Economies of Scale

International Economics
Session 5: New Trade Theories : Economies

of Scale and Trade
Faculty: Prof. Sunitha Raju
Session Date: 12.07.2018

MBA(IB)2017-20(Weekend)
Trade Patterns: Some Questions

 Does Comparative Advantages explain the trade

patterns of Manufactured and Primary goods
 Factor endowments determine trade patterns of
Primary goods. But, differences in labour
productivity important for manufactured goods.
 Intra-industry trade
 Why do trade patterns change over time?
H-O Model: Empirical Issues

 Leontief Paradox
 Export of goods with intensive use of scarce factor
and Import of Goods with intensive use of abundant
factor
 But, US a capital abundant country had exports that
are 30% more labour intensive than US imports
THE LEONTIEF PARADOX

Exports Import Substitutes
Capital (1947 $) $2,550,780 $3,091,339
Labor (person-years) 182 170
Capital-labor ratio ($ per person- $14,015 $18,184

year)
Modification of the H-O Model

 Cross country Tastes differences

 Taste bias can dominate production bias
 Classification of inputs
 Categorisation of inputs as Capital and Labour not
adequate
 Technology differences across countries
 Adjusting unbalanced Trade
Economies of Scale and
Comparative Advantage
 The standard trade model assumes that cost of

production same in countries and trade is
costless
 Economies of scale interact with comparative
advantage to determine the pattern of trade.
(Location of firms and range of products)
Hypothetical Example of Gains
from market Integration
Hypothetical Example of Gains from market Integration
Home Market, Foreign Market, Integrated Market,

Before Trade Before Trade After Trade
Total sales of autos 900,000 1,600,000 2,500,000
Number of firms 6 8 10
Sales per firm 150,000 200,000 250,000
Average cost $10,000 $8,750 $8,000
Price $10,000 $8,750 $8,000

Mutually Beneficial Trade Based

Solely on Scale Economies
Productive specialization provides an additional benefit – lower costs – with economies of scale
Imperfect Competition and

International Trade
1. Trade models based on Comparative
Advantage assumes Perfect Competition
 Differences between countries only reason for trade
 Constant Returns to Scale
2. With Scale economies Monopoly profits exist
 Large firms have an advantage over small firms
 Market tends to be dominated by a few firms
3. Economies of Scale and International Trade
 Increasing returns to trade- incentive for
international trade
 Each country specialises in limited range of goods
 Product differentiation leads to trade
Review of Scale Economies and
Imperfect Competition
 Economies of Scale and Market Structure

 Internal Economies of Scale
 External Economies of Scale
 External Economies of scale consist of many
small firms and can be perfectly competitive
 Internal Economies of Scale consist of few
large firms and leads to imperfectly competitive
market structure
Internal and External Scale
Economies
- In an industry characterized by internal economies of scale, the firm’s average costs fall with increases in the firm’s output
- In an industry characterized by external economies of scale, firms’ average costs fall with increases in industry output
Basics of Imperfect Competition

 Firms and Price setters

 Monopoly Vs Monopolistic
 Oligopolistic Market
Monopolistic Competition and
Trade
 How trade improves the trade off between scale

and variety
 World market larger than national market.
Hence, trade has the same effect as growth of a
market within a country
 Effects of increased market size
 Produce more with lower average cost
 Gains from Integrated Market
 Integrated market supports more firms and reduces
price
Trade
 Inter industry
 Intra industry
 Relative importance of Inter vs Intra industry
trade depends on how similar countries are
Trade
External Scale Economies and
Comparative Advantage
Interaction of External Scale Economies
and Comparative Advantage
Panel (a) combines weak scale economies and strong comparative advantage. Temporary protection of A’s market could allow
country A firms to capture the market even if country B firms enjoyed a head start. Panel (b) combines strong scale economies and
weak comparative advantage. Temporary protection of A’s market would not necessarily allow country A firms to capture the
market from already established B firms, despite A’s comparative advantage
Intra-Industry Trade
 Export and import correspond to the same

industry
 Expansion of IIT
- Differentiated products
- Transportation costs
- Production processes divided across countries
Intra-Industry Trade (IIT)

1. Export and Import correspond to the same

industry
2. Measure of IIT
Exports - Imports
IIT = 1- Exports + Imports
IIT ranges from 0 to 1

