Economies of Scale Introduction and appropriation issues

2 Outline 1. Definition5 2. Example 5 3. External scale economies Production function 3.2. Example of location and persistence 3.3. Competition 3.4. Appropriation 3.5. Volume of trade 3.6. Welfare 4. Internal scale economies What is the difference between external scale economies and internal scale economies? 4.2. Monopoly power 5. Cournot oligopolies Assumptions Trade opportunities and competitive effect of trade price and quantity produced by the Duopoly?27

3 Outline Cont. 5.4 Dumping Definition What are the conditions for the existence of dumping? What happens when a firm in monopolistic position on the domestic market begins to export somewhere else? 35 A) Increasing marginal costs.36 B) Constant marginal costs How can two monopolistic companies practice reciprocal dumping? Assumptions How do firms chose their production levels? How is the local firm going to react? How can the government react? Partial equilibrium welfare effect60

4 Outline Cont Exchange rate: “pass through” Differentiated products Assumptions Utility and demand Equilibrium at zero profit73 7. Which kind of trade emerges from scale economies?78 8. Closer look at the meaning of the word “competitiveness” for countries.80

5 1.Definition The economies of scale can be seen from two points of view: Decreasing average costs with output expansion. Increasing returns to scale with inputs expansion. 2.Example (Taken from Debraj Ray, 1998) Two countries (E and W), that share the same preferences and use the same technology to produce two goods (ships and aircrafts), which have economies of scale on their production, will have an incentive to trade.

6 The existence of decreasing average costs implies that the average cost curve is downward sloping, as unit costs decrease with scale. In autarky both countries will produce both goods, limited by their resources. As everything has been assumed to be identical price of ships relative to aircrafts are identical in both countries, which implies that there is no initial incentive to trade. However if one of the countries, lets say E, produces more ships and W produces more aircrafts, they will turn out to have a comparative advantage in the production of these goods. The existence of increasing returns to scale will lead country E to fully specialized in the production and exports of ships and country W to fully specialize in production and exports of aircrafts.

7 AircraftsShips Time 0 represents the situation in autarky and 1 the situation under trade. Aircrafts Ships

8

9 By specializing and trading, countries confront a higher demand given by the local demand plus the demand of the other country which has specialized in the production of a different good. Then, trade flows will increase as all ships will be produced in country E and all aircrafts will be produced in W. Gains from trade are given by the fact that prices are lower than in the autarkic situation. The only problem that arises is that there is no way to know a priori the specialization pattern of each country. History shows that countries which started first in the production of certain goods acquired more experience and performed better developing these sectors. Be the first is the major determinant for production allocation. What is certain is that economies of scale lead to production concentration and trade increase.

10 3. External scale economies External scale economies are linked to the size of the industry, sector or country in which it takes place, without special regards to the size of a single firm. They lead to production concentration in a special location, where each company takes advantage of the size of the sector. 3.1 Production function The firms production functions depend on the labour that it uses and the industry output: The industry output is the result of production function g that depends on the labour and the industry output: For each single firm the level of industry output (Q*) is given, but for the industry it depends on the output level reached by all the firms.

11

Example and location of production Example: Swiss watches. Watch producers located in the west of Switzerland have developed external economies of scale. Any country that wants to start producing watches needs to compete with Swiss industry. Suppose that Taiwan wants to start producing watches, but it is not competitive in the international market as it can only offer watches at the price p T, while the international price is p S. The authorities decide to protect the sector by establishing trade barriers, and allow local producers to supply local demand. Average costs are lower in Taiwan than in Switzerland, as wages are lower. In autarky Taiwanese producers can supply the quantity Q M at the price p M.

13 Watches Watches market

14 Taiwan needs a bigger market in order to be competitive at international level. Once the Asian market is created, watches production of Taiwan increases, while average cost moves in the direction of the arrow. Once the production level is high enough, Taiwan will be ready to compete in the international market.

15 Which is the alternative for small countries? The success of Switzerland in watches production shows that small countries have an opportunity to become competitive at international level. The conditions for the success are: Be first mover, start first in producing something. This can be done by finding new products. Ensure market big enough. If a country does not have a big market on it’s own, it must find a big market in which the product is new and it is not protected. Provide temporary protection in order to be able to start producing and create incentives for local companies to be ready for external competition.

16 The paradox of external scale economies. The presence of external scale economies causes that no matter which was the original source of production location, historical production matters. Large producer countries in these sectors remain as such. Historical determination of production patterns could maintain specialization even when the comparative advantages that lead to the initial location of production are not there anymore Scale economies and perfect competition (next slide)

17 External Scale Economies : How firms act under perfect competition FirmIndustry Production Function Product per worker Marginal product Total cost Average cost Marginal cost = > > = Firms take  as given, hence P=MC firm =AC firm and industry (If X large,  low for industry)

Appropriation of scale economies How does external scale economies appropriation takes place? Firms can use vertical or horizontal integration to be able to take advantage of external scales economies. E.g. cartels formation. Government can introduce fiscal measures (e.g. taxes) to increase prices. Workers unions that lead to wages increases. If inputs work under monopsony this will lead to prices increases. These measures are seen by an increase in the average costs. The problem that might arise is that if prices increase too much it will attract other producers, destroying the advantage of scale economies that created their opportunity to avoid competition.

19 External scale economies appropriation

20 What happens if demand is higher than maximal output possibilities? An excess demand leads to an price increase that attracts external competitors to the sector. Firms can react by specializing in one hole of the market. Appropriation is limited by the risk of competition.

External economies and volume of trade Exploiting scale economies in one place creates trade. This applies even with strictly identical countries (same relative abilities, endowments or size) 3.6. External economies and welfare External economies and perfect competition : Welfare gains from scale economies go to consumers. Small countries may gain more than large ones (larger fall in price). External scale economies and appropriation : Welfare gains may go to producer. Welfare loss for large countries is possible if scale economies are appropriated by small country (with high prices). ( Helpman & Krugman, 1985, p , and exercise 2.2.)

22 4. Internal Scale Economies 4.1. Internal scale economies : Introduction Under internal scale economies the price and production costs depend on the behavior of a single firm. Firms increase their efficiency as its own output increases. Internal economies of scale leads to creation of big companies which lead to imperfect competition conditions. In the following sections we will study the following cases: Monopoly power (4.2.). Homogenous products (section 5) -Cournot oligopolies and competitive effect of trade, -Cournot Duopoly, -Dumping, -Reciprocal dumping. Differentiated products (section 6)

Monopoly power : the difference between external scale economies and internal scale economies The existence of external scale economies leads firms to behave as if they were in perfect competition. Most of the gains of external scale economies will be captured by consumers through low prices, as each company ignores the potential of the scale economy and prices will be equal to marginal costs. External scale economies are not individually appropriated. However under the existence of internal scale economies firms are aware of their condition and will influence prices of the goods they produce. Quantities will be set to equal marginal costs to marginal revenue. Prices will be on the demand curve and may be higher or lower than average cost. Compared to perfect competition, monopolies reduce quantities to raise prices.