Intra-Industry Trade: Economies of Scale Revisited

The Krugman model shows that international trade can trigger mutual gains for the participating countries even when they are similar in technology and endowments. The emerging intra-industry trade between countries is based on economies of scale, the exchange of different types of products produced under monopolistic competition, and heterogenous preferences. We extend the baseline model by considering two dynamic settings, with special focus on the producer. The former reveals that gains in the long run are concomitant with short term losses for workers in the smaller country due to the competitiveness gap. Until the competitiveness gap is narrowed, lower nominal wages or the decline in the exchange rate are required for the country to keep its production capacity and a balanced international trade position. Furthermore, we consider that the cost structure of an industry also depends on factors that cannot depreciate via exchange rate. Here, the employees of companies that are at a competitive disadvantage, due to a low efficiency starting point, may feel a negative impact during the transition as they lose purchasing power. While the country as a whole gains, some country agents might lose, at least in the short term. Results are illustrated numerically, using MATLAB, calibrated against the example in Krugman and Obtsfeld (2006).