Econ452 Learning Unit 11 - Part 1 - 2020 fall
- 1. Learning Unit 11 New Trade Model Part 1: External Economies of Scale ECON452 International Economics
- 2. Objectives 1. Recognize why international trade often occurs from increasing returns to scale 2. Differentiate between internal and external economies of scale. 3. Explain the sources of external economies of scale and how it affects pattern of trade 4. Descibe the roles of external economies and knowledge spillovers in shaping comparative advantage and international trade patterns.
- 3. Introduction • The models of comparative advantage assumed constant returns to scale: – When inputs are doubled, output will double as well. • In developed countries, we observe many industries and firms operating under increasing returns to scale (economies of scale): – When inputs are doubled, output will increase by more than double. – A larger scale is more efficient: the cost per unit of output falls as a firm or industry increases output. • 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.
- 4. Two Types of Economies of Scale • Economies of scale could mean either that larger firms or a larger industry would be more efficient. • 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.
- 5. Two Types of Economies of Scale - Example • There are 10 firms in industry, producing the same quantity (perfect competition). • When the industry size doubles (the demand doubles), a number of firms increases to 20, so each firm is still producing the same quantity. After the expansion of industry, the average cost of each firm decreases due to external economies of scale. • When the number of firms in industry halves, where five firms double output and maintain the total output of the industry. After the expansion of output of each firm, the average cost of each firm decreases due to internal economies scale.
- 6. Reasons for Economies of Scale • External economies of scale may occur when an expansion of industry result in more specialized services becoming available at lower cost (e.g. infrastructure such as road, power line, Internet) • Internal economies of scale may occur when a firm can spread overhead cost (e.g. management cost) or large production makes more efficient (e.g. learning curve).
- 7. Economies of Scale and Market Structure • Both external and internal economies of scale are important causes of international trade. • They have different implications for the structure of industries: – 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.
- 8. Industry Cluster • Industry cluster: a group of firms in the same industry and related-industries are concentrated in one geographic area. – Clusters consist of companies, suppliers and service providers. • Examples of industry clusters: – In the U.S., the semiconductor industry is concentrated in Silicon Valley, investment banking in New York, and the entertainment industry in Hollywood. – In developing countries, manufacturing industry clusters are observed in China: One town in China produces most of the world’s underwear, another nearly all cigarette lighters. – In India, information services companies are clustered in Bangalore and Mumbai.
- 9. External Economies and Industry Cluster • The industry cluster benefits from external economies of scale. – 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. • Sources of external economies – Specialized equipment or services may be needed for the industry, but are only supplied by other firms if the industry is large and concentrated. – Labor pooling: a large and concentrated industry may attract a pool of workers, reducing employee search and hiring costs for each firm. – Knowledge spillovers: workers from different firms may more easily share ideas that benefit each firm when a large and concentrated industry exists
- 10. PPF with External Economies • Assumption: Two nations have identical production possibilities frontier and indifference curves. • Production possibilities frontier: External economies (Increasing Return to Scale) makes PPF convex from the origin (inward-bending). – As resources are allocated more in one industry, its output increases at an increasing rate, while an output of other goods whose resources are taken decreases at decreasing rate. Quantity of Food (QF) A Indifference Curve Quantity of Cloth (QC) PPF QC A QF A
- 11. Equilibrium under Autarky • At autarky, each country produces and consumes at A, where each country can reach the highest indifference curve. – Each country produces and consumes QC A units of cloth and QF A units of food. – The relative price under autarky is a slope of tangent line at A. – Since the relative prices are same in tow countries, neither country has a comparative advantage to produce either goods. Quantity of Food (QF) A Indifference Curve Quantity of Cloth (QC) PPF QC A QF A
- 12. External Economies and Pattern of Trade • Two countries can gain from specialization and trade. • Home specializes to produce cloth at QH, while Foreign specializes to produce food at QF. – Choice of specialization is not based on comparative advantage, but incidental. • After trade, each country reach Point D at the highest utility, where DC units of cloth and DF units of food are consumed. • Each country is better off as compared with the autarky at A. Quantity of Food (QF) QH Indifference Curve Quantity of Cloth (QC) PPF Slope = -PC/PF Isovalue Line QF D DF DCQC A QF A A
- 13. External Economies and Pattern of Trade • Each country may end up with monopoly due to increasing returns to scale. • This model explains why we observe large trades of intermediate goods across countries. – Each country specializes to produce certain parts of the final products to take an advantage of external economies. – In the end, all parts are shipped to a country to be assembled into the final products with eternal economies. – Off-shoring and outsourcing keep costs down in manufacturing. Quantity of Food (QF) QH Indifference Curve Quantity of Cloth (QC) PPF Slope = -PC/PF Isovalue Line QF D DF DCQC A QF A
- 14. Model of External Economies • Model of external economies is represented by assuming that the larger the industry, the lower the industry’s average costs. • There is a forward-falling supply curve: the larger the industry’s output, the lower the price at which firms are willing to sell. • As in ordinary supply-and-demand analysis, market equilibrium is at point 1, where the supply curve intersects the demand curve, D. The equilibrium level of output is Q1, the equilibrium price P1.
