Chapter 7 External economies and international …...Title Chapter 7 Author Krugman/Obstfeld/Melitz Subject Economies of Scale, Imperfect Competition, and International Trade Created

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-1

Chapter 7

External economies and international distribution of

production


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


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.


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.


• 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.



• 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).



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.


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…).


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.


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.


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


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.



• 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.



Figure 7.1: External economies and equilibrium

Price,

average cost

Production of toys


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


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


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.


• 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)


• 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.



Figure 7.3: International Trade and prices

AC China

Price,

average cost

D China World D

Production of buttonsProduction of

buttons in China



• 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.


• 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.



Figure 7.4: The importance of an established advantage

Quantity of buttons

Price,

average cost

AC China

AC Vietnam

D World


• 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.



• For the world, it is better for every industry with external economies to be concentrated somewhere.

External economies and international trade (continuation)


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.

–


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”.


Figure 7.6: The learning curve

Price,

average cost

Production over

time


• 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)


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.

–


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.


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.

Chapter 7 External economies and international …...Title Chapter 7 Author Krugman/Obstfeld/Melitz Subject Economies of Scale, Imperfect Competition, and International Trade Created

Documents