The Krugman Model

Saurabh Batra(559)

Tuhina Dubey(572)

Objective

Overview of Krugman Model

Main characteristics with graph

Two country instance(Auto Pact)

Potential result

What Krugman Model is?

Krugman Model is a model of trade Under monopolistic competition. With economies of scale in production.

Krugman model shows that trade can be beneficial to consumers even with this form of market.

Monopolistic Competition

Each firm acts like a monopolist

Presence of many substitutes (not a homogeneous product)

Product Differentiation –Advertising and Sales promotion

Encouragement of Brand Loyalty

Start in Autarky

There are number of firms in each country

Labor assumed to be the only factor of production

Production exhibits Economies of scale , scale limited to home market

Countries start to trade

With larger world market some firms try to expand their production Firms realize their economies of scale hence

average cost falls so does the price of the good

Some firms fade out and exit

There are fewer firms in the world with trade; but there are MORE FIRMS SELLING IN EACH MARKET

Hence with trade, consumers get more selection and lower prices than without trade

Krugman Model

Market is characterized by monopolistic competition with increasing returns to scale.

Average cost of production falls for each firm falls as output increases. (Marginal cost is constant)

Returns to scale : Labour is only factor of production

L= a + b Q ; b > 1, a > 0.

Example, b = 2, a = 30

If Q = 50, L = 130,

If Q = 100, L = 230 < 260

-production exhibits increasing returns to scale

Krugman Diagram

This diagram analyzes relationship between per capita consumption of a product, c (horizontal axis) and real cost to purchaser (relative to wage), P/W (vertical axis)

Basic Krugman Diagram

First: PP curve

as consumption of a company’s good increases (demand increases … shift outward in a

demand/supply)

P/W for the good also increases because demand becomes less elastic as Q increases. elasticity of demandΔQ/Q/ΔP/Por (Q2-Q1)/(Q1+Q2) /(P2-P1)/(P1+P2)

The ZZ curve

As per capita consumption (c) rises, output rises and brings scale economies. P falls relative to W as c rises

reductions in unit cost lead to lower prices and zero economic profit

above ZZ curve profits are greater than zero

below ZZ curve profits are less than zero

Trade in the Krugman Model

International trade allows economies of scale to be realized, more so than with limited or no trade

Total production of each good increases as more people buy it

The ZZ curve moves down, P/W falls (meaning real wage W/P rises) because goods become cheaper.

Also, c drops for each good per capita consumption decreases as more choice is

available

Two Firms instance Suppose this firm exists in

country 1.

Let country 2 be identical to country 1 on both the demand and the supply sides of the economy.

Traditional trade theory posits that these countries would not trade.

However, because trade effectively increases the market size in each country, economies of scale are realized in the Krugman model.

Trade effectively shifts the ZZ curve to the left

Z΄

Z

P

P

Z΄

Z

(P/W)1

(P/W)2

cc1c2

The Canada—United States Automotive Products Agreement

It removed tariffs on cars, trucks, buses, tires, and automotive parts between the two countries (greatly benefitted the large American car makers)

GM,Ford,Chrysler,Volvo agreed for a stagnant level of production- sales ratio

Reduction in production costs in Canada ,more efficient production of a smaller range of vehicles and components, and lower vehicle prices for consumers

Initially Canada exported $ 16 million worth of automotive parts to US and imported parts worth $519 million. But after this pact the number increased to $ 2.4 billion within a decade.

 The agreement is said to have benefitted Canadian workers and consumers by lowered prices and increased production creating thousands of jobs and increasing wages. 

The Auto Pact was though abolished in 2001 after a World Trade Organization ruling declared it illegal.

We conclude..

Although trade causes per capita consumption (c) to fall, total consumption of the firm’s output has risen.

P/W has decreased because of trade; this also means that its reciprocal (W/P) rises.

This suggests that trade causes the real wage of workers to rise.

Thank You..

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