CHAPTER THREE LITERATURE REVIEW
3.1 Theoretical Review
3.1.1 The Theories of IIT in Final Products
3.1.1.2 Models of Horizontal IIT in Final Products
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the lower (average)-income country specialising in lower-quality products. Since trade drives down prices in general and consumers prefer higher quality, it is lowest-quality firms that tend to be driven from the market. Thus, all other things being equal, VIIT is more likely, the greater the degree of taste overlap between economies. The opening up of two-way trade will be welfare improving in both of the above cases, since competition will drive down prices, while market expansion will induce overall quality improvement.
As a result, according to the Shaked and Suttan model, the more dissimilar the economies are, the larger the number of producers will be and the more the distribution of income becomes closer, the lower the number of firms in the combined economy.
iii. Model of North-South and Vertical Product Differentiation
Flam and Helpman (1987) developed a model of North-South trade based on vertical product differentiation (that is, differentiation according to quality). They assumed that two commodities exist: homogeneous product and a vertically differentiated product.
The homogenous products can be consumed in every desirable quantity, whereas the consumer can choose the quantity of differentiated product from those available in the market. The North produces and exports high quality, high cost varieties, while the South exports low quality, low cost varieties. Given an overlap in income distribution, there exists IIT. The Flam and Helpman (1987) opine that the higher the relative income of the North and the larger the share of income of southern individuals that consume imported varieties, the larger is the share of IIT. They predicted further that the share of IIT depends on relative country size, on income distribution in both trading countries.
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(Greenaway, 1983). These models can be categorised as ‗neo-Chamberlinian6‘ ‗neo-Hotelling‘ and ‘Reciprocal Dumping Model‘. All these models exist under conditions of
‗monopolistic competition‘. However, the treatment of consumer preferences differs between these three models.
i. Neo-Chamberlinian models
The neo-Chamberlinian works of Dixit and Stiglitz (1977), Krugman (1979, 1980), Lancaster (1980), Lawrence and Spiller (1983) and Helpman and Krugman (1985) developed a setting of differential factor endowments and monopolistic competition.
Under these models, goods are horizontally differentiated – that is, their characteristics differ (this differential may be perceived or real). The demand for greater variety of goods on the part of the consumers, free entry and exit, and decreasing production costs over the relevant range of output combine to generate IIT in differentiated commodities.
The Krugman (1979) model assumes an economy has one fixed factor of production (labour), which is fixed in supply. There are a large number of firms, each producing a different variety of the same good. It is assumed that all individuals have the same utility function and that all varieties enter the utility function symmetrically such that the consumption of one more unit of any variety has the same marginal utility.
In order to increase total utility, more varieties must be consumed without increasing total consumption, and welfare can increase as long as different varieties are consumed.
The symmetry of the model ensures that in equilibrium, each firm will produce the same quantity of their chosen variety and each will sell at the same price. Now assume another economy that is identical to the first in every way. When the economies open to trade, assuming transportation costs to be zero, two firms are now producing the same product, but one of the firms will change its variety to one which is not produced elsewhere (it is assumed in the model that altering one‘s product specification is costless). Each firm can sell the same quantity of the new variety as it sold of the old. A given variety will be produced in only one country, where half is sold in the home market and the other half will be exported. The model is indeterminate however, as to which variety is produced in which country. Consumer‘s utility shall increase as they face a wider choice. The
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Krugman model illustrates that trade between identical economies where consumers demand greater variety, there are decreasing costs of production, and where there is free entry and exit, there will be welfare increasing IIT.
ii. Neo-Hotelling models
These models build on the work of Lancaster (1980) and Helpman (1981), and suggest that IIT opens up as a consequence of preference diversity and decreasing costs. Products are assumed to be horizontally differentiated and consumer preferences are uniformly distributed around a ‗spectrum‘. Each consumer has an ideal variety, the closer their consumption is to the ‗ideal‘ the more they are willing to pay; the further, or less ideal the variety, the less they are willing to pay for the good. Preferences for variety differ between consumers. He who creates this situation under autarkic equilibrium and calls it perfect monopolistic competition. To capture IIT, Lancaster assumes two economies, operating as above, identical in every way.
In autarky, equilibrium would be the same in every, with the same varieties and quantities being produced in each. Assuming no trade barriers, if trade opens-up between the two countries, effectively one large market is being created to replace the original two-smaller markets. However, the factors of production are not free to move between the countries. Each differentiated variety is produced by only one firm, and in only one country. Half of the domestic consumers shall prefer an imported variety, the other half a home produced variety. The final distribution of varieties along the spectrum will be such that each domestic variety shall be evenly positioned between two imported varieties. The average distance between varieties on the spectrum decreases post trade, while the total number of varieties produced shall be higher.
iii. Reciprocal Dumping Model
This model developed by Brander and Krugman (1983) assumes two-countries which are identical in every respect, with one producer of an identical commodity in each. Each firm displays Cournot behaviour, that is, the assumption that each firm knows what its rival produces, takes the rivals‘ output as given, and selects its own output so as to
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maximise its own profit. The assumption of constant marginal costs allows the markets to be segmented, and each firm chooses the profit maximising output in each market separately. IIT in identical commodities shall result from Cournot behaviour, (where each firm will produce half the output in each country). The results of the model are very similar to the standard Cournot duopoly model; the only difference is that the producers are located in different countries. The reciprocal dumping model extends the above to include transport costs. These increase the marginal cost of exporting, and thus the export price. The volume of a firms‘ exports decreases, resulting in a cost advantage for the domestic producers and increase in their volume of sales. Each firm‘s output in each market will be set at the point where MC=MR, although MC is greater in the export market, much of the increase in transportation costs are absorbed by the firm.