External economies and international distribution of production

outline Economies of scale and market structure External economies and international trade Interregional trade and economic geography

Introduction In the models of the comparative advantage we have examined so far, we have assumed that there are constant or diminishing returns to scale: 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) The large scale is more efficient: the cost per unit of production decreases as production of an industry or firm increases.

Introduction (continued) The amount of labour required depends on the number of toys produced. Doubling the input of labour more than doubles the output produced. The average amount of labour used to produce each toy decreases as the industry produces more toys.

Introduction (continued) 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 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 firms that are purely competitive. Internal economies of scale give large firms a cost advantage and lead to a market structure that is not pure competition (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 (continuation) External economies have played an important role in the emergence of India as a leader in exporting information services.

the external economies of scale External Economies of scale lead to a clustering of firms in one location for three main reasons: Specialized suppliers: by locating next to firms in the same industry, you can specialize in one 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 theory of external economies (continuation) 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. Diffusion of knowledge: Workers employed in different businesses can more easily share innovative ideas when there is a large and concentrated industry.

The theory of external economies (continuation) 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.

and equilibrium Price, average cost Production of toys

External economies and international trade China, USA

before international trade Price, average cost Price, average cost AC China AC US D China D China Production of buttons in China Production of buttons in USA

External economies and international trade (continuation) After international trade has started The button industry in China will be expanded, while the button industry in the US will shrink. Finally, all the production of buttons will be concentrated in China.

External economies and international trade (continuation) Before trading, the prices of the buttons in China were lower than the corresponding prices in the USA. As production increases in China, prices fa;;. International trade leads to a reduction in the price of buttons in both countries!

External economies and international trade (continuation) According to the standard model of trade, prices converge as a result of international trade. On the contrary, when there are external economies, international trade reduces prices everywhere.

Figure 7.3: International Trade and prices Price, average cost AC China D China World D Production of buttons Production of buttons in China

External economies and international trade (continuation) One possibility is that this country has a comparative advantage due to differences in technology or resources. Countries that initially dominate in a sector tend to retain their advantage even when another country can produce this product with a lower cost.

External economies and international trade (continuation) Unfortunately, however, this does not necessarily mean that Vietnam will supply the global button market. A commodity characterised by external economies may not always be produced by the “right” country.

Figure 7.4: The importance of an established advantage Price, average cost AC China AC Vietnam D World Quantity of buttons

External economies and international trade (continuation) 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.

External economies and international trade (continuation) For the world, it is better for every industry with external economies to be concentrated somewhere.

Dynamic economies of scale 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 Graphically, Dynamic economies of scale can be depicted by the learning curve.

Figure 7.6: The learning curve Price, average cost Production over time

Dynamic economies of scale(continued) 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 the temporary usually persists for a long time… Hence it is difficult to recognize when there are indeed external economies of scale.

Interregional trade and economic geography Many film-producing companies are located in Los Angeles and create films that are displayed throughout 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 (continuation) 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) 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.