to achieve exogenously given targets for trade, production, or consumption at home, and (iv) trade taxes could be used to correct distortions due to market failure.We shall consider each of these separately.

The models of trade considered in Chapters 1–6 were all concerned with the theory of comparative advantage and its ramifications. In this chapter we return to questions of trade, but with the important difference that we now look at trade in the context of economies of scale. It is well-known and fairly obvious that scale economies create potential gains from trade–it simply reflects Adam Smith's observation that the division of labour is limited by the extent of the market. It is also quite apparent that scale economies matter empirically. In particular, the large volume of intraindustry trade–estimated at 50% of world trade by Grubel and Lloyd (1975)–can only be understood within the context of product differentiation and economies of scale. Both theoretically and empirically, therefore, there is a strong case for explicit analysis of the importance of non-convexities for trade.

It is not easy to give a precise treatment of trade based on scale economies. The difficulties relate to the market structure under which such trade will occur. Perfect competition is in general incompatible with economies of scale, so some form of imperfect competition will prevail. For descriptive purposes, one must then choose among the numerous alternative ways in which imperfect competition can be modelled; and the conclusions one arrives at will in general depend on the particular specification chosen. To arrive at a general theory of trade with imperfect competition is therefore impossible; the most one can hope for is a catalogue of special models.The same goes for welfare assessments.

There are two broad themes in the theory of international trade. One is qualitative, being concerned with the pattern of trade, i.e. which country will export which good. The standard theory relates this to comparative advantage, i.e. to international differences in relative opportunity costs, and then tries to explain comparative advantage in terms of differences in technologies, factor supplies, etc. This theme is also concerned with the way in which trade in return affects such determinants of comparative advantage. The other theme is more quantitative, and seeks to explain the terms of trade, i.e. relative prices of exports and imports in a trading world. It also examines how they are affected by changes in data such as factor supplies or technology, and policies such as tariffs. While we have stated the themes as descriptive, it is clear that normative analyses will have to be based on, and will benefit from, a proper understanding of them. Questions of the state of the balance of payments, or of determination of exchange rates, can also be seen as elaborations and extensions of the same basic ideas.

In developing these themes, one should bear in mind two important points. The first is that the very concepts of trade theory– relative costs and relative prices–call for consistent use of general equilibrium analysis. This need not always be Walrasian competitive analysis, but in a problem with several goods and factors, and several producing and consuming units, an approach which constantly reminds us of their mutual relationships is essential if errors of oversight are to be avoided. While obvious, this is sometimes forgotten.

In this chapter we begin to make use of the analytical techniques developed in the previous one. Our aim is to establish some of the most basic propositions concerning the pattern of trade and the gains from trade. To this end, we first set up models for one country in autarky, and in a trading equilibrium. Simple ‘revealed preference’ comparisons allow us to prove the results concerning gains from trade. Then we consider a model of two countries in a trading equilibrium, which gives some insights into the reasons for trade, and the patterns of trade. Finally, we derive various well-known models as special cases, and compare their properties. The general model will be the workhorse for later chapters, where we study some further properties of trade equilibria, and carry out some comparative statics and policy analyses.

The exposition will proceed from very simple models to successively more complex ones: from one consumer to many, from inelastic factor supplies to variable ones, and from all goods being tradeable to some being non-tradeable. The simpler models serve to introduce concepts and techniques in settings where they are more easily understood; this familiarity will then make the more complex and more realistic cases easier to grasp. In later chapters, we sometimes revert to simpler models for similar reasons; when the complication is not material to the particular purpose, allowing it only confuses the issue.

All models of this chapter, and those of Chapters 4–7, share two important underlying assumptions: (1) each agent, consumer or producer, is a price-taker, (2) prices adjust instantaneously to levels which clear all markets.

It is common in elementary textbooks to introduce balance of payments adjustment as a manifestation of real disequilibrium. If relative prices are not compatible with clearance of all goods markets, as can happen when enough nominal prices and exchange rates are sticky, then the real imbalances will be reflected in payments imbalances. Each country will, given its competitive assumption that it can transact at the going market prices, plan to remain on its budget constraint, but since all these trades are not mutually compatible in disequilibrium, each will in fact end up violating the constraint.

