Week 6: Chapter 7 and 8
The models of comparative advantage thus far assumed constant returns to scale: when inputs to an
industry increase at a certain rate, output increases at the same rate. When inputs where doubled,
output would double as well. However, there may be increasing returns to scale or economies of
scale. This means that when inputs to an industry increase at a certain rate, output increases at a
faster rate. If this is the case a larger scale is more efficient: the cost per unit of output falls as a firm
or industry increases output.
Mutually beneficial trade can arise as a result of economies of scale. International trade allows each
country to produce a limited range of goods without sacrificing variety in consumption. With trade, a
country can take advantage of economies of scale to produce more efficiently than if it tried to
produce everything for itself.
Economies of scale could mean either that larger firms or a larger industry would be more efficient.
External economies of scale occur when the cost per unit of output depends on the size of the
industry.
Internal economies of scale occur when the cost per unit of output depends on the size of a
firm.
Both external and internal economies of scale are import causes of international trade. They have
different implications for the structure of industries:
An industry where economies of scale are purely external will typically consist of many small
firms and be perfectly competitive.
Internal economies of scale result when large firms have a cost advantage over small firms,
causing the industry to become imperfectly competitive.
The Theory of External Economies
In developing countries such as China, external economies are pervasive in manufacturing: one town
in China produces most of the world's underwear, another nearly all cigarette lighters. External
economies played a key role in India's emergence as a major exporter of information services: Indian
information services companies are still clustered in Bangalore. Concentrating production of an
industry in one or few locations can reduce the industry's costs, even if the individual firms in the
industry remain small.
External economies may exist for a few reasons:
1. Specialised equipment or services may be needed for the industry, but are only supplied by
other firms if the industry is large and concentrated. When firms cluster, e.g. in Silicon Valley,
these machines are cheaper and more easily available there than elsewhere.
2. Labour pooling: a large and concentrated industry may attract a pool of workers, reducing
employee search and hiring costs for each firm.
3. Knowledge spillovers: workers from different firms may more easily share ideas that benefit
each firm when a large and concentrated industry exists.
,External economies can be represented simply by assuming that the
larger the industry, the lower the industry's costs. There is a forward-
falling supply curve: the larger the industry's output, the lower the
price at which firms are willing to sell. Without international trade, the
unusual slope of the supply curve doesn't matter much.
External Economies and International Trade
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.
If China and the U.S. open up the potential for
trade in buttons the Chinese button industry will
expand, while the U.S. button industry will
contract. As the Chinese industry's output rises, its costs will fall
further; as the U.S. industry's output falls, its costs will rise. In the
end, all button production will be in China.
Chinese button prices were lower than U.S. button prices before
trade. Because China's supply curve is forward-falling, increases
production as a result of trade leads to a button price that is
lower than the price before trade. Trade leads to prices that are
lower than the prices in either country before trade. In the
standard trade morel relative prices converge as a result of trade.
With external economies, by contrast, the effect of trade is to reduce prices everywhere.
One country might have an initial advantage, a lower price, due to comparative advantage resulting
from differences in technology and resources. If external economies exist, however, the pattern of
trade could be due to historical accidents. Countries that start as large producers in certain
industries tend to remain large producers even if another country could potentially produce more
cheaply.
If the Vietnamese cost curve lies below the Chinese curve because Vietnamese wages are lower than
Chinese wages. At any given level of production, Vietnam could manufacture buttons more cheaply
than China. One might hope that this would always imply that Vietnam will in fact supply the world
market, but this need not always be the case if China has enough of a head start. No guarantee that
the right country will produce a good that is subject to external economies.
Trade based on external economies has an ambiguous effect on national welfare:
There will be gains to the world economy by concentrating production of industries with
external economies.
It's possible that a country is worse off with trade than it would have been without trade.
Countries may be better off if they produce everything for the domestic market rather than
paying for imports.