Indexes of Intra-industry Trade for
U.S. Industries, 1993
Inorganic chemicals 0.99

Power-generating machinery 0.97
Electrical machinery 0.96
Organic chemicals 0.91
Medical and pharmaceutical 0.86
Office machinery 0.81
Telecommunications equipment 0.69
Road vehicles 0.65
Iron and Steel 0.43
Clothing and Apparel 0.27
Footwear 0.00
Intra-Industry Trade Indexes,
1985
High-Income IIT Index Middle-Income IIT Low-Income IIT Index
Countries Countries Index Countries
United States .1371 Israel .0721 Thailand .0286
Canada .0550 Spain .0807 Dominican .0120

Republic
Australia .0306 Ireland .0746 Sri Lanka .0186
West Germany .1473 Taiwan .0569 Philippines .0240
Belgium- .1347 South Korea .0644 India .0305

Luxembourg
Average .0876 Average .0274 Average .0089

Why Intra industry Trade Matters

 Intra industry trade will be a dominant

source of gains from trade when
 Countries are similar in their relative factor
endowments
 Scale economies and product differentiation become
important
Trade in a World without
Increasing Returns
Cloth Food
Home
(capital-abundant)
In a world without economies of
scale, there would be a simple
exchange of cloth for food.
Foreign
(labout-abundant)
Trade with Increasing Returns and
Monopolistic Competition
Cloth Food
Home
(capital-abundant)
Inter industry trade
Intra industry trade
Foreign
(labout-abundant)
If cloth is a monopolistically competitive industry, Home and Foreign will produce differentiated
products As a result, even if Home is a net exporter of cloth goods, it will import as well as export
cloth, giving rise to intra industry trade.
Intra-Industry Trade
a) In homogenous products
 Transportation costs
 Seasonality
b) In differentiated products
 Vertical specialization in breaking up of
production chain
Trade Pattern : Role of Transport
Costs
1. Non-traded goods
 When transport costs are prohibitive, trade does
not take place
2. Agglomeration effects
 High transportation costs leads to clustering in
specific location. Also results in economies of
scale.
3. Who pays
 Exporter or Importer
Transportation Costs and the
International Market for Goods X
PX PX
ExportsAX ExportsAX
PBX PoX
F
E
T G
PttX PttX
H
P1 X
M J
ImportsBX ImportsBX
O O
X* Trade in X X*T X* Trade in X
(a) Trade with No Transportation Costs (b) Trade with Transportation Costs
Transportation costs of T per unit cause the quantity of good X traded to fall from X* To X*T. The
price consumers pay rises from PttX to PoX, and the price producers receive falls from PttX to P1X

Economies of Scale

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International Economics

Session 5: New Trade Theories : Economies

Session Date: 12.07.2018

Trade Patterns: Some Questions

 Does Comparative Advantages explain the trade

H-O Model: Empirical Issues

THE LEONTIEF PARADOX

Capital (1947 $) $2,550,780 $3,091,339

Labor (person-years) 182 170

Capital-labor ratio ($ per person- $14,015 $18,184

Modification of the H-O Model

 Cross country Tastes differences

 The standard trade model assumes that cost of

Hypothetical Example of Gains from market Integration

Home Market, Foreign Market, Integrated Market,

Total sales of autos 900,000 1,600,000 2,500,000

Sales per firm 150,000 200,000 250,000

Average cost $10,000 $8,750 $8,000

Price $10,000 $8,750 $8,000

Mutually Beneficial Trade Based

Imperfect Competition and

 Economies of Scale and Market Structure

Basics of Imperfect Competition

 Firms and Price setters

 How trade improves the trade off between scale

 Export and import correspond to the same

Intra-Industry Trade (IIT)

1. Export and Import correspond to the same

IIT ranges from 0 to 1

Inorganic chemicals 0.99

United States .1371 Israel .0721 Thailand .0286

Canada .0550 Spain .0807 Dominican .0120

Australia .0306 Ireland .0746 Sri Lanka .0186

West Germany .1473 Taiwan .0569 Philippines .0240

Belgium- .1347 South Korea .0644 India .0305

Average .0876 Average .0274 Average .0089

Why Intra industry Trade Matters

 Intra industry trade will be a dominant

Intra industry trade

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