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External economies of scale and trade

Posted by mjmedlock on July 6, 2011 in international economics |

Effects of external economies of scale on trade

The effects of external economies of scale in international trade may not be entirely beneficial to all countries. A country with a large production in an industry will tend to have lower costs in producing a good. This will lead to positive circle, whereby lower costs will lead to increased production, and increased production will lead to lower costs. Therefore, countries that begin as large producers tend to remain large producers: Even if another country has the potential to produce the goods more cheaply.

The figure below shows the economies of scale in producing widget X. These economies are all external economies of scale, in other words there are no economies of scale at the level of the firm.

graph shows exteranl economies of scale

Country A’s cost curve lies below country B’s. This means that at any given level of production A’s costs are below B’s. This should mean that A should be able to supply the world market. However, suppose that B is already in the market and A is just thinking about it. At the moment B produces Q1 units at a price of P1(point 1 on demand curve). If A were to enter the market the price would drop to point 2 on the demand curve. Yet there is a problem. When A enters the market its production will be C0. Any individual firm from A that enters the market will have a higher cost than firms from country B. It is therefore unlikely, or at least risky, to enter the market. B’s head start allows it to continue to hold onto the market.

 

Dynamic increasing returns (learning curves)

We have seen that external economies mean there is no guarantee the best most suitable economy will produce a particular good. But why did they produce the good in the first place, and why do they continue to do so?

We have said before that historical accident and virtuous circles may the cause of external economies carrying on. Are there any other factors?

Internal economies of scale depend on current output to gain efficiencies. External economies tend to rely on cumulative output. This means all the output from the beginning of production until now. This is the learning curve: costs reduce over time due to cumulative experience and are known as dynamic increasing returns.

The graph below shows how the learning curve can help an economy lock in advantage by starting first.

graph shows effect of learning curve

This effect is often used as justification for protectionism. After all, if your country could potentially produce goods at a lower cost (by using cheaper labor or having better access to ray materials for example), it would be a benefit both to your country and to the global economy. The only thing stopping your country’s firms entering the market is that they need time to realize the dynamic scale economies. It seems reasonable therefore to protect or subsidize your firms to give them time to gain experience. This is called the infant industry argument. However, as with many things in economics, there is a problem in identifying which situations will lead to increasing returns.

Other posts on economies of scale on this site

Economies of scale and internaltional trade patterns

The Economics of dumping

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