Model Answer
0 min readIntroduction
Intra-industry trade (IIT) refers to the exchange of similar products between countries, such as different varieties of automobiles or electronics. Traditionally, trade theories like Ricardian and Heckscher-Ohlin models explained trade based on comparative advantage stemming from differences in factor endowments. However, a significant portion of world trade occurs within the same industry. The Brander-Krugman model, developed by James Brander and Paul Krugman in the early 1980s, provides a compelling explanation for IIT, particularly in oligopolistic markets characterized by differentiated products and increasing returns to scale. This model challenges the classical assumptions and highlights the role of strategic firm behavior in driving trade flows.
The Core of the Brander-Krugman Model
The Brander-Krugman model operates within a framework of imperfect competition, specifically an oligopoly. It assumes two countries, typically referred to as Home and Foreign, each with a small number of firms producing differentiated products. Key assumptions include:
- Differentiated Products: Consumers value variety, and products are not perfect substitutes.
- Increasing Returns to Scale: Production costs fall as output increases, leading to economies of scale. This is crucial as it allows firms to benefit from larger markets.
- Imperfect Competition: A small number of firms dominate the market, allowing them to influence prices.
- Transport Costs: These costs are assumed to be relatively low but non-zero, influencing trade patterns.
Strategic Interaction and Market Structure
The model focuses on the strategic interaction between firms. Each firm aims to maximize its profits by choosing its output level, considering the output decisions of its rivals. Before trade, each country’s market is served by its domestic firms. However, opening up to trade changes the competitive landscape.
The Role of Market Size
A larger market size (due to trade) allows firms to exploit increasing returns to scale, lowering average costs. This is a key driver of trade. Firms will choose to export to the foreign market if the potential increase in profits from serving a larger market outweighs the transportation costs.
Nash Equilibrium and Output Levels
The model predicts that firms will engage in a Cournot-Nash competition, where each firm chooses its output level assuming the output levels of its rivals are fixed. The resulting equilibrium output levels and prices are determined by the interaction of these strategic decisions. Firms will strategically choose output levels to maximize profits, considering the demand elasticity and the actions of competitors.
Trade Patterns and Welfare Implications
The Brander-Krugman model predicts that trade will occur even between countries with similar factor endowments and tastes. This is because firms are motivated by the opportunity to exploit economies of scale and increase their market share. The model also suggests that trade can lead to:
- Increased Product Variety: Consumers benefit from a wider range of choices.
- Lower Prices: Increased competition can lead to lower prices for consumers.
- Potential for Market Concentration: Firms that are more efficient or have a first-mover advantage may gain a larger market share, leading to some degree of market concentration.
Example: Automobile Industry
The automobile industry provides a classic example of IIT. Germany and Japan, both with advanced manufacturing capabilities, extensively trade cars with each other. They don’t trade based on cost advantages (like cheaper labor) but on product differentiation – different brands, features, and designs cater to varying consumer preferences. Each country exports and imports different models, demonstrating IIT within the same industry.
| Feature | Brander-Krugman Model | Heckscher-Ohlin Model |
|---|---|---|
| Basis of Trade | Increasing returns to scale & product differentiation | Comparative advantage (factor endowments) |
| Market Structure | Oligopoly/Imperfect Competition | Perfect Competition |
| Trade between | Similar countries | Countries with differing factor endowments |
Conclusion
The Brander-Krugman model offers a valuable framework for understanding intra-industry trade, particularly in industries characterized by differentiated products and increasing returns to scale. It highlights the importance of strategic firm behavior and market structure in driving trade patterns. While the model simplifies reality, it provides a powerful explanation for why countries trade similar goods with each other, even in the absence of traditional comparative advantages. Further research explores the role of government policies, such as subsidies and trade barriers, in influencing the outcomes predicted by the model.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.