Endogenous Market Structures and International Trade: Theory and Evidence

• Date: 01 July 2015
• Published date: 01 July 2015
• DOI: http://doi.org/10.1111/sjoe.12084

Scand. J. of Economics 117(3), 918–956, 2015

DOI: 10.1111/sjoe.12084

Endogenous Market Structures and

International Trade: Theory and Evidence∗

Federico Etro

Ca̍Foscari, University of Venice, 30123 Venice, Italy

federico.etro@unive.it

Abstract

Under constant elasticity of substitution (CES) preferences and Cournot (or Bertrand) com-

petition, a larger market induces exits of domestic firms, lower prices, and larger production

of surviving firms because of competition from more foreign f irms, even without resort-

ing to the selection effects of Melitz. The elasticity of the number of firms to population

decreases with substitutability between goods, and it reaches 0.5 under Cournot competi-

tion with homogeneous goods: empirical evidence supports this structural relation against

the unitary elasticity of monopolistic competition. The results hold also in a 2 ×2×2

Heckscher–Ohlin model with imperfect competition generating inter- and intra-industry trade

due to comparative advantage or comparative preferences.

Keywords: Comparative advantage; comparative preferences; gains from trade; Krugman

model

JEL classification:F11; F12

I. Introduction

In traditional theories of trade, such as the neoclassical theory based on

perfect competition and the Krugman theory based on monopolistic com-

petition, the impact of trade and the gains from trade are associated with

international specialization or with the consumption of new varieties of

goods. These two approaches (integrated in Helpman and Krugman, 1985)

neglect the fact that trade usually affects the structure of markets, and, in

particular, the degree of competition, the number of firms active in each

country, the production level of each firm, and the mark-ups, with conse-

quences for welfare as well. A separate line of research started by Brander

(1981) and Markusen (1981) has shown that opening up to trade in imper-

fectly competitive markets generates price reductions. However, the main

∗I am grateful to Beverly Lapham, Jonathan Eaton, Jacques Thisse, and two anonymous

referees for insightful comments, and to Elena Stepanova for excellent research assistance.

Dirk Czarnitzki has worked jointly with me on a preliminary version of the empirical

results of Section IV and I am highly indebted with him. Finally, I am grateful to Aditya

Bhattacharjea, Parishit Ghosh, Debasis Mondal, Mausumi Das, and other seminar participants

at the Delhi School of Economics (India).

CThe editors of The Scandinavian Journal of Economics 2014.

F. E t r o 919

implications of this endogenous-market-structure approach have not been

investigated in a systematic way; it is not by chance that leading interna-

tional trade economists (such as Neary, 2010) talk about “two and a half

theories of trade”.

In this paper, first we develop a rather general one-sector partial equi-

librium model of endogenous market structures (EMSs) with Cournot and

Bertrand competition. We show that gains from trade emerge under general

conditions and can be associated with both the increase in the number of

goods consumed and the reduction of their prices.1Then, we focus on a

microfounded demand based on the constant elasticity of substitution (CES)

preferences, introduced by Dixit and Stiglitz (1977) and applied to trade in

the models of Krugman (1980) and Melitz (2003) under monopolistic com-

petition with homogeneous and heterogeneous firms, respectively. In both

models, the mark-up was constant for all the firms and the number of fir ms

was linearly increasing with respect to the size of the market under free

trade.2We depart from monopolistic competition and examine Cournot and

Bertrand competition. With competition in quantities, an expansion of the

market associated with trade increases less than proportionally the number

of firms, because stronger competition reduces the mark-ups and forces

the firms to produce more in order to cover the fixed costs. For instance,

in the case of homogeneous goods, the elasticity of the number of firms

with respect to the size of the market is β=0.5. This means that doubling

the size of a market increases the number of firms by about 40 percent,3

expands their production, and reduces their average cost and mark-up, with

relevant welfare gains even if there are zero gains from variety. When

the substitutability between goods decreases, the implied elasticity of the

number of firms increases (but remains below unity), and trade creates

gains from both the consumption of new varieties and the reduction of

their prices. Similar results emerge in the case of competition in prices;

expanding the market size attracts more firms (in this case, approximately

in a linear way), which strengthens competition, reduces the prices, and

requires a larger production for each firm.

The model is then extended to a general equilibrium 2 ×2×2 set-

up with identical preferences and different factor endowments between

countries. A trading equilibrium with diversification induces factor price

1This is in line with the estimates of Feenstra and Weinstein (2010) on the US, for which

the gains from variety are quantitatively similar to the gains from lower mark-ups.

2For an alternative microfoundation of monopolistic competition, see Bertoletti and Etro

(2013), who assume additive indirect utility, as opposed to additive direct utility (as in Dixit

and Stiglitz, 1977). For a generalization, see Bertoletti and Etro (2014).

3If the relation between the number of firms Nand the size of the market Sis ln N=βln S,

a doubling in the size of the market attracts 2βfirms. The model of Krugman (1980) with

monopolistic competition implies β=1.

CThe editors of The Scandinavian Journal of Economics 2014.

920 Endogenous market structures and international trade

equalization, and equal output and mark-ups for all firms (under both

price and quantity competition). Assuming EMSs in the capital-intensive

sector and perfect competition in the labor-intensive sector, the trading

equilibrium induces intra-industry trade in the capital-intensive sector with

positive net exports of the capital-abundant country.4Assuming Cobb–

Douglas production functions in both sectors, we can fully solve the model

in closed form and we can verify that the mentioned relation between the

total number of firms and the size of the integrated market is robust to this

extension; the relation between the market size and the number of domestic

firms depends on multiple factors, but follows a similar logic in the case

of symmetric countries.

We employ the model to consider the case of different homothetic pref-

erences in the two countries, analyzing the realistic situation in which the

imperfectly competitive sector is the capital-intensive sector and one coun-

try has a relative preference for the goods of this capital-intensive sector.

In the extreme case of identical factor endowments (no technological com-

parative advantage), this country produces more capital-intensive goods in

autarky, but reduces their production under free trade and starts importing

them. Therefore, the process of local business destruction can be much

more drastic for one of the two countries. As far as we know, this is the

first formalization in this set-up of the implications of trade due to com-

parative preferences rather than comparative advantage. Finally, we extend

the model to differences in productivities between firms, as in the model

of Melitz (2003), which is based on monopolistic competition and, under

free trade, preserves the linearity of the number of firms in the size of the

market (because the average profit of the firms is invariant in market size).

Introducing strategic interactions restores the role of trade in inducing local

business destruction, larger production of each surviving firm, and lower

prices without resorting to trade costs.

We also provide a preliminary test of the structural relation between the

number of firms in manufacturing sectors and the market size measured

by industry sales. Because our model of market integration abstracts from

transport costs and trade barriers, we focus on market structures emerging

in a large integrated market. Our investigation is based on a panel of

industry-level data for German manufacturing. We reject a linear relation

between the number of firms and the market size (against the Dixit–Stiglitz

monopolistic competition case) and the absence of a relation (against the

perfectly competitive case), and we estimate an elasticity βbetween 0.5

and 0.65, in support of the case of Cournot competition. This is in line

with the elasticity of 0.65 found by Eaton et al. (2011) in a French dataset

4Our generalized 2 ×2×2 model nests traditional models: the Heckscher–Ohlin model, the

Brander–Markusen model, and the Helpman–Krugman model.

CThe editors of The Scandinavian Journal of Economics 2014.