- 15. External Economies and Market Equilibrium • Prior to international trade, equilibrium prices and output for each country would be at the point where the domestic supply curve intersects the domestic demand curve. • Assuming the same technology (forward-falling supply curves are same in two countries), due to greater demand for the products in China, in the absence of trade, the price of the product in China, PCHINA, is lower than the price of the product in the United States, PUS.
- 16. External Economies and International Competition • When two countries open-up for trade in the products, consumers in both countries will purchase cheaper products produced in China. • The Chinese button industry will expand, while the U.S. button industry will contract. • This process feeds on itself: As the Chinese industry’s output rises, its costs will fall further; as the U.S. industry’s output falls, its costs will rise. • In the end, all the products will be produced in China. • Output rises from Q1 to Q2, leading to a fall in the price of buttons from P1 to P2, which is lower than the price of the product in either country before trade.
- 17. External Economies and International Trade • Very different from the implications of models without increasing returns. • In the standard trade model relative prices converge as a result of trade. – If a cloth is relatively cheap in the home country and relatively expensive in the foreign country before trade opens, the trade will raise cloth prices in Home and reduce them in Foreign. – In the end, both countries produce cloth at the same price which is between pre-trade prices. • With external economies, by contrast, the effect of trade is to reduce prices everywhere. – Countries drop out from production because they cannot achieve the same low cost of production.
- 18. Importance of Established Advantage • What might cause one country to have an initial advantage from having a lower price? • One possibility is comparative advantage due to 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. – Ex. Silicon Valley, Hollywood, NYC
- 19. Established Advantage and International Competition • Assume that the Vietnamese cost curve (ACVIETNAM) lies below the Chinese curve (ACVIETNAM) because Vietnamese wages are lower than Chinese wages. • At any given level of production, Vietnam could manufacture goods more cheaply than China. Thus Vietnam could potentially supply the world market more cheaply than China. • If the Chinese industry gets established first, it can produce and sell goods at the price P1. • When the Vietnamese industry starts producing the goods, it costs at C0 (with small production). • Because the Chinese industry has already established the market and reached at lower price at P1, the Vietnamese industry cannot compete.
- 20. Established Advantage and Pattern of Trade • Ideally, the country which can produce at cheapest cost should produce and supply to the world market, then the world economy as a whole benefits. • However, under external economies once a country establishes the market and supplies the products to the world market at the low price, even if new comer can manufacture goods more cheaply, new comer may not be able to enter the world market and compete with the country. • No guarantee that the right country will produce a good that is subject to external economies. • So a pattern of specialization established by historical accident may persist even when new producers could potentially have lower costs.
- 21. Welfare under External Economies – Autarky or Trade • Imagine that Thailand could make watches more cheaply, but Switzerland got there first. • Thailand imports watches from Switzerland, which is able to supply the world market (DWORLD) at a price (P1) low enough to block entry by Thai producers, who must initially produce the watches at cost C0. • If Thailand were to block all trade in watches, it would be able to supply its domestic market (DTHAI) at the lower price, P2. • Trade could make Thailand worse off, creating an incentive to protect its potential watch industry from foreign competition.
- 22. Trade and Welfare under External Economies • 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. • It’s still to the benefit of the world economy to take advantage of the gains from concentrating industries. – Each country wanting to reap the benefits of housing an industry with economies of scale creates trade conflicts. – Overall, it’s better for the world that each industry with external economies be concentrated somewhere.
- 23. Dynamic Increasing Returns • So far, 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 increasing returns to scale exist if average costs fall as cumulative output over time rises. • 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.
- 24. The Learning Curve • The learning curve shows that unit cost is lower the greater the cumulative output of a country’s industry to date. • A country that has extensive experience in an industry (L) may have a lower unit cost than a country with little or no experience, even if that second country’s learning curve (L*) is lower— for example, because of lower wages.
- 25. Effect of Dynamic Increasing Returns • 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 also be used to justify protectionism. – Temporary protection of industries enables them to gain experience: infant industry argument. – But temporary is often for a long time, and it is hard to identify when external economies of scale really exist.
- 26. Economic Geography • Economic geography: Study of international trade, interregional trade and the organization of economic activity in metropolitan and rural areas. – Economic geography studies how humans transact with each other across space. – Communication changes such as the Internet, e-mail, text mail, video conferencing, mobile phones (as well as modern transportation) are changing how humans transact with each other across space.
- 27. Disclaimer Please do not copy, modify, or distribute this presentation without author’s consent. This presentation was created and owned by Dr. Ryoichi Sakano North Carolina A&T State University Disclaimer Please do not copy, modify, or distribute this presentation without author’s consent. This presentation was created and owned by Dr. Ryoichi Sakano North Carolina A&T State University