CHAPTER 7 – External Economies of Scale and the Internal Location of Production

There are two reasons why countries specialize and trade:

1. Countries differ either in their resources or in their technology and specialize in the things
they do relatively well (comparative advantage)
2. Economies of scale (or increasing returns) make it advantageous for each country to
specialize in the production of only a limited range of goods and services, to increase output
and decrease costs.

The models of comparative advantage observed up until now – Ricardian, Specific factor, HO –
assumed constant returns to scale and are perfectly competitive
Constant returns to scale: when inputs to an industry increase at a certain rate, output increases at
the same rate – if inputs were doubled, output would double as well.

External economies of scale  Internal economies of scale

External economies of scale apply at industry level, while internal economies of scale apply at the
firm’s level.
External economies of scale are situations of perfectly competitive markets, while internal
economies of scale are sources of market imperfection.

However, the crucial difference between the models of comparative advantage and the models of
economies of scale is that the latter assumes increasing returns to scale.
Increasing return to scale: (1) when inputs to an industry increase at a certain rate, output increase
at faster rate – doubling the input, more than doubling the output. (2) At the same time, the higher
the industry output the lower the average cost per unit – large scale is more efficient.

Example – to convey the significance of economies of scale for international trade

Here is shown the relationship between inpunt and output of a hypothetical industry. Does this
industry face external economies of scale?

This industry produces widgets using only one factor of production, labour. The table shows that
the amount of labour required depends on the output produced.

The presence of economies of scale can be detected for two reasons:

(1) doubling the input results in more than doubling output:
Doubling the input= doubling total labour input  15*2= 30
Before doubling the input (L=15), output was 10. Once doubled the input at L=30, the output is 25.
Since 10*2= 20 but actual output at L=30 is 25  20 < 25  doubling the input 15*2, produces
more than doubling output.
in fact, output increases by a factor of 2,5  more than a factor of 2

(2) As the output increases, the average labour used decreases – in other words, as the output
increases the average cost per unit decreases

This example tells us that economies of scale provide an incentive to trade because mutual
benefits for the countries involved can arise.

Imagine a world consisting of two countries, USA, and Britain, both of which have the same
technology in producing widgets.
- Suppose each country initially produces 10 widgets each, requiring 15 hours of labour in
each country
- The world as a whole would produce 20 widgets using 30 hours of labour
- Now suppose to concentrate the production of widgets in USA and let the 30 hours of labour
in the widget industry.
- In a single country, these 30 hours can produce 25 units (more than what the world’s
economy produced before specialization) – so by concentrating the production of widget in
the USA, the world’s economy can produce more output for the same price.

USA produces more widgets even if national consumption of widgets is still – the difference
between production and consumption will be exported to Britain  Britain need to import widgets
because it gave up the production of widgets (since USA is more efficient) but it still needs to
satisfy national demand for widgets.

But where does the USA get the extra hours of labour to reach 30 hours in widget production? USA
would take away labour from other sector x, decreasing labour in sector x, thus decreasing output x
– deficit in the availability of good x  USA needs to import good x in order to offset the negative
difference between production of x and its consumption rate.

Since Britain does not produce widgets anymore, it specialized in the production of good x.
Because Britain needs less workers for widgets, it takes away labour in widget and reallocate labour
in good x sector in order to be able to export.

This is something that must happen if we want to observe both countries gaining from trade.

International trade permits each country to produce a limited range of goods without scarifying
variety in consumption – the specialize economies that trade between each other and makes possible
to not scarify consumption.
With trade, a country can take advantage of economies of scale to produce more efficiently that if it
tried to produce everything for itself – if each country produces only some goods, then each good
can be produced at larger scale for the same cost.
Economies of Scale and Market Structure

External: the cost per unit depends on the size of the industry, but not necessarily on the size of
the belonging firms.
Internal: the cost per unit depends on the size of an individual company, but not necessarily on
the industry size

Both external and internal economies of scale are important causes of international trade.
However, they have different characteristics in terms of industry and market structure:
- An industry where economies of scale are purely external will typically consists of many
small firms and be perfectly competitive. The economies of scale arise accordingly to the
industry size, not according to the individual firm’s size – as the industry enlarges, the cost
of production of each firm decreases  the efficiency of firms is increase by having a
larger industry, even if each firm is the same size.

