Ch 6 (Cont.

)
Economies of Scale, Imperfect Competition
and International trade

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 5-1

 The Theory of External Economies
• Up till now, we have just discussed about
internal economies of Scale.
• However, not all scale economies apply at the
level of individual firms and concentration of
production of an industry in a location can
reduce the industry’s cost.
• Economies of scale which apply at the level of
industry rather than at level of firm are known
as external economies of scale.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 6-2

 The Theory of External Economies
• If external economies exist, a country that has
a large industry will have low costs of
producing that industry’s good or service.
• The origin of this concept dates back to
Marshall time when there were industrial
districts which represented the geographical
concentration of an industry in a specific
location. (agglomeration of firms).
• The most famous among them was the
cluster of cutlery manufacturers in Sheffield.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 6-3

 External Economies of Scale (cont.)
The cluster of firms in a location is more efficient than a
single firms on account of three main reasons.
1. Specialized Suppliers
• Specialized equipment or services may
be needed for the industry, but are only supplied by
other firms if the industry is large and concentrated.
 For example, Silicon Valley in California has a
dense network of specialized suppliers who
provide capital goods to the high technology
firms.
 These capital goods/machines are cheaper and
more easily available for Silicon Valley firms than
for firms elsewhere.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 6-4
 External Economies of Scale (cont.)
2. Labor pooling: A large and concentrated
industry may attract a pool of workers.
• Pooled market will comprise of both the
larger no. of employees and employers and
will benefit the both.
• The employers are less likely to suffer from
labor shortage while workers are less likely
to become unemployed.
• Example: How labor pooling benefits
employers as well as employees.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 6-5
 External Economies of Scale (cont.)
• If there are two firms located in close proximity, and
demand for one firm's product is high. It can take
advantage of large pool of workers by hiring them
immediately, which reduce the hiring cost faced by
the firm.
• Similarly, if workers will be laid of from one firm, they
will readily join the 2nd firm which implies a very low
search cost for the workers.
• Hence, the labor pooling reduces both kind of above-
mentioned costs and is beneficial for both the
workers and the employers.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 6-6

 External Economies of Scale (cont.)
• 3. Knowledge Spill Over:
• Knowledge and access to new technologies is
important especially in innovative industries.
• This knowledge either can be acquired
through firms’s own R&D investment or by
learning from your competitors.
• However, another important source of
knowledge is the informal exchange of
information, which takes place between the
individuals when firms are in close proximity
to each other.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 6-7
 External Economies of Scale (cont.)
• Workers from different firms may more easily
share ideas that benefit each firm when a
large and concentrated industry exists.
• This kind if informal diffusion of knowledge
thus attract many other firms to join that
industry.
• Example: Many internet firms (paypal, face
book) moved to Silicon valley to capitalize this
benefit while several multinational firms
have also established their research centers
in Silicon Valley.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 6-8
 External Economies of Scale and
International Trade
• External economies of scale, like internal
economies play a very important role in
international trade but their effects are
different .
• External economies of scale can lead to lock
the countries in undesirable pattern of
specialization and can even lead to losses
from international trade.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 6-9

 External Economies and Pattern of Trade
• External economies of scale generally lead to
inter industry trade.
• If external economies exist, the pattern of
trade may be due to historical accidents:
 countries that start out as large producers in
certain industries tend to remain large producers
even if some other country could potentially
produce the goods more cheaply.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 6-10

 External Economies and Pattern of Trade
• Fig 6.9 shows the AC Curves both for Swiss and Thai industries.
• ACThai lies below AC Swiss, which implies that Thailand can
produce these watches at less cost as compared to Switzerland.
• Thailand can also charge a less price at point 2 ( where ACThai
intersects World Demand Curve.
• However, world equilibrium will be settled at point 1( where
ACswiss intersects World Demand Curve).
• This is because Swiss industry was established earlier and they
have a head start in this market.

•
Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 6-11
 External Economies and Pattern of Trade
• Since Co, the initial cost faced by Thai is greater than the
price P1 charged by Swiss industry. So Thai industry will not
serve the market.
• A historical accident or a pioneering start of the business by
Swiss industry never allow the Thai industry or any other new
entrant to join this business, even though the new potential
entrant can provide this good at a cheaper rate and at less
cost.
• This implies that external economies give important role to
historical accidents in determining the production and it also
allows the pattern of trade to persist even though it runs
contrary to comparative advantage.

6-12
•
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
 External Economies
of Scale and Trade (cont.)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 6-13

 Trade and Welfare with External
Economies
• Trade based on external economies has an
ambiguous effect on national welfare.
 There may be gains to the world economy by
concentrating production of industries with
external economies.
 But there is no guarantee that the right country will
produce a good subject to external economies.
 It is even possible that a country is worse off with
trade than it would have been without trade: a
country may better off if it produces everything for
its domestic market rather than pay for imports.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 6-14

 Trade and Welfare with External
Economies
• Fig 6.10 shows, in absence of trade, equilibrium for
Thai market is attained at point no. 2 (where DThai
intersects ACThai).
• This equilibrium is attained at low price P2.
• However, in presence of trade, the equilibrium is
settled at point 1(where Dworld intersects ACSwiss).
• Since Swiss industry has a head start so it will never
allow the Thai industry to enter in world business of
watches.
• So, Thailand is forced to import watches at a higher
price even though it can produce them at lower
prices.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 6-15
 Trade and Welfare with External
Economies
• Trade thus worse off the Thailand, one option to avoid
trade and imports is to apply high tariff rates on the
swiss imported watches.
• However, protectionism and tariff imposition is not
easy to exercise(as its difficult to identify the industry
that actually need protection).

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 6-16

 External Economies
of Scale and Trade (cont.)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 6-17

 Dynamic Increasing Returns

• We have considered cases where external

economies depend on the amount of current
output at a point in time.
• But external economies may also depend on
the amount of cumulative output over time.
• Dynamic external economies of scale
(dynamic increasing returns to scale) exist if
average costs fall as cumulative output over
time rises.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 6-18
 External Economies
of Scale and Trade (cont.)
• 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 called a
learning curve.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 6-19

 External Economies
of Scale and Trade (cont.)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 6-20

 External Economies
of Scale and Trade (cont.)
• Fig 6.11 shows the learning curve (L) for domestic
economy which has pioneered the production.
• While L* shows the learning curve for foreign
economy which has less production experience but
lower AC(on account of lower wages).
• The domestic country will not allow the foreign
country to join this business and will serve the market
by producing QL units of this good.
• This is because the initial cost Co* faced by foreign
country industry is greater than C1(the current cost)
faced by domestic industry.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 6-21

 External Economies
of Scale and Trade (cont.)
• Like external economies of scale at a point in time,
dynamic increasing returns to scale can lock in an
initial advantage or head start in an industry.
• Like external economies of scale at a point in time,
dynamic increasing returns to scale can be used to
justify protectionism.
 Temporary protection of industries enables them to gain
experience: infant industry argument.
 But it is difficult to identify the industries experiencing
dynamic increasing returns.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 6-22