An example will clarify this. Suppose that in a pure exchange of goods, the equilibrium price ratio between UK and Japan would be 62.5 bottles of whisky per television set. Now suppose the UK price of whisky is sticky at ℒ4 per bottle, and the Japanese price of TV sets at 100,000 yen per set. This will be compatible with equilibrium at an exchange rate of 400 yen/ℒ. But suppose this rate is also sticky at a value of 450. Then the Japanese can exchange each TV set for only 55 bottles of whisky, and the UK needs to offer only 55 bottles to acquire one TV set. Given a stability condition, called the Marshall- Lerner condition, there will be a world excess demand for TV sets and an excess supply of whisky. If trade is attempted under these prices, we will observe a UK balance of payments deficit: If they could sell all their whisky they would operate on their budget constraint, but in the prevailing state of real disequilibrium this plan fails to materialize.

An addition to the large stock of books on trade theory calls for strong justification. We believe we have one, although not in any novelty of basic aims. On the contrary, we claim that previous treatments fail, often in not pursuing their own avowed aims far enough, and almost always in not pursuing them by the most efficient means.

It is always said that trade theory is a showcase for the theory of general economic equilibrium. Too much of it, however, usually considers only a part of the whole equilibrium, namely the comparative statics of production in one country. This occurs in some discussions of the effects of changes in factor endowments or technologies and of tariffs, but most importantly in dealing with factorprice equalization. The usual way to pose that question is as one of determining factor prices given output prices, or assuming diversified production. Both of these assumptions should really be a part of the whole equilibrium being studied. It turns out that the usual partial insights are very misleading when it comes to such a complete equilibrium of trading countries.

Secondly, when generalizing the simple two-by-two model, trade theorists often forget the lessons to be learnt from general microeconomic theory as to the right questions to be asked.

A number of important questions regarding international trade relate to the effects of changes in the parameters that determine equilibrium prices. Is it necessarily true that a transfer of goods leads to higher welfare for the recipient country? Or could a transfer lead to a deterioration in the recipient's terms of trade sufficient to offset the direct gain from the transfer? Is it necessarily to the advantage of a country to get better production technology, or could this induce terms of trade changes making the country worse off? Is economic growth, in the sense of growth in factor endowments, to the advantage of a country, or is so-called immiserizing growth possible? Is economic growth in one country to the advantage of other countries? Is it to the advantage of both countries to move a factor from a country where its marginal productivity is low to a country where its marginal productivity is higher? To show how answers to such questions can be provided, we must show how parameter changes affect equilibrium prices and utility levels. That is what we do in this chapter. The method is the standard microeconomic one: We take total differentials of the equilibrium equations and solve for changes in prices and utility levels. It will be seen that the formulations adopted in Chapters 2 and 3 make this task much simpler than one might expect.

To avoid unnecessary complications, we shall stick to the simplest version of the catalogue of models set out in Chapter 3

If two countries have the same relative prices of commodities in autarky, and trade is allowed to open up, there is a general equilibrium with zero imports and exports. In the case of a unique equilibrium, therefore, comparative advantage–meaning differences in autarky relative prices–is the basis for trade. However, this is a trivial point, and the theory of comparative advantage goes beyond it to postulate a systematic relationship between the pattern of comparative advantage and the commodity composition of trade. In the first part of this chapter, we examine whether such a systematic relationship exists.

The hypothesis that the pattern of trade reflects comparative advantage is meaningful in the sense that we could test it by computing autarky prices for the countries and comparing them with the observed trade pattern. However, this is hardly in the realm of practical empirical work. Propositions relating trade patterns to easily observable variables are, therefore, much more attractive. That is why the factor abundance hypothesis merits careful consideration: it is the only hypothesis regarding the commodity composition of trade that requires only limited information about demand patterns and production technologies. We therefore look closely at this hypothesis. First we look at the relationship between factor abundance and autarky relative prices. Then we examine some properties of a free trade equilibrium in which the countries differ only in their factor endowments. Under this heading we here study the effect of trade on international factor price differences, and the question of the extent of production specialization induced by trade.