Chapter 5: Beyond Comparative Advantage
Class Notes: these count for 1% of your total grade
1. Definitions
Intradindustry trade: International trade of products made within the same industry, such as
trading steel for steel or cars for cars. It is common among industrial countries and is often
associated with economies of scale and product differentiation.
Interindustry trade: International trade between two different industries, such as trading steel
for bread. This type of trade aligns more closely with traditional comparative advantage models.
Economies of scale: Decreasing average costs over a relatively large range of output (as
opposed to constant or increasing costs)
Internal economies of scale: lead to larger firms because size confers a competitive advantage
External economies of scale: lead to larger industries (however, larger firms have no inherent
advantage over smaller ones)
Oligopoly: A market structure in which a small number of firms produce the entire market
output, and each firm’s strategies are influenced by the actions of its competitors.
Monopolistic Competition: A market structure in which many firms compete, but each firm
differentiates its product to gain a competitive advantage. Increased competition in such markets
typically leads to lower prices.
Market Failure: Failure by the market economy to deliver an optimal quantity of goods and
services; the value of a good to private consumers (private returns) and to society (social returns)
fails to equal to its cost of production
2. Based on the figure above, we can conclude that market failure has arisen. What is the
result of this?
Based on the figure, we can see two supply curves:
Sp (Social Supply) – Represents the true cost to society, including externalities.
Ss (Private Supply) – Represents the cost considered by private firms.
D (Demand Curve) – Represents consumer willingness to pay.
This graph suggests the presence of a negative externality, such as pollution, where the social
cost (Sp) is higher than the private cost (Ss). This means that firms overproduce because they
do not account for the external harm their production causes (e.g., environmental damage, health
risks).
Since firms produce at the intersection of Ss and D, rather than the intersection of Sp and D, we
see:
1. Overproduction – More quantity is produced than socially optimal.
2. Higher Social Costs – The market ignores the external costs (e.g., pollution).
3. Deadweight Loss – The extra production leads to inefficiency and a loss of overall
societal welfare.
Possible Policy Solution:
- Taxes (Pigouvian Tax) – A tax equal to the external cost can shift Ss to Sp.
- Regulations – Setting production limits or stricter environmental rules.
- Tradable Permits – A cap-and-trade system to control negative externalities.
Thus, this graph illustrates market failure due to a negative externality, leading to inefficient
resource allocation and overproduction.