, It is however still to the benefit of the world economy to take advantage of the gains from
concentrating industries. Each country desiring to obtain the benefits of housing an industry with
economies of scale creates trade conflicts. Overall, it's better for the world that each industry with
external economies be concentrated somewhere.
Dynamic Increasing Returns
External economies may also depend on the amount of
cumulative output over time. 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. Dynamic increasing returns to scale could
arise if the cost of production depends on the accumulation of
knowledge and experience, which depend on the production
process over time. A graphical representation of dynamic
increasing returns to scale is the so called learning curve.
Dynamic increasing returns to scale can lock in an initial advantage or a head start in an industry.
This can also be used to justify protectionism. Temporary protection of industries enables them to
gain experience: infant industry argument. But temporary is often for a long time, and it is hard to
identify when external economies of scale really exist.
International Trade and Economic Geography
External economies may also be important for interregional trade within a country. Some non-
tradable goods like veterinary services must usually be supplied locally. If external economies exist,
the pattern of trade may be due to historical accidents: regions that start as large producers in
certain industries tend to remain large producers even if another region could potentially produce
more cheaply.
More broadly, economic geography refers to the study of international trade, interregional trade
and the organisation of economic activity in metropolitan and rural areas. Economic geography
studies how economic agents interact with each other across space. Communication changes such
as the internet, video conferencing, mobile phones, and modern transportation are changing how
economic agents interact with each other across space.
Internal economies of scale
Internal economies of scale result when large firms have a cost advantage over small firms, causing
the industry to become uncompetitive. Internal economies of scale imply that a firm's average cost
of production decreases the more output it produces. Perfect competition that drives the price of a
good down to marginal cost would imply losses for those firms because they would not be able to
recover the higher costs incurred from producing the initial units of output. As a result, perfect
competition would force those firms out of the market. In most sectors goods are differentiated
from each other and there are other differences across firms.
Integration causes the better-performing firms to thrive and expand, while the worse-performing
firms contract. As production is concentrated toward better-performing firms, the overall efficiency
The models of comparative advantage thus far assumed constant returns to scale: when inputs to an
industry increase at a certain rate, output increases at the same rate. When inputs where doubled,
output would double as well. However, there may be increasing returns to scale or economies of
scale. This means that when inputs to an industry increase at a certain rate, output increases at a
faster rate. If this is the case a larger scale is more efficient: the cost per unit of output falls as a firm
or industry increases output.
Mutually beneficial trade can arise as a result of economies of scale. International trade allows each
country to produce a limited range of goods without sacrificing variety in consumption. With trade, a
country can take advantage of economies of scale to produce more efficiently than if it tried to
produce everything for itself.
Economies of scale could mean either that larger firms or a larger industry would be more efficient.
External economies of scale occur when the cost per unit of output depends on the size of the
industry.
Internal economies of scale occur when the cost per unit of output depends on the size of a
firm.
Both external and internal economies of scale are import causes of international trade. They have
different implications for the structure of industries:
An industry where economies of scale are purely external will typically consist of many small
firms and be perfectly competitive.
Internal economies of scale result when large firms have a cost advantage over small firms,
causing the industry to become imperfectly competitive.
The Theory of External Economies
In developing countries such as China, external economies are pervasive in manufacturing: one town
in China produces most of the world's underwear, another nearly all cigarette lighters. External
economies played a key role in India's emergence as a major exporter of information services: Indian
information services companies are still clustered in Bangalore. Concentrating production of an
industry in one or few locations can reduce the industry's costs, even if the individual firms in the
industry remain small.
External economies may exist for a few reasons:
1. Specialised equipment or services may be needed for the industry, but are only supplied by
other firms if the industry is large and concentrated. When firms cluster, e.g. in Silicon Valley,
these machines are cheaper and more easily available there than elsewhere.
2. Labour pooling: a large and concentrated industry may attract a pool of workers, reducing
employee search and hiring costs for each firm.
