New Theories of International Trade and Industrial policy

• Increasing Returns, Product Differential and Imperfect Competition

• Political Economy of Protection and Industrial Policy

Increasing Returns• Increase in output that is proportionally greater than a

simultaneous and equal % change in the use of all inputs, resulting in a decline in average cost.

In Economics, return to and economies of scale are related terms that describe what happens as the scale of production increase in the long run, when all input level including physical capital usage are variable (Chosen by the firm). They are different terms and should not be used interchangeably.

Cont….The term return to scale arises in the context of a firm’s

production function. It refers to hangs in output resulting from a proportional change in all inputs. If output increases by that same proportional change then there are constant returns to scale (CRS). If output increases by less than that proportional change, there are decreasing returns to scale(DRS).If output increases by more than that proportional change, there are increasing return to scale(IRS).Thus the retunes to scale faced by a firm are purely technologically imposed and are not influenced by economic decisions or by market conditions.

Types of Return to ScaleA firms production function could exhibit different

types of return to scale in different ranges of output. Typically there could be increasing returns at relatively low output levels, decreasing return at relatively high output levels, and constant returns at one output level between those ranges.

Examples

When all inputs increases by a factor of 2,new values for output will be:

• Twice the previous output if there are constant returns to scale (CRS)

• Less than twice the previous output if there are decreasing return to scale (DRS)

• More than twice the previous output if there are increasing return to scale (IRS)

Assuming that the factor costs are constant (that is, that the firm is a perfect competitor in all input markets), a firm experiencing constant returns will have constant long-run average costs, a firm experiencing decreasing returns will have increasing long-run average costs, and a firm experiencing increasing returns will have decreasing long-run average costs. However, this relationship breaks down if the firm is not a perfect competitor in the input markets. For example, if there are increasing returns to scale in some range of output levels, but the firm is so big in one or more input markets that increasing its purchases of an input drives up the input's per-unit cost, then the firm could have diseconomies of scale in that range of output levels. Conversely, if the firm is able to get bulk discounts of an input, then it could have economies of scale in some range of output levels even if it has decreasing returns in production in that output range.

Product differentiation

In economics and marketing, product differentiation (also known simply as "differentiation") is the process of distinguishing a product or offering from others, to make it more attractive to a particular target market. This involves differentiating it from competitors' products as well as a firm's own product offerings. The concept was proposed by Edwar Chamberlin in his 1933 Theory of Monopolistic Competition.

• Differentiation can be a source of competitive advantage. Although research in a niche market may result in changing a product in order to improve differentiation, the changes themselves are not differentiation. Marketing or product differentiation is the process of describing the differences between products or services, or the resulting list of differences. This is done in order to demonstrate the unique aspects of a firm's product and create a sense of value.

• In economics, successful product differentiation leads to monopolistic competition and is inconsistent with the conditions for perfect competition, which include the requirement that the products of competing firms should be perfect substitutes.

Types of Product Differentiation

There are three types of product differentiation: 1. Simple: based on a variety of characteristics

2. Horizontal : based on a single characteristic

but consumers are not clear on quality

3. Vertical : based on a single characteristic and consumers are clear on its quality

Cont…• The brand differences are usually minor; they can be merely a

difference in packaging or an advertising theme. The physical product need not change, but it could. Differentiation is due to buyers perceiving a difference; hence causes of differentiation may be functional aspects of the product or service, how it is distributed and marketed, or who buys it. The major sources of product differentiation are as follows.

• Differences in quality which are usually accompanied by differences in price

• Differences in functional features or design

• Ignorance of buyers regarding the essential characteristics and qualities of goods they are purchasing

• Sales promotion activities of sellers and, in particular, advertising

• Differences in availability (e.g. timing and location).

Cont…• The objective of differentiation is to develop a position that

potential customers see as unique. The term is used frequently when dealing with freemium business models, in which businesses market a free and paid version of a given product. Given they target a same group of customers, it is imperative that free and paid versions be effectively differentiated.

• Differentiation primarily impacts performance through reducing directness of competition: As the product becomes more different, categorization becomes more difficult and hence draws fewer comparisons with its competition. A successful product differentiation strategy will move your product from competing based primarily on price to competing on non-price factors (such as product characteristics, distribution strategy, or promotional variables).

Cont…• Most people would say that the implication of

differentiation is the possibility of charging a price premium; however, this is a gross simplification. If customers value the firm's offer, they will be less sensitive to aspects of competing offers; price may not be one of these aspects. Differentiation makes customers in a given segment have a lower sensitivity to other features (non-price) of the product

Imperfect competitionIn economic theory, imperfect competition is the

competitive situation in any market where the conditions necessary for perfect competition are not satisfied. It is a market structure that does not meet the conditions of perfect competition.

Forms of imperfect competition include:• Monopoly, in which there is only one seller of a good.• Oligopoly, in which there are few sellers of a good.• Monopolistic competition, in which there are many

sellers producing highly differentiated goods.• Monopsony, in which one buyer faces many seller.• Information asymmetry when one competitor has the

advantage of more or better information.