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Markups, Scale Economies, and Trade

How market power and scale effects reshape trade outcomes, industrial policy design, and the returns to international coordination.

markupsscale economiesmarket powergains from tradeindustrial policy

Most trade theory assumes either perfect competition or a specific form of monopolistic competition that makes markups constant and symmetric. Relax either assumption and the standard results shift. Gains from trade change in magnitude, the case for industrial policy strengthens, and the welfare cost of trade wars rises.

Markups as international transfers

A firm charging above marginal cost extracts a rent. When the firm sells domestically, the rent is a transfer from domestic consumers to domestic owners, a distributional issue but not a national welfare loss in a closed-economy accounting. When the firm exports, the rent comes partly from foreign consumers. Lashkaripour (AEJ:Micro 2020) shows that rich and geographically remote economies specialize in high-markup product segments within industries. This specialization pattern accounts for roughly 30 percent of the measured gains from trade and explains 37 percent of cross-national income inequality. The mechanism is straightforward: countries that sell differentiated, hard-to-substitute goods extract more surplus per unit sold.

Ding, Lashkaripour, and Lugovskyy (2026) push this logic further. They show that markups function as shadow tariffs, wedges that are welfare-equivalent to tariff barriers in their effect on international surplus allocation. High-income countries capture a disproportionate share of global excess profits, equivalent on average to a 17.6 percent shadow tariff. The implication for trade negotiations is direct: reciprocity measured only in observed tariffs misses a large part of the actual protection structure.

Scale economies and misallocation

Scale economies create a different but related distortion. When average costs fall with output, the efficient allocation concentrates production in fewer locations. Decentralized markets may not reach this allocation because individual firms do not internalize the cost savings from sectoral expansion. Lashkaripour and Lugovskyy (AER 2023) study the interaction of markups and scale economies jointly. Their central finding is that standalone trade policy (tariffs, export subsidies) is remarkably ineffective at correcting misallocation when both distortions are present. Unilateral industrial policy does better in principle but can produce immiserizing growth through terms-of-trade deterioration.

The cost of conflict, the value of coordination

Lashkaripour (JIE 2021) quantifies the cost of a global tariff war when markups are heterogeneous across sectors and countries. The markup wedges amplify the welfare losses from a tariff war beyond what constant-markup models predict, and they raise the gains from cooperation correspondingly. Across the papers collected here, the pattern is consistent: the distortions created by market power and scale effects are real, unilateral correction is weak or counterproductive, and coordinated policy through deep agreements delivers gains that no country can capture alone.

Related papers

Profits, Scale Economies, and the Gains from Trade and Industrial Policy

This paper explains why unilateral trade policy is a weak tool for fixing distortions created by profits and scale economies. It argues that coordinated industrial policy inside deep agreements can be much more effective.

The Cost of a Global Tariff War: A Sufficient Statistics Approach

This paper develops a tractable way to estimate the cost of a global tariff war using observable shares, trade elasticities, and markup wedges. It shows that tariff-war losses and the gains from cooperation both rose sharply over time.

Within-Industry Specialization and Global Market Power

This paper argues that rich and remote countries sort into high-market-power product segments. That pattern helps explain both export price differences and a large part of the gains from trade.

Markups as Shadow Tariffs: How Market Power Skews Trade Reciprocity

This paper shows that markups behave like shadow tariffs because they both distort domestic allocation and shift surplus across borders. It reframes trade reciprocity through the lens of global excess profits.

Direct-answer pages

Question

How Markups Distort Trade Reciprocity

Market power functions as a shadow tariff, shifting surplus across borders and undermining reciprocity metrics that count only observed tariff rates.

Key questions

Why do markups matter for trade policy?

Markups drive a wedge between price and marginal cost. In a closed economy this is a domestic misallocation problem. In an open economy it becomes an international transfer problem: firms with market power extract surplus from foreign consumers, and the pattern of who extracts from whom is shaped by trade costs, specialization, and country size. This means tariff negotiations that ignore markups are optimizing over the wrong objective.

Why are scale economies policy-relevant?

When production technologies exhibit increasing returns, sectoral composition affects aggregate productivity, not just through comparative advantage but through the cost structure itself. A country that hosts more scale-intensive production operates at lower unit costs. The policy relevance is that interventions shifting production across sectors or countries do not merely reallocate output; they change how efficiently it is produced.