3. Knowledge spillovers: workers from different firms may more easily share ideas that benefit
each firm when a large and concentrated industry exists.
,External economies can be represented simply by assuming that the
larger the industry, the lower the industry's costs. There is a forward-
falling supply curve: the larger the industry's output, the lower the
price at which firms are willing to sell. Without international trade, the
unusual slope of the supply curve doesn't matter much.
External Economies and International Trade
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.
If China and the U.S. open up the potential for
trade in buttons the Chinese button industry will
expand, while the U.S. button industry will
contract. As the Chinese industry's output rises, its costs will fall
further; as the U.S. industry's output falls, its costs will rise. In the
end, all button production will be in China.
Chinese button prices were lower than U.S. button prices before
trade. Because China's supply curve is forward-falling, increases
production as a result of trade leads to a button price that is
lower than the price before trade. Trade leads to prices that are
lower than the prices in either country before trade. In the
standard trade morel relative prices converge as a result of trade.
With external economies, by contrast, the effect of trade is to reduce prices everywhere.
One country might have an initial advantage, a lower price, due to comparative advantage resulting
from differences in technology and resources. If external economies exist, however, the pattern of
trade could be due to historical accidents. Countries that start as large producers in certain
industries tend to remain large producers even if another country could potentially produce more
cheaply.
If the Vietnamese cost curve lies below the Chinese curve because Vietnamese wages are lower than
Chinese wages. At any given level of production, Vietnam could manufacture buttons more cheaply
than China. One might hope that this would always imply that Vietnam will in fact supply the world
market, but this need not always be the case if China has enough of a head start. No guarantee that
the right country will produce a good that is subject to external economies.
Trade based on external economies has an ambiguous effect on national welfare:
There will be gains to the world economy by concentrating production of industries with
external economies.
It's possible that a country is worse off with trade than it would have been without trade.
Countries may be better off if they produce everything for the domestic market rather than
paying for imports.
, It is however still to the benefit of the world economy to take advantage of the gains from
concentrating industries. Each country desiring to obtain the benefits of housing an industry with
economies of scale creates trade conflicts. Overall, it's better for the world that each industry with
external economies be concentrated somewhere.
Dynamic Increasing Returns
External economies may also depend on the amount of
cumulative output over time. 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. Dynamic increasing returns to scale could
arise if the cost of production depends on the accumulation of
knowledge and experience, which depend on the production
process over time. A graphical representation of dynamic
increasing returns to scale is the so called learning curve.
Dynamic increasing returns to scale can lock in an initial advantage or a head start in an industry.
This can also be used to justify protectionism. Temporary protection of industries enables them to
gain experience: infant industry argument. But temporary is often for a long time, and it is hard to
identify when external economies of scale really exist.
International Trade and Economic Geography
External economies may also be important for interregional trade within a country. Some non-
tradable goods like veterinary services must usually be supplied locally. If external economies exist,
the pattern of trade may be due to historical accidents: regions that start as large producers in
certain industries tend to remain large producers even if another region could potentially produce
more cheaply.
More broadly, economic geography refers to the study of international trade, interregional trade
and the organisation of economic activity in metropolitan and rural areas. Economic geography
studies how economic agents interact with each other across space. Communication changes such
as the internet, video conferencing, mobile phones, and modern transportation are changing how
economic agents interact with each other across space.
Internal economies of scale
Internal economies of scale result when large firms have a cost advantage over small firms, causing
the industry to become uncompetitive. Internal economies of scale imply that a firm's average cost
of production decreases the more output it produces. Perfect competition that drives the price of a
good down to marginal cost would imply losses for those firms because they would not be able to
recover the higher costs incurred from producing the initial units of output. As a result, perfect
competition would force those firms out of the market. In most sectors goods are differentiated
from each other and there are other differences across firms.
Integration causes the better-performing firms to thrive and expand, while the worse-performing
firms contract. As production is concentrated toward better-performing firms, the overall efficiency
