Chapter 7.
External Economies of Scale &
the International Location of Production
Two reasons why countries specialize and trade
- Difference in resources or technology specialization
- Economies of scale specialization
When there are increasing returns, large firms may have an advantage over small ones, so that
markets tend to be dominated by one firm or by a few firms.
However, economies of scale need not lead to imperfect competition if they take the form of
external economies, which apply at the level of the industry rather than at the level of the
individual firm.
Preview
Trade & Gains from Trade are created from comparative advantages based on differences in
technology (Ricardian Model) & differences in factor endowments (H-O).
- Those comparative advantage theories predict that gains from trade are obtained when
there are big differences in economic structures, in which markets are all perfectly
competitive.
In view of comparative advantage, it is easy for trade to happen when there are big differences
in technology of factor endowment.
- This say that trades between the industrialized and less developed countries are more active
than those among the industrialized countries
- But the reality is that the trade among the industrialize are much bigger than those between
the industrialized and the less developed countries.
Thus, Ricardian & H-O failed in (are not satisfactory in) explaining trades under the imperfectly
competitive markets and trade among the industrialized nations.
Chapter 3~5, all trade is based on comparative advantage with CRS.
This chapter focuses on increasing returns, in which markets are typically imperfectly
competitive
- Ricardo (technology differences) & H-O (factor endowments) -> Comparative advantage
- Markets are perfectly competitive both in Ricardo & H-O theories(weakness)
Key terms: economies of scale, external economies & knowledge spillovers.
7.1. Economies of Scale and International Trade: An Overview
Each country specializes in producing a limited range of products efficiently & These
specialized economies then trade with each other to be able to consume the full range of goods.
- Efficient production by utilizing economies of scale
- Increased consumption choice by trade
7.2. Economies of Scale & Market Structure
Two kinds of economy of scale
- External economies of scale: The cost per unit depends on the size of the industry but not
necessarily on the size of any one firm. The efficiency of firms is increased by having a
larger industry.
No advantage for the bigger firms perfect competition
- Internal economies of scale: The cost per unit depends on the size of an individual firm but
not necessarily on that of the industry. The efficiency of a firm is increased by having a
larger production.
A firm is more efficient if its output is larger imperfect competition
Consequences & economies of scale
- Purely external (no advantages for large firms): Many small firms & perfectly competitive
- Internal (a cost advantage over small firms): imperfectly competitive market structure.
In this chapter, External economy only!
7.3. The Theory of External Economies
Definition: Economies of scale applied at the level of the industry
- Concentrating production in one or a few locations reduces the industry’s cost even if the
individual firms remain small
Cluster of firms may be (“Industrial Districts” by Alfred Marshall)
- Specialized suppliers -IT in Silicon Vally
-Investment Banking in NY
- Labor market pooling -Entertainment in Hollywood
-IT, Information Services in Bangalore
- Knowledge spillovers
-Underwear in China
<Specialized Suppliers>
Dens network of specialized suppliers Considerable advantages
(specialized equipment or support services) (Silicon Valley, Hollywood, 대구 염색공단, 포항제철 등)
- 교재의 Silicon Valley 사례 읽어라
<Labor Market Pooling>
Pooled market for workers with highly specialized skills More flexibility
The producers are less likely to suffer from labor shortage, while the workers are less likely to
become unemployed.
<Knowledge Spillovers>
Informal Diffusion of knowledge New Ideas, Innovation
- New ideas from R&D, Reverse Engineering, informal exchange of information & ideas
- Employees of different companies meet socially and talk freely about technical issues.
<External Economies & Increasing Returns>
To have a large concentration of firms it needs to possess a large industry; The larger the
industry’s output’s, the lower the price at which firms are willing to sell their output.
P, C
1 • When there are external economies of
scale, AC of producing a good falls as Q
produced rises.
AC
Q
<Fig 7-1: External Economies and Market Equilibrium>
7.4. External Economies & Int’l Trade
External economies drive a lot of trade both within and between countries.
- NY exports financial services to the rest of the U.S., largely because external economies in
the investment industry have led to a concentration of financial firms in Manhattan.
