Question

Consider two identical countries, country A and country B, that both produce shampoo, a good characterized by product differentiation, with identical increasing returns to scale technology. Each variety of shampoo is produced by a different firm, so the market exhibits all the characteristics of the monopolistic competition model of trade.

1)If country A and country B trade, what type of trade would be more likely to occur: intra industry or inter industry? WHY?

2)If two countries are allowed to trade what can you say about the pattern of trade?

3)In the free trade, describe the gains from trade in country A and country B. How are the gains from trade different from trade based on comparative advantage?

4)If two countries allowed to trade what can you say about the income distribution effects of trade?

Answer 1

The trade that is more likely to occur would be intra industry. As, shampoos belongs same industry just different firms are producing the different variety of it.

2. The trade would be lesser in volume as both the nations are already having the shampoo, the only variation is of the variety of it.

3. The gains from trade here, is different from gains in comparative advantage as, in comparative advantage, one participant nation has the luxury of producing the same good at lower cost due to factor endowments then the other. Then they trade it and gain profits which are better than the profits which will be gained in this case as in comparative advantage case, there is rather a scarcity of good in one nation as compared to other but here, there isn't any scarcity.

4 I don't think the trade will cause any major changes in the income distribution of the participants nations.