1. The Ricardian model and HO can’t explain intra-industry trade. The monopolistic competition model does so by introducing imperfect competition and increasing returns.
2. New gains from trade: Trade exploits economies of scale by increasing the extent of the market. It lowers prices and increases the variety of products.
3. There may be short-run costs of adjustment in addition to these long-run benefits. Example: NAFTA.
4. The gravity equation predicts that intra-industry will be most common between large economies. This is well supported by the data.
When firms have differentiated products and increasing returns to scale, the potential exists for gains from trade above and beyond those that we studied in earlier chapters under perfect competition. We have demonstrated these additional gains using a model of monopolistic competition. In this model, trade will occur even between countries that are identical because the potential to sell in a larger market will induce firms to lower their prices below those charged in the absence of trade. When all firms lower their prices, however, some firms are no longer profitable and exit the market. The remaining firms expand their output, lowering their average costs through increasing returns to scale. The reduction in average costs lowers the prices charged by firms, creating gains for consumers in the importing country. In addition, because each firm produces a differentiated product, trade between countries allows for the importing of product varieties that are different from those produced domestically, creating a second source of gains for consumers.
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When some firms have to exit the market, short-run adjustment costs arise within this model because of worker displacement. Using examples from Canada, Mexico, and the United States, we have argued that the short-run adjustment costs are less than the long-run gains. Regional trade agreements like the North American Free Trade Agreement (NAFTA) are a good application of the monopolistic competition model. Another application is the “gravity equation,” which states that countries that are larger or closer to one another will trade more. That prediction is supported by looking at data on trade between countries. Research has also shown that trade within countries is even larger than trade between countries.