- Internal economies of scale result when large firms have a cost advantage over small firms,
causing industry to become imperfectly competitive. The economies of scale arise
accordingly to the individual company’s size, not according to the size of the industry.

The Theory of External Economies

As we said, when economies of scale apply at the level of the industry rather than at the level of the
individual firm, we are in a situation of external economies of scale.

Many modern examples of industries – industrial districts - that seem to be powerful external
economies. In the United States, the semiconductor industry is concentrated in Silicon Valley,
investment banking in New York, and the entertainment industry in Hollywood.
China manufacturing industry has high external economies, while India in information services.

For a variety of reasons, concentrating production of an industry in one or few locations can
reduce the industry’s costs, even if the individual firm in the industry remains small

Concentrating production of an industry in one or few locations give rise/strengthen external

economies of scale
Particularly, there are three events occurring in industrial districts that give rise to external
economies of scale – these three are the reasons why industrial districts may be more efficient than
individual firms in isolation.
1. The ability of a cluster to support specialized suppliers
2. The way that a geographically concentrate industry allows labour market pooling
3. The way that an industrial district helps foster knowledge spill overs.

1. Specialized Suppliers
In many industries, the production of goods and services requires the use of specialized equipment
or services.
An isolated company does not provide a large enough market to keep the suppliers in a long-term
and continuous relationship, so it is harder and more expensive for isolated firms to get the supply.
Instead, a localised industrial cluster can solve this problem by bringing together many firms that
collectively provide a large enough market to support a wide range of specialized suppliers. In this
case, the industrial district can “lobby” suppliers and get inputs easier and more accessibly.
For example, in Silicon Valley there are suppliers of chip that makes easier and cheaper the
procurement of those chips for computer producers.

The availability of this dense network of specialized suppliers, has given considerable advantage to
the firms belonging to the cluster.
Key inputs are cheaper and more easily available because there are many suppliers competing to
provide them in a single location, and firms can concentrate on what they do best, contracting out
other aspects of their business.

2. Labour Market Pooling

A large and concentrated industry may attract a pool of workers, reducing employee research and
hiring costs for the firms.

Industry district can create pooled market for workers with similar highly specialized skills.
The advantage is of both producers and workers, as the producers are less likely to suffer from
labour shortage and the workers are less likely to become unemployed.

Imagine there are two companies that both use the same kind of specialized labour. If the demand
for the product is high, both companies will want to hire 150 workers. If the demand is low, they
will want to hire only 50. However, they are uncertain about the demand.

It the two companies are isolated  100 workers in city x, and 100 workers in city y.
If one is doing well and the other is doing bad, the firm that is doing well cannot hire as much
employee as it wants because only 100 are available in the city. The company that is doing bad
instead will only employ 50 in the other city  this causes unemployment

If the two companies belong to the same geographic cluster  200 workers in the same place. If
one firm is doing good and the other in doing bad, the former can employ 150 and the latter can
employ 50 – both can hire as many workers as they want  low labour demand in the bad company
can be offset by the high demand of the other firm  as result, workers would have lower risk of
unemployment. In addition, concentration of firms in a single location makes it easy to search and
switch employer.

By locating near each other, the companies increase the likelihood that they will be able to take
advantage of business opportunities – reducing the likelihood of facing labour shortage and
decreasing the hiring costs.

3. Knowledge Spill Overs

Workers from different firms may more easily share ideas that benefits each firm when a large
and concentrated industry exist – being closer to each other makes the flow of information and
ideas, smoother and quicker across firms belonging to the same district.
It is especially true for highly innovative and technological industries, where being even few
months being the cutting edge in production techniques can put a company at a major disadvantage.
This kind of informational flow means it is easier for companies to stay near the technological
frontier.
External Economies and Market Equilibrium

The strength of concentrated industries depends on the industry’s size – the bigger the industry the
stronger are the external economies  the larger the industry, the lower are the industry’s costs
(the costs of the firms belonging to the concentrated industry)

Ignoring international trade – we represent the equilibrium of country having external economies of
scale (but not trading)

Still, market equilibrium can be represented with a supply-demand diagram, where the equilibrium
is represented by the interception between supply and demand.
However, the supply curve of a country facing economies of scale in not upward sloping as usual,
it is instead forward-falling sloping (downward sloping). This because the supply curve of the
country when it has external economies of scale is equal to the average cost curve. Since the
country is facing economies of scale, the average cost declines (price) as the quantity increase – the
larger the industry output, the lower is the price at which firms are willing to sell.

