ECON7530

Lecture 7
The New Trade Theory (part 1)
Nhan Phan
UQ School of Economics
Last Week – Summary
• The terms of trade refers to the price of exports relative to the price
of imports.
• Export-biased growth reduces a country’s terms of trade, reducing its
welfare and increasing the welfare of foreign countries.
• Import-biased growth increases a country’s terms of trade, increasing
its welfare and decreasing the welfare of foreign countries.
• When a country imposes an import tariff, its terms of trade increase
and its welfare may increase.
• When a country imposes an export subsidy, its terms of trade
decrease and its welfare decreases.
Refresh – Summary of International Trade
Country Main Target Reasons of Trade

Difference in
Inter-industry
Ricardian model different technology
trade
(labour productivity) Comparative
Advantage
Inter-industry Difference in factor
Hecksher-Ohlin model different
trade endowment

can be Intra-industry Economies of Scale

(Old) New trade theory
identical trade (Internal & External)
can be Heterogeneous productivity across
(New) New trade theory Firm-level exports
identical firms
Learning Objectives
• Recognize why international trade often occurs from increasing
returns to scale.
• Understand the differences between internal and external economies
of scale.
• Discuss the sources of external economies.
• Discuss the roles of external economies and knowledge spillovers in
shaping comparative advantage and international trade patterns.
UQ Extend – Introduction
• The models of comparative advantage thus far assumed constant
returns to scale
• Example: 𝑌 𝐿, 𝐾 = 𝐾𝐿
• When inputs to an industry increase at a certain rate, output increases at the
same rate.
• But there may be increasing returns to scale or economies of scale:
• Example: 𝑌 𝐿, 𝐾 = 𝐿 × 𝐾
• When inputs to an industry increase at a certain rate, output increases at a
faster rate.
• A larger scale is more efficient: the cost per unit of output falls as a
firm or an industry increases output.
UQ Extend – Economies of Scale
• Economies of scale means:
• doubling the input of labor more than doubles the industry’s output.
• the average amount of labor used to produce each widget is less when the
industry produces more.
• Mutually beneficial trade can arise as a result of economies of scale.
• International trade permits 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.
UQ Extend – Example
• 2 Countries: US and China Production of Drums
Input Output
• 2 Goods: Guitars and Drums 10 units of Labour 20 Drums
• Production technology is the same in 20 units of Labour 50 Drums
both countries.
Production of Guitars
• Economies of scale exists in production Input Output
of both goods. 10 units of Labour 10 Guitars
• 20 units of Labor in US and China each. 20 units of Labour 30 Guitars

• Consumers in US and China like variety

in consumption
UQ Extend – Example
Production of Drums Production of Guitars
Input Output Input Output
10 units of Labour 20 Drums 10 units of Labour 10 Guitars
20 units of Labour 50 Drums 20 units of Labour 30 Guitars

In Autarky With Trade

US China US China
20 drums 20 drums 25 drums 25 drums
10 guitars 10 guitars 15 guitars 15 guitars

With trade, each country has more than in autarky

 Types of Economies of Scale
• Economies of scale exists whenever average cost falls
as production (or output) increases.
• It 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 the firm.
• Both external and internal economies of scale are
important causes of international trade.
Source: iStock
Types of Economies of Scale
Different implications for the market structures:
• 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 (e.g. natural monopolies, oligopolies,
monopolistic competition).
• This week we study the external economies (of scale).
UQ Extend – Why External Economies?
Many modern examples of industries that seem to be powerful
external economies: semiconductor industry in Silicon Valley, U.S.,
production of electronic devices in Shenzhen, China.
For 3 main reasons, concentrating production of an industry in one or a
few locations can reduce the industry’s costs, even if the individual
firms in the industry remain small.
1. Specialised equipment or services
2. Labour pooling
3. Knowledge spillovers
UQ Extend – Why External Economies?
1. Specialised equipment or services
• These may be needed for the industry, but are only supplied by other firms if
the industry is large and concentrated.
• An individual firm investing in such equipment will incur high fixed costs and
high average costs of production.
• However, if the industry is concentrated, there can be a supplier of specialised
services to other firms.
• Example: Silicon Valley in California has a large concentration of silicon chip
companies, which are serviced by companies that make special machines for
manufacturing silicon chips.
• “Fabless” companies in Silicon Valley
Saxenian (1994)
“engineers left established semiconductor companies to start firms that
manufactured capital goods such as diffusion ovens, step-and-repeat
cameras, and testers, and materials and components such photomasks,
testing jigs, and specialized chemicals. . . . This independent equipment
sector promoted the continuing formation of semiconductor firms by
freeing individual producers from the expense of developing capital
equipment internally and by spreading the costs of development. It also
reinforced the tendency toward industrial localization, as most of these
specialized inputs were not available elsewhere in the country.”
UQ Extend – Why External Economies?
2. Labour pooling
• Reducing employee search and hiring costs for each firm.
• Example: Suppose there are 2 firms that use the same kind of labour.
• Both employers uncertain about how many workers are needed.
• If an employer faces high Demand, it needs 150 workers
• If Demand is low, it needs only 50 workers
• Compare 2 situations
• One where both firms and all 200 workers are in the same city
• Another where each firm and 100 workers, are located in 2 different cities
• Saxenian (1994): “it wasn’t that big a catastrophe to quit your job on Friday
and have another job on Monday. . . . You didn’t even necessarily have to
tell your wife. You just drove off in another direction on Monday morning.”
UQ Extend – Why External Economies?
3. Knowledge spillover
• Companies stay competitive by:
• Acquire knowledge internally through Research and Development
• Reverse-engineer competitors’ products
• Learn from other companies’ workers by
• directly hiring them;
• exchange of information and knowledge at a personal level
during informal socialization and networking
• Workers from different firms may more easily share ideas that
benefit each firm when a large and concentrated industry exists.
Saxenian (1994)
“Every year there was some place, the Wagon Wheel, Chez Yvonne,
Rickey’s, the Roundhouse, where members of this esoteric fraternity,
the young men and women of the semiconductor industry, would head
after work to have a drink and gossip and trade war stories about
phase jitters, phantom circuits, bubble memories, pulse trains,
bounceless contacts, burst modes, leapfrog tests, p-n junctions, sleeping
sickness modes, slow-death episodes, RAMs, NAKs, MOSes, PCMs,
PROMs, PROM blowers, PROM blasters, and teramagnitudes…”
 UQ Extend
The Theory of External Economies
• Forward-falling supply
curve.
• The larger the industry,
the lower the industry’s
costs.
• Without international
trade, the unusual slope
of the supply curve
doesn’t matter much.
• In autarky: 𝑃𝐶𝐻𝐼𝑁𝐴 < 𝑃𝑈𝑆
UQ Extend
External Economies and International Trade
• When trade is opened:
• Chinese button industry will expand
• U.S. button industry will contract
• The process feeds on itself
• Eventually, China ends up producing
buttons for the world market.
• Output rises from 𝑄1 to 𝑄2
• Price falls from 𝑃1 to 𝑃2 .
• Trade leads to prices that are lower
than the prices in either country
before trade!
Compare and Contrast
• This is very different from the implications of models without
increasing returns.
• In the standard trade model, relative prices converge as a result of
trade.
• Suppose cloth is relatively cheap in the home country and relatively expensive
in the foreign country
• The effect of trade was to raise cloth prices in Home and reduce them in
Foreign.
• With external economies the effect of trade is to reduce prices
everywhere.
UQ Extend
External Economies and International Trade
• What might cause one country to have an initial advantage from
having a lower price?
• One possibility is comparative advantage
• Underlying 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.
 Interesting Fact
• More than 85 percent of the carpets sold in
the United States, and around 45 percent of
the residential and commercial carpets found
worldwide, are made within a 65-mile radius
of Dalton, Georgia.
• Whitener was 15 years old when she crafted a
bedspread for her brother’s wedding in 1895.
• Within days of the wedding Whitener was
swamped with more orders than she could
possibly fill, so she began to teach her
neighbours the technique. Catherine Evans Whitener, Dalton’s
“First Lady of Carpet.”

