Ch 6

Economies of Scale, Imperfect Competition

and International trade
(Lecture 1)

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

 Introduction

• Brief Recount of 1st lecture: Reasons for countries to

engage in trade
 Difference in relative productivities and factor
supplies
 Economies of Scale or Increasing return to scale
• Past 3 chapters: trade was based on comparative
advantage due to difference in relative productivities
and factor supplies.
• This chapter will introduce the role of economies of
scale in international trade.

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

 Introduction (Cont.)

• Introduction to Economies of Scale or study of

Imperfect Competition
• Models of international trade based on economies of
scale and imperfect competition models
• Examine the role of different kind of increasing
returns or external economies in determining trade
patterns

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

 Economies of Scale and International
Trade: An Overview
• When defining comparative advantage, the Ricardian
model and the Heckscher-Ohlin model both assume
constant returns to scale:
 If all factors of production are doubled then output will
also double.

• But a firm or industry may have increasing returns

to scale or economies of scale:
 If all factors of production are doubled, then output will more
than double.
 Larger is more efficient: the cost per unit of output falls as a
firm or industry increases output.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 6-4

 Economies of Scale and International
Trade: An Overview (Cont.)
Example: Significance of economies of scale
Table 6.1: Relationship of Input and Output for a Hypothetical Industry

Output Total labor input Avg. labor Input

5 10 2
10 15 1.5
15 20 1.333
20 25 1.25
25 30 1.2
30 35 1.16

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 6-5

 Economies of Scale and International
Trade: An Overview
• Table 6.1 shows the different level of widgets output
employing the respective labor input.
• 10 units of widgets are produced by employing 15
hours of labor input
• However, 25 units are produced by employing 30
labor hours
• It clearly implies increasing return to scale (as
doubling the input has more than double the output).

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

 Economies of Scale and International
Trade: An Overview
• Using this example , how can we see that economies
of scale leads to provide an incentive for international
trade.
• Take two countries: US and UK
• Each country produces 10 widgets with 15 hrs. of
labor
• Total World Output=20 Widgets(with 30 hrs of labor)
• Now if production is concentrated only in US
• US produces 25 Widgets with 30 hrs of labor
• World production higher when production is
concentered in single country
Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 6-7
 Economies of Scale and International
Trade: An Overview
• How US has increased the total output?
• There has been a reshuffling of labor both in US and UK.
• US: labor from other industries has switched to Widget industry to
increase this production
• UK: With zero production of Widgets now, labor has moved from
this industry to concentrate on other sectors.
• Imagine that there are many goods subject to economies of scale in
production, and give them numbers: 1,2, 3,4, 5, 6 ....
• To take advantage of economics of scale, each of the countries must
concentrate on producing only a limited number of goods.
• US produces only goods 1, 3, 5
• UK produces goods 2,4,6
•

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 6-8

 Economies of Scale and International
Trade: An Overview
• By specializing in limited range of the goods , they
produce them at larger scale and world economy as
a whole can produce more of each good.
• How to introduce international trade here and what
would be the significance of trade or exchange?
• Trade would allow each country to concentrate the
production in limited range of goods but still enjoy the
variety in consumption by importing the other products
from international market.
• Hence, trade would be welfare enhancing, expanding
the consumption possibilities for residents of both the
countries.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 6-9
 Economies of Scale and Market
Structure
• Economies of scale could arise either on
account of increase in size of the industry or
on account of increase in size of the firm.
• External economies of scale occur when
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.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 6-10
 Economies of Scale and Market
Structure
• Example: Consider 1,000 widgets produced in an industry, with 10
firms , each producing 100 units.
• If industry double in size (now consist of 20 firms and each firm still
producing 100 units), decrease in cost per unit of each firm will be
external economies of scale. (b/c of increase in size of industry,
output rises to 200 widgets)
• If no. of firms is reduced to 5, each one now producing 200 units,
then decrease in cost per unit will be internal economies of scale (b/c
of increase in size of the firm).

• External economies of scale occur when cost per unit of output

depends on the size of the industry.
• Internal economies of scale occur when the cost per unit of output 6-11
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
 Economies of Scale and Market
Structure (cont.)
• External economies of scale may result if a
larger industry allows for more efficient provision
of services or equipment to firms in the industry.
 Many small firms that are competitive may comprise
a large industry and benefit from services or
equipment efficiently provided to the large group
of firms.
• Internal economies of scale result when
large firms have a cost advantage over small
firms, which leads to an imperfectly competitive
market.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 6-12

 Ch 6 (Cont.)
(Lecture 2)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 5-13

 The Theory of Imperfect Competition

• A comparison of Perfectly Competitive Market

structure with Imperfect Competition

• Monopoly: A Brief Review

• A monopoly is an industry with only one firm.
• A characteristic of a monopoly (and to some degree
an oligopoly) is that is marginal revenue generated
from selling an additional unit of output is lower than
the price of output.
• The marginal revenue curve lies below the demand curve
(which determines the price of units sold).

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

 A Review of Monopoly (cont.)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 6-15

 A Review of Monopoly (cont.)

• If monopolistic firms have linear demand curves,

 then the relationship between price and quantity may be
represented as:
Q = A – BxP (Eq 6.1)
 where A is a constant and B is slope parameter
 and marginal revenue may be represented as
MR = P – Q/B (Eq 6.2)
• When firms maximize profits, they set marginal
revenue = marginal cost:
MR = P – Q/B = c

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

 A Review of Monopoly (cont.)

• Average cost is the cost of production (C)

divided by the total quantity of output
produced (Q) at a time.
 AC = C/Q

• Marginal cost is the cost of producing an

additional unit of output.

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

 A Review of Monopoly (cont.)
• Now we relate AC and MC with the help of a formula
and also show their relationship in Fig 6.2.
• Suppose that costs are measured by
• C = F + cQ (Eq 6.3)
 where F represents fixed costs, independent of the level
of output.
 c represents a constant marginal cost: the constant cost of
producing an additional unit of output Q.

• AC = F/Q + c (Eq 6.4)

• A larger firm is more efficient because average cost
decreases as output Q increases: internal economies
of scale.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 6-18
 A Review of Monopoly (cont.)
• As illustrated in Fig 6-2, AC and MC correspond to a
TC function
• C=5 + x (where x represent MC = 1 )
 AC = F/Q + c
 AC = 5/1 + 1 =6 (With Q= 1, AC = 6)
 With Q= 2,
 AC = 5/2 + 1 = 2.5 +1 = 3.5 (With Q= 2, AC = 3.5)
 (This declining AC along with a constant MC is is
depicted in fig 6-2)
 Finally in Fig 6-1, equilibrium output is attained
where MR=MC, and Pm > AC (implying monopolist
is earning monopoly profits)
Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 6-19
 A Review of Monopoly (cont.)

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

 Monopolistic Competition

• Monopolistic competition is a model of an

imperfectly competitive industry which
assumes that
1. Each firm produces the differentiated product
from its rivals Which implies that each firm has a
kind of monopoly in that particular product and is
insulated from competition.
2. Each firm is assumed to take price of other
firms as given because there are competitors in
market.

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

 Monopolistic Competition

• Monopolistic competition model is a

simple model and it gives clear guidelines
how economies of scale can give rise to
mutually beneficial trade.
• To examine the trade patterns based on
economies of scale, we need to develop a
basic monopolistic model.

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