External Economies and International Trade

External economies drive a lot of trade both within and between countries. For example, new your
exports financial services to the rest of the united states (within). Similarly, Britain exports financial
services to the rest of Europe (between)

N.B. partial equilibrium analysis

Prior to international trade, equilibrium prices and output for each country would be at the point
where the domestic supply curve intersects the domestic demand curve.
- Two countries US and China (not trading) produce buttons, and the industry of buttons in
both countries is subject to economies of scale – so the supply curve is downward sloping,
and it is equal to the industry’s average cost curve.
- In absence of trade, the price of buttons in China appears to be lower than the buttons price
in the united states (China has stronger economies of scale in the industry of buttons)

Introducing trade between China and USA

- Chinese button industry will expand, while the USA button industry will contract.
- This process feeds on itself: China has economies of scale from the beginning – so by
increasing output level in China (after trade), China can further decrease its cost, thus
decrease price.
- Consequently, US industry’s output drops and its costs will rise.
- We can expect all button production to be concentrate in China
- Before opening to trade, China supplied only its own domestic market, after trade China
produces buttons for both China and USA.
Since China’s supply curve is downward sloping, an increase in output as result of trade leads to a
decrease in price of buttons produced by China. And bear in mind that Chinese buttons prices
were lower than USA’s before trade.

This tells us that trade leads to button prices that are lower than the prices in both countries
before trade.

This last point is very different form the implications of standard models where the relative prices
converge as result of trade. In the previous models, if Home price of good x is lower than in
Foreign before trade, then Home will export good x and the price of good x after trade will be
higher than the price at home before trade.

In our button examples, we can say that concentrating production of a good in a country that has
stronger external economies of scale reduce prices everywhere.

External Economies and Patterns of Trade

In our example of world trade buttons, we simply assumed the Chinese industry started out with
lower production costs than the American industry. What might lead to such initial advantage?

First explanation is comparative advantage due to underlying difference in technology and

resources – which is a positive reason for China to be specialized in buttons.
China as a comparative advantage because wage rates are lower than elsewhere, so it can perform
more efficiently manufacturing of buttons.

Second, the initial advantage could be given by historical reasons – which is not always a positive
reason for the world’s economy.
Something (an event) gives a particular location an initial advantage in a particular industry, and
this advantage gets locked in by external economies of scale even after the circumstances that
created the initial advantage are no longer relevant. For example, London became Europe
dominant financial centre in the 19th century, when Britain was the world’s leading economy and
the centre of an empire. It has retained that role even though the empire is long gone, and
modern Britain is only a middle size economic power.

However, historical contingencies cause that industries are not always located in the right place.
Countries that start as large produces in certain industries tend to remain large producers even if
another country could poetically produce more cheaply.

Example – the importance of initial established advantage

The graph shows the cost of

producing buttons as a function of
the quantity produced.

The Chinese and Vietnamese cost

of producing one button is ACChina
and ACVietnam
DWORLD represents the world
demand for buttons, which we
assume can be satisfied either by
China or by Vietnam (we have to
choose who will undertake world’s
production)

Both countries face external

economies of scale in button
sector.
We assume that Vietnamese supply curve (average cost curve) lies below China’s, because
Vietnam can produce the same amount at lower cost of China (stronger economies of scale). We
suppose this is the case because Vietnam wage rate is lower – at any given level of production,
Vietnam could manufacture buttons more cheaply than China.

Only if all firms move to Vietnamese, Vietnam could become the only button’s supplier. Instead, if
only one or few firms decide to produce buttons in Vietnam, they would face a cost of C 0 which is
higher than Chinese cost, thus China appear to be the more efficient – C 0 is above the price at
which established Chinese industry can produce buttons. So, although Vietnamese industry could
be potentially cheaper, China’s head start enables it to hold on to the industry.

Trade and Welfare with External Economies

In general, we can presume that external economies of scale lead to gains from trade over and
above those of comparative advantage. The world is more efficient and thus richer because
international trade allows nations to specialize in different industries.