Source: https://www.atlasobscura.com/articles/from-the-bedspread-capital-of-the-world-to-the-carpet-capital-of-the-world
 UQ Extend
External Economies & Established Advantage
• Assume that the Vietnamese cost curve lies
below the Chinese curve.
• Vietnamese wages are lower than Chinese wages.
• At any given level of production, Vietnam could
manufacture buttons more cheaply than China.
• Classical trade theory implies that Vietnam will
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.
External Economies and International Trade
Effects on National Welfare
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
• A country may be better off if it produces everything for its domestic market
rather than pay for imports.
External Economies – Example
• Suppose Thailand could make
watches more cheaply.
• But Switzerland got there first.
• The price of watches could be lower
in Thailand with no trade.
• Trade could make Thailand worse off
• This creates an incentive for
protectionism in Thailand.
• What if Thailand reverts to autarky?
UQ Extend – Dynamic Increasing Returns
• External economies may also depend
on cumulative output over time.
• Dynamic increasing returns to scale
exist if average costs fall as cumulative
output over time rises.
• Dynamic external economies of scale.
• Graphically represented by a learning
curve.
• Cost of production depends on the
accumulation of knowledge and
experience. In turn, this depends on
the production process over time.
UQ Extend
Dynamic Increasing Returns – Implications
• Like external economies of scale at a point in time, dynamic
increasing returns to scale can lock in an initial advantage or a head
start in an industry.
Can be used to justify protectionism.
• Infant industry argument: Temporary protection of industries enables
them to gain experience.
• But temporary is often for a long time, and it is hard to identify when
external economies of scale really exist.
Interregional Trade and Economic Geography
• External economies may also be important for interregional trade
within a country.
• Many movie producers located in Los Angeles produce movies for consumers
throughout the United States.
• Many financial firms located in New York provide financial services for
consumers throughout the United States.
• 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.
Financial Services
• The U.S. and the UK are the two largest
exporters of financial services.
• However, much of that is located in only a
few locations:
• City of London & Canary Wharf
• Wall Street in New York
• Historical events played an important role Source:
Wikimedia
for these two locations. Commons
• External economies.
• However, the importance of external
economies remain to be seen with the
advance of technologies.
Interregional Trade and Economic Geography
• Economic geography: the study of international trade, interregional
trade, and the organization of economic activity in metropolitan and
rural areas.
• Theoretical model: Krugman, P. (1991). Increasing returns and economic
geography. Journal of political economy, 99(3), 483-499.
• Fujita, M., & Krugman, P. (2004). The new economic geography: Past, present
and the future. Fifty years of regional science, 139-164.
• How do humans transact with each other across space?
• Constant change by communication changes
• Examples: the Internet, e-mail, text mail, video conferencing, and mobile
phones, as well as modern transportation.
Summary
1. Trade need not be the result of comparative advantage. Instead, it
can result from increasing returns or economies of scale.
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. 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
Summary
5. When external economies are important, countries can conceivably
lose from trade.
6. 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.
7. Economic geography refers to how humans transact with each
other across space, including through international trade and
interregional trade.