In a perfectly competitive market a market in which there are many buyers and sellers, none of whom represents a large part of the market (firms are price takers). That is, sellers of products believe that they can sell as much as they like at the current price and cannot influence the price they receive for their product. In imperfect competition, firms are aware that they can influence the prices of their products and that they can sell more only by reducing their price. Imperfect competition is characteristic both of industries in which there are only a few major producers and of industries in which each producer's product is seen by consumers as strongly differentiated from those of rival firms. Under these circumstances each firm views itself as a. price setter, choosing the price of its product, rather than a price taker. Underlying the application of the monopolistic competition model to trade is the idea that trade increases market size. In industries where there are economies of scale, both the variety of goods that a country can produce and the scale of its production are constrained by the size of the market. By trading with each other, and therefore forming an integrated world market that is bigger than any individual national market, nations are able to loosen these constraints. Each country can specialize in producing a narrower range of products than it would in the absence of trade; yet by buying goods that it does not make from other countries, each nation can simultaneously increase the variety of goods available to its consumers. As a result, trade offers an opportunity for mutual gain even when countries do not differ in their resources or technology. Suppose, for example, that there are two countries, each with an annual market for 1 million automobiles. By trading with each other, these countries can create a combined market of 2 million autos. In this combined market, more varieties of automobiles can be produced, at lower average costs, than in either market alone. The monopolistic competition model can be used to show how trade improves the tradeoff between scale and variety that individual nations face. We will begin by showing how a larger market leads, in the monopolistic competition model, to both a lower average price and the availability of a greater variety of goods. Applying this result to international trade, we observe that trade creates a world market larger than any of the national markets that comprise it. Integrating markets through international trade therefore has the same effects as growth of a market within a single country. Gains from Trade: A Numerical Example
International trade can create a larger market. We can illustrate the effects of trade on prices, scale, and the variety of goods available with a specific numerical example. Imagine that automobiles are produced by a monopolistically competitive industry. The demand curve facing any given producer of automobiles is described by Q = S X [V n - b X (P - P) l with b = 1/30,000. Thus the demand facing any one producer is given by Q = S X [1/n - (1/30,000) X (P - P)], where Q is the number of automobiles sold per firm, S the total sales of the industry, n the number of firms, P the price that a firm charges, and P the average price of other firms. We also assume that the cost function for producing automobiles is described by C = F + cXQ, with a fixed cost F = $750,000,000 and a marginal cost c = $5000 per automobile. The total cost is
C = 750,000,000 + (5000 X Q).
The average cost curve is therefore
AC = (750,000,000/0 + 5000.
Now suppose there are two countries, Home and Foreign. Home has annual sales of 900,000 automobiles; Foreign has annual sales of 1.6 million. The two countries are assumed, for the moment, to have the same costs of production. In the absence of trade, Home would have six automobile firms, selling at a price of $10,000 each. To confirm that...