The importance of established advantage explains why a country may be worsen off due to trade
– a country may be better off if it produces everything for its domestic market rather than pay for
imports.
 - Imagine Thailand and Switzerland could both producing watched. Thailand could make
them more cheaply, but Switzerland has an established advantage (got there first).
- Let’s add the DTHAI which is the domestic demand curve for watches in Vietnam
- If there was not trade, Vietnam equilibrium would be at point 2, this means that Thailand
could be better off if it self-produced watches because P2 is lower than P1 (the latter is the
price in can of trade)

We have presented a situation in which the price of a good that Thailand imports is actually higher
than the price than Thailand would face for the same good if it was not involved in trading.

Trade could then make Thailand worsen off, creating an incentive to give rise to protectionism.
What Thailand could do is to stop import watches and close the economy so that watched are
produced and sold only nationally. Thailand closed economy would start at C 0 (not a problem since
T is not facing foreign competition). Then it should keep protectionism until it reached the point in
which ACTHAI intercept DWORLD. At this point, if Vietnam open again to trade, it will have a better-
established advantage compared to China and could become the only supplier.

However, the above mentioned possible Thai strategy is not good for the world’s economy. Each
country wanting to reap the benefits of housing an industry with economies of scale creates trade
conflicts. Overall, it’s better for the world’s economy that each industry with external economies
be concentrated somewhere.

Dynamic Increasing Returns

So far, we have considered cases where external economies depend on the amount of current
output at a point in time. But external economies may also depend on the amount of cumulative
output over time.
The spill over of knowledge gives rise to a situation in which the production costs of individual
firms fall as the industry as a whole accumulates experience. In this alternative situation, industry
costs depend on experience, usually measured by the cumulative output of the industry to date.

Dynamic increasing returns to scale exist if average costs fall as cumulative output over time rises
- Dynamic increasing returns to scale imply dynamic external economies of scale

A graphical representation of dynamic increasing returns to scale is called learning curve.

The curve is downward sloping because it

reflects the effect on costs of the experience
gained through production. As the experience is
increased – as cumulative output increases –
the unit cost decreases.
When costs fall with cumulative production
over time rather than with the current rate of
production, is a situation of dynamic
increasing returns.

Like external economies of scale, dynamic

increasing returns can lock an initial advantage
in an industry. L is the curve of a country that
pioneered an industry, while L* is the curve of a
country with lower input costs but less experience.

Dynamic scale economies, like external economies, potentially justify protectionism

- Temporary protection of industries enables them to gain experience – infant industry
argument
- But temporary is often a long time, and it is hard to identify when it will occur.

Interregional Trade and Economic Geography

External economies may also be important for interregional trade within a country.
- Many movie producers located in US in Los Angeles produce movies for consumers
throughout the whole US.
- Many financial firms locate in NYC provide services throughout the whole US

However, some non-tradable goods like veterinary services must usually be supplied locally.
Economic geography: it refers to the study of international trade, interregional trade, and the
organization of economic activity in metropolitan and rural areas
It studies how humans transact with each other across space
- Communication changes such as the Internet, email, text mail, video conferencing, mobile
phones are changing how humans transact with each other’s

SUMMARY

1. Trade need not be the result of comparative advantage. Instead, it can result from increasing
returns or economies of scale, that is, from a tendency of unit costs to be lower with larger
output.

2. Economies of scale give countries an incentive to specialize and trade even in the absence of
differences in resources or technology between countries.

3. Economies of scale can be internal (depending on the size of the firm) or external (depending
on the size of the industry).

4. Economies of scale can lead to a breakdown of perfect competition, unless they take the form
of external economies, which occur at the level of the industry instead of the firm.

5. External economies give an important role to history and accident in determining the pattern
of international trade.
- When external economies are important, a country starting with a large advantage may
retain that advantage even if another country could potentially produce the same goods
more cheaply.
6. When external economies are important, countries can conceivably lose from trade.
- Also, the free trade price can fall below the price before trade in both countries.
7. Economic geography refers to how humans transact with each other across space, including
through international trade and interregional trade.
8. Trade based on external economies of scale may increase or decrease national welfare, and
countries may benefit from temporary protectionism if their industries exhibit external
economies of scale either at a point in time or over time.