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Chapter 7
External economies and international distribution of
production
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outline
• Types of economies of scale
• Economies of scale and market structure
• The theory of external economies
• External economies and international trade
• Dynamic increasing returns
• Interregional trade and economic geography
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Introduction
• In the models of comparative advantage we have examined so far, we have assumed that there are constant or diminishing returns to scale:
• Constant returns:
• When inputs increase by a certain percentage, production increases by the same percentage.
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Introduction (continued)
• There can be positive economies of scale (or simply economies of scale)
– This means that when inputs are increased by a certain percentage, the product increases by a greater percentage.
– The large scale is more efficient: the cost per unit of production decreases as production of an industry or firm increases.
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• For example, suppose that a firm produces toys using a single input, labour.
• The amount of labour required depends on the number of toys produced.
• The existence of economies of scale can be traced in case
• doubling the input of labour more than doubles output produced or
• the average amount of labour needed to produce each toy decreases as the industry produces more toys.
Introduction (continued)
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• Economies of scale are an incentive for mutually beneficial trade.
• International trade allows each country to produce a limited range of goods, without sacrificing the variety of consumption.
• When there is international trade, a country can exploit economies of scale to produce more efficiently (than if it produced everything locally).
Introduction (continued)
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Economies of scale and the market structure
• Economies of scale may depend on either the size of the industry or the size of the firm.
• External economies of scale exist when the cost of each unit of production depends on the size of the industry.
• Internal economies of scale exist when the cost of each unit of production depends on the size of the firm.
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Economies of scale and market structure (continued)
• Internal economies as well as external economies of scale represent an important incentive for international trade.
• internal and external economies of scale have different effects on the structure of the market:
• A sector characterized by external economies is comprised by many small competitive firms.
– Internal economies of scale offer a cost advantage to large firms and lead to a market structure that is not pure competition (monopoly, oligopoly, monopolistic competition…).
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The theory of External Economies of scale
• Examples of industries, characterized by external economies:
– In the US, The semiconductor industry (semiconductors) is concentrated in Silicon Valley,
– investment-banking industry in New York and
– the entertainment industry in Hollywood.
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The theory of external economies (continued)
– In developing countries such as China, external economies are very common in the manufacturing sector.
– External economies have played an important role in the emergence of India as a leader in exporting IT services.
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External Economies of scale lead to a clustering of firms in one location for three main reasons:
1. Specialized suppliers: by locating next to firms producing similar products, a firm can specialize in a certain aspect of production and outsource other stages of production to neighboring firms.
For example, in California's Silicon Valley there is a high
concentration of firms of the semiconductor industry. These cooperate with companies producing special equipment used to produce semiconductors.
– These equipment are cheaper and more readily available in Silicon Valley compared to other places.
–
the external economies of scale
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2. Labour market concentration: a large and concentrated industry can attract workers with very special skills, reducing the cost of searching and hiring staff for each firm.
3. Diffusion of knowledge: Workers employed in different businesses can more easily share innovative ideas when there is a large and concentrated industry.
The theory of external economies (continued)
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• With external economies, the cost of production of an industry falls as its size increases.
• The supply curve is downward sloping
• Without international trade, the unusual slope of the supply curve is not very important.
The theory of external economies (continued)
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Figure 7.1: External economies and equilibrium
Price,
average cost
Production of toys
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External economies and international trade
• Without international trade, equilibrium in each country is attained at the point where domestic supply curve intersects with domestic demand curve.
• China, USA
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Figure 7-2: External economies before international trade
Price,
average cost
Price,
average cost
Production of
buttons in China
Production of
buttons in USA
AC China
D China
AC US
D China
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External economies and international trade (continued)
• After international trade has started
• The button industry in China will expand, while the button industry in the US will shrink.
• As button output grows in China, the cost is further reduced. As button output decreases in the US, the cost is further increased.
• Finally, production of buttons will be concentrated in China.
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• How does the concentration of production affect prices?
• Before trading, the prices of the buttons in China were lower than the corresponding prices in the USA.
• As production increases in China, prices falls.
• International trade leads to a reduction in the price of buttons in both countries!
External economies and international trade (continuation)
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• These results are different from results related to models without increasing returns.
• According to the standard model of trade, prices converge as a result of international trade.
• With external economies, international trade reduces prices everywhere.
External economies and international trade (continued)
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Figure 7.3: International Trade and prices
AC China
Price,
average cost
D China World D
Production of buttonsProduction of
buttons in China
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External economies and international trade (continued)
• Where can the initial advantage, of a country with a lower price, be attributed?
• One possibility is that this country has a comparative advantage due to differences in technology or resources.
• However, when there are external economies the structure of trade may be due to the special circumstances:
• Countries that initially dominate in a sector tend to retain their advantage even when another country can produce this product with a lower cost.
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• We assume that the cost curve of Vietnam is below the cost curve of China, because wages in Vietnam are lower than wages in China.
• At each given level of production, Vietnam can produce buttons at a lower cost than China.
• Unfortunately, however, this does not necessarily mean that Vietnam will supply the global button market.
• If China's button industry is first established, its initial lead allows it to dominate.
• A commodity characterized by external economies may not always be produced by the “right” country.
External economies and international trade (continued)
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Figure 7.4: The importance of an established advantage
Quantity of buttons
Price,
average cost
AC China
AC Vietnam
D World
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• International trade has an uncertain effect on the welfare of a country when there are external economies.
• The global economy benefits when the production of industries characterized by external economies are geographically concentrated.
• International trade can bring a country in a worse position than it would have without it: it may be better for a country to produce everything for its domestic market instead of paying for imports.
External economies and international trade (continued)
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• For the world, it is better for every industry with external economies to be concentrated somewhere.
External economies and international trade (continuation)
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Dynamic economies of scale
• Until now, we have looked at cases where external economies depend on the existing amount of producing at some point in time.
• But external economies may also depend on the cumulative quantity of production in time.
• Dynamic economies of scale exist when the average cost decreases, as the cumulative product increases over time.
– The existence of dynamic increasing returns means that there are dynamic external economies of scale.
–
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Dynamic economies of scale
• Dynamic economies of scale may occur when the cost of production depends on the accumulation of knowledge and experience during the production process, over time.
• Graphically, dynamic economies of scale can be depicted with the “learning curve”.
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Figure 7.6: The learning curve
Price,
average cost
Production over
time
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• Dynamic economies of scale can lead to an initial advantage or a lead in the industry.
• Also, dynamic economies of scale may justify protectionism
– The temporary protection of the industries allows them to accumulate experience: the argument of the infant industry.
– But “temporary” often persists for a long time… Hence it is difficult to recognize when and where there are indeed external economies of scale.
Dynamic economies of scale(continued)
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Interregional trade and economic geography
• External economies also play an important role in shaping the structure of interregional trade within the same country.
• Many film-producing companies are in Los Angeles and create films that are displayed all over the United States.
– Many financial corporations are established in New York and carry out transactions for customers across the U.S. territory.
–
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Interregional trade and economic geography (continued)
• Certain non-tradeable goods, such as veterinary services, must be offered locally.
• When there are external economies, the structure of trade may be attributed to random events:
• Areas that start as large producers in specific sectors tend to remain large producers, even when another region could potentially produce at a lower cost.
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Interregional trade and economic geography (continuation)
• More generally, economic geography refers to the study of international trade, interregional trade and the Organization of economic activity in metropolitan and rural areas (center and the periphery).
• Economic Geography Studies economic interaction in the world.
• Changes in communications such as the Internet, e-mail and mobile phones (as well as modern transportation) change the way people trade their goods across regions and countries.