Economies of scale and international trade patterns part 1

Economies of scale a quick review

Economies of scale, definition: When you produce a good or service at lower unit cost for each extra unit you produce, you are achieving economies of scale.

Example:

Cost to produce 10,000 cars = €70,000                   Cost per car = €7,000

Cost to produce 25,000 cars = €150,000 Cost per car = €6,000

Economies of scale are often achieved because the fixed costs are absorbed by more units.

Economies of scale and market structure

There are two kinds of economies of scale, external economies of scale and internal economies of scale.

The difference between the two types of economies of scale can be shown by these examples. Suppose and industry consists of 20 firms each producing 100 widgets.  In scenario one the industry doubles in size by doubling the number of firms. There are now 40 firms each still producing 100 widgets. If efficiency of production rises, we have a case of external economies of scale.

In scenario two, total industry production remains the same, but the number of firms is halved. Each firm now produces 200 widgets. If the efficiency of production rises, we have a case of internal economies of scale.

In an industry in which there are mostly external economies of scale we tend to see many small firms. This is because there is no advantage in being big. This leads to perfect competition. In an industry in which there are mostly internal economies of scale we tend to see an industry with a few, large firms. This is because size brings a cost advantage. This leads to an imperfectly competitive market.

Imperfect competition and international trade

For the purposes of this explanation we will assume that imperfectly competitive markets will result in a market characterized by monopolistic competition. In monopolistic competition firms differentiate their products. For example, Apple and Dell both produce computers, but they appeal to very different sets of buyers with very different requirements and expectations. This means that price is not important for competition between the firms. (Although price will still of course affect the demand for each firm’s products).

In autarky (a closed market) where internal economies of scale are possible, the variety of goods and the opportunity to gain from economies of scale are limited by the size of the home market. There is a trade-off between cost and variety: consumers can have more variety, but at a higher price. In a situation of free (or even just freer) international trade firms have access to a larger market. This means that each country can specialize in making a narrower range of goods and yet at the same time allowing the consumers to choose from an increased variety of goods.

For example imagine that two countries each have a market for 2 million televisions per year. If they trade with each other there would be a combined market for 4 million televisions. In this market there is an opportunity to have more variety produced at a lower average cost.

The figure shows that everyone is better off through integration of two (or more) markets. Customers have more choice, and each firm can produce more at a lower unit cost.

How economies of scale affect the pattern of trade

Suppose we calculate that an integrated market will support 10 firms making computers. From this result can we predict the pattern of trade? The answer is no. The firms may all be located in one country, equally divided between both countries or skewed in favor of one country.  To understand where production might take place we need to think about how comparative advantage interacts with economies of scale.

Suppose we live in a world with two economies, Inner and Outer. Each of these countries has two factors of production, capital and labor.  Inner is a capital-abundant country (it has a higher capital-labor ratio). There are also two industries in this world, manufactures and food. Manufactures is the more capital intensive industry.

Scenario 1: A world without economies of scale

Factor models of trade would lead us to the conclusion that because Inner is more capital-abundant it would have a relatively larger supply if manufactures and would therefore tend to export manufactures and import food. Trade would be a simple exchange of equal value of food for equal value of manufactures.

Scenario 2: A world with economies of scale and monopolistic competition

In reality firms mostly create differentiated products. This means that they are being monopolistically competitive. In this, more realistic scenario, economies of scale will not allow for the efficient production of a full range of manufactures in each country. Therefore each country will produce some manufactures, but will manufacture different things. (Due to local demands and tastes)

Although Inner will still be a net exporter of manufactures, Outer will still produce manufactures that some inhabitants of Inner will prefer to buy. Inner therefore will both import and export manufactures.

Two kinds of trade

In this model we can see two kinds of trade. Trade of manufactures for manufactures is called intraindustry trade. The exchange of manufactures for food is called interindustry trade. There are four important points about this kind of trade:

1. Interindustry trade reflects the comparative advantage of the countries.
2. Intraindustry trade does not reflect the comparative advantage of the countries. Economies of scale are stopping the countries producing the full range of products at home. This means that economies of scale can be a source of international trade.
3. We cannot predict the precise pattern of intraindustry trade. We cannot say anything about which country will produce which goods. This is often a result of history and randomness.
4. How import interindustry and intraindustry trade are depends on the similarity between the two countries. If they have similar capital-labor ratios there won’t be much interindustry trade.  In this case intraindustry trade centered on economies of scale will be the dominant pattern. However, if there are significant differences in capital-labor ratios, there will be little if any intraindustry trade centered on economies of scale.

Importance of intraindustry trade

Intraindustry trade is often seen among advanced nations trading manufactured goods. This is probably because over time advanced nations look increasingly similar in terms of resources and technology. This means that there is rarely any clear comparative advantage and so trade is probably mostly a result of economies of scale. Such goods tend to be sophisticated manufactured goods. Where goods are less sophisticated and more labor-intensive there is relatively little intraindustry trade. Clothing, simple toys and shoes are typical examples of these kinds of goods. These goods tend to be produced by developing economies that have a clear comparative advantage in production.

Intraindustry trade is also politically important. Loosening trade regulations when the trade is mainly driven by differences in comparative advantage is politically hard to sell. Many workers will lose their jobs as trade shift from one nation to another. It is hard to convince these workers that their sacrifice is worthwhile for society as a whole. Intraindustry trade on the other hand, tends to give consumers more choice and cheaper goods, with far less risk of people losing jobs having to accept significantly lower salaries. Therefore, it is much easier to convince citizens of the benefit of EU economic integration than of European and East Asian integration.

Tags: trade theory