International trade and imperfectly competitive firms

Recent research in international trade has attempted to apply modern analyses of the firm and industrial organisation to trade across national boundaries. CEPR Research Fellow Tony Venables analyses international trade between economies each containing an imperfectly competitive industry. In Venables's model, all the firms in this industry produce an identical output under conditions of increasing returns to scale. Firms may enter and exit from the industry in response to profits, and the presence of increasing returns ensures that there are only a finite number of firms, each with some degree of monopoly power.

What happens if international trade is introduced into this model? This generally leads to intra-industry trade. This unambiguously raises social welfare in both countries, despite the fact that resources appear to be wasted in cross-trading the same product. The welfare gains arise because trade reduces the degree of monopoly in each country and induces firms to increase output. This reduces average costs of the firm, since it can benefit from increasing returns to scale.

Both parties gain from trade, but the division of these gains depends on the two countries' relative size, technical efficiency, and tax and subsidy policies. Venables establishes that the gains from trade are greater for a country which is large relative to its trading partner, and for a country with superior technology in its imperfectly competitive industry.

What are the effects of an import tariff under these circumstances? If retaliation does not occur, then such a tariff raises welfare in the country imposing the tariff. How does this come about? The import tariff is effectively a tax on foreign firms. They respond to this tax by reducing their output, and this raises their costs (because of increasing returns to scale). Firms in the country imposing the tariff, on the other hand, expand their output, and this reduces their average costs.

What effect does a subsidy to domestic industry have? This depends on the nature of the subsidy employed. If the domestic producers receive a subsidy to their marginal cost of producing output, they are encouraged to expand output and this reduces their average cost, because of the economies of scale. Meanwhile, foreign producers reduce their output and experience increasing average costs. A subsidy to fixed costs may not be desirable, however, since it reduces returns to scale for the firm, and so may be associated with a reduction in firm size. In this case the social average cost of production for the country employing the subsidy rises, reducing this country's welfare.

International Trade in Identical Commodities: Cournot Equilibrium with Free Entry
A J Venables

Discussion Paper no. 9, March 1984 (IT)