<External Economies, Output & Prices>
P, C P, C
PUS
ACUS
PChina
ACChina
DChina DUS
Q Q
<Fig 7-2: External Economies Before Trade>
P, C
• Trade leads to button prices that are
lower than the price in either country
before trade.
- When there are external economies of
scale, international trade makes it possible
P1 to concentrate world production in a single
P2 location, and therefore to reduce costs by
reaping the benefits of even stronger
DChina DWorld external economies.
Q1 Q2 Q
<Fig 7-3: Trade and Prices>
(비교)In the standard model in chapter 6, relative prices converge as a result of trade
- If cloth is relatively cheap in Home & relatively expense in Foreign before trade opens, the
effect of trade will be to raise cloth prices in Home & reduce them in Foreign.
<External Economies & the pattern of Trade>
Suppose the economy of scale is entirely to firms, and that since there are no economies of scale
at the level of the firm the watch industry in each country consists of many small perfectly
competitive firms.
- Competition therefore drives the price of watches down to its average cost
P, C • ACVietnam is below ACChina.
(C0 >P1 이라서 Vietnam이 진입 못한다)
C0 1 - Thus, Vietnam could potentially supply the
P1
ACChina
world market more cheaply than China.
ACVietnam - If the Chinese industry gets established first,
2
however, it may be able to sell button at P1.
- So a pattern of specialization established by
DWorld
historical accident may persist even when new
Q1
Q producers potentially have lower costs.
<Fig 7-4: The Importance of Established Advantage> - Violating the prediction of trade according to
Comparative Advantage.
Examples: financial centers in London & NY
Silicon Valley: Stanford graduates Hewlett & Packerd
Bangalore
<External Economies & the pattern of Trade>
The world is more efficient and thus richer because international trade allows nations to
specialize in different industries and thus reap the gains from external economies as well as
from comparative advantage.
But trade based on external economies has more ambiguous effects on national welfare.
- Trade based on external economies may actually leave a country worse off than it would
have been in the absence of trade.
P, C - If Thai were to block all trade in watches, it
would be able to supply its domestic market at
P2 (lower price).
C0
1
P1
2 ACSwiss • But the difficulty of identifying external
P2
economies in practice is one of the main
ACThai
arguments against activist government
policies toward trade.
DThai DWorld
Q
<Fig 7-5: External Economies and Losses from Trade>
While external economies can sometimes lead to disadvantageous pattern of specialization &
trade, it is virtually certain that it is still to the benefit of the world economy to take advantage
of the gains from concentration industries.
<Dynamic Increasing Returns>
External economies arising from the accumulation of knowledge differ somewhat from the
external economies considered so far, in which industry cost depend on current output.
- Industry costs depend on experience, usually measured by the cumulative output of the
industry to date.
- When costs fall with cumulative production over time rather than with the current rate of
production, this is referred to as a case of dynamic increasing returns.
- Like ordinary external economies, dynamic external economies can lock in an initial
advantage or head start in an industry.
Unit
cost
• The Learning curve shows that unit cost is
*
C0 lower the greater the cumulative output of a
C1 country’s industry to date.
L
*
L
QL Cumulative
output
<Fig 7-6: The Learning Curve>
Dynamic scale economies, like external economies at a point in time, potentially justify
protectionism.
- A country might increase its long-term welfare either by encouraging the protection of the
good by a subsidy or by protecting it from foreign competition until the industry could stand
on its own feet. (Infant industry argument)
7.5. Interregional Trade and Economic Geography
External economies play an important role in shaping the pattern of international trade, but they
are even more decisive in shaping the pattern of interregional trade.
- Studies of the location of U.S. industries suggest that more than 60% of U.S. workers are
employed by industries whose output is nontradable even within the U.S.
- Tradable vs. Nontradable
Motion pictures Newspaper publishers
Securities, Commodities Savings institutions
Scientific Research Veterinary Services
The share of nontradable industries in employment is pretty much the same across the U.S. But
tradable industries vary greatly in importance across regions.
- Manhattan accounts for only about 2% of America’s total employment, but it accounts a
quarter of those employed in trading stocks and bonds and about 1/7 employment in the
advertising industry.
What determines the location of tradable industries?
- Natural Resources; Houston is a center for the oil industry.
- External economies are the main reason for regional specialization and interregional trade.
(accident of history plays a crucial role)
NY, London
