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6.7 The Costs and Benefits of Free Trade under Monopolistic Competition

Learning Objectives

  1. Identify the reasons why consumers gain from trade in a monopolistically competitive market.
  2. Understand that the movement to free trade in a monopolistically competitive market may cause losses to some individuals under more realistic assumptions.

The Benefits of Free Trade

Welfare of individual consumers who purchase the representative product will be enhanced for three main reasons. First, trade increases the number of varieties of products for consumers to choose from. Second, free trade reduces the price of every variety sold in the market. Third, free trade may increase the supply of products in other markets and result in lower prices for those products.

  1. If the product is such that an individual consumer seeks to purchase a product closest to her ideal variety, then presumably with more varieties available, more consumers will be able to purchase more products closer to their ideal. For these consumers welfare will be improved. Other consumers, however, may not be affected by the increase in varieties. If, for example, the new varieties that become available are all more distant from one’s ideal than the product purchased in autarky, then one would continue to purchase the same product in free trade. In this case, the increase in variety does not benefit the consumer.

    If the product is one in which consumers purchase many different varieties over time (love of variety), then because trade will increase the number of varieties available to each consumer, trade will improve every consumer’s welfare. Of course, this is based on the assumption that every consumer prefers more varieties to less. Thus regardless of whether the product is characterized by the ideal variety or the love-of-variety approach, free trade, by increasing the number of varieties, will increase aggregate consumer welfare.

  2. The second effect of trade for consumers is that the price of all varieties of the product will fall. The prices fall because trade allows a firm to produce further down its average cost curve, which means that it lowers its per-unit cost of production. This implies that each product is being produced more efficiently. Competition in the industry, in turn, forces profit to zero for each firm, which implies that the efficiency improvements are passed along to consumers in the form of lower prices.
  3. Finally, the improvement in productive efficiency for each firm may lead to a reduction in the use of resources in the industry. This effect would occur if industry output falls or if output does not rise too much. Although the use of resources per unit produced falls, total output by each firm rises. Thus it is uncertain whether an individual firm would have to lay off workers and capital or whether it would need to hire more. However, even if it hired more, the possibility that some firms would drop out of business in the adjustment to the long-run equilibrium might mean that industry resource usage falls. If resource usage does fall and capital and labor are laid off, then in a general equilibrium system (which has not been explicitly modeled here), these resources would be moved into other industries. Production in those industries would rise, leading to a reduction in the prices of those products. Thus free trade in the monopolistically competitive industry can lead to a reduction in prices of completely unrelated industries.

The Costs of Free Trade

There are two potential costs of free trade in this model. The first involves the potential costs of adjustment in the industry. The second involves the possibility that more varieties will increase transaction costs. Each cost requires modification of the basic assumptions of the model in a way that conforms more closely with the real world. However, since these assumption changes are not formally included in the model, the results are subject to interpretation.

  1. The movement to free trade requires adjustment in the industry in both countries. Although firm output rises, productive efficiency rises as well. Thus it is possible that each firm will need to lay off resources—labor and capital—in moving to free trade. Even if each firm did not reduce resources, it is possible (indeed likely) that some firms will be pushed out of business in moving to the long-run free trade equilibrium. It is impossible to identify which country’s firms would close; however, it is likely to be those firms that lose more domestic customers than they gain in foreign customers or firms that are unable or unwilling to adjust the characteristics of their product to serve the international market rather than the domestic market alone. For firms that close, all the capital and labor employed will likely suffer through an adjustment process. The costs would involve the opportunity cost of lost production, unemployment compensation costs, search costs associated with finding new jobs, emotional costs of being unemployed, costs of moving, and so on. Eventually, these resources are likely to be reemployed in other industries. The standard model assumption is that this transition occurs immediately and without costs. In reality, however, the adjustment process is likely to be harmful to some groups of individuals.
  2. A second potential cost of free trade arises if one questions the assumption that more variety is always preferred by consumers. Consider for a moment a product in which consumers seek their ideal variety. A standard (implicit) assumption in this model is that consumers have perfect information about the prices and characteristics of the products they consider buying. In reality, however, consumers must spend time and money to learn about the products available in a market. For example, when a consumer considers the purchase of an automobile, part of the process involves a search for information. One might visit dealerships and test-drive selected cars, purchase magazines that offer evaluations, or talk to friends about their experiences with different automobiles. All these activities involve expending resources—time and money—and thus represent what we could call a “transactions cost” to the consumer.

Before we argued that because trade increases the number of varieties available to each consumer, each consumer is more likely to find a product that is closer to his or her ideal variety. In this way, more varieties may increase aggregate welfare. However, the increase in the number of varieties also increases the cost of searching for one’s ideal variety. More time will now be needed to make a careful evaluation. One could reduce these transaction costs by choosing to evaluate only a sample of the available products. However, in this case, a psychological cost might also arise because of the inherent uncertainty about whether the best possible choice was indeed made. Thus, welfare would be diminished among consumers to the extent that there are increased transaction costs because of the increase in the number of varieties to evaluate.

The Net Welfare Effects of Trade

The welfare effects under the basic assumptions of the model are entirely positive. Improvements in productive efficiency arise as firms produce further down along their average cost curves in free trade. Consumption efficiency is raised because consumers are able to buy the products at lower prices and have a greater variety to choose from.

Potential costs arise in the model only if we introduce the additional assumptions of adjustment costs or transactions costs. The net welfare effect in the presence of adjustment and transactions costs will still be positive if the production and consumption efficiency effects are larger.

Key Takeaways

  • Consumers benefit from trade in a monopolistically competitive (MC) market because they can consume a greater variety of goods at a lower price.
  • Free trade in an MC market may also lower the prices of products in other markets if reduced resource usage results in a shift to other industries causing an increase in supply and thereby a lower price.
  • Because some firms may close when an MC market moves to free trade, some of those resources may suffer costs of adjustment.
  • Consumer transaction costs to identify the most ideal variety may rise with an increase in the number of varieties available in free trade.

Exercise

  1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”

    1. Of increase, decrease, or stay the same, this is the effect of international trade on the number of varieties of a good available to consumers in a monopolistically competitive market.
    2. Of increase, decrease, or stay the same, this is the effect of international trade on the price of a good available to consumers in a monopolistically competitive market.
    3. Of increase, decrease, or stay the same, this is the effect of international trade on productive efficiency of firms remaining in business in a monopolistically competitive market.
    4. The two costs associated with adjustment to a trading equilibrium in a monopolistically competitive market.
    5. Of positive, negative, or the same, this is the net welfare effect of international trade in a monopolistically competitive market under the standard assumptions.