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Lecture 6. External Economies of Scale

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22 views25 pages

Lecture 6. External Economies of Scale

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mehnaz k
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Lecture 6

External Economies of Scale


Introduction to Economies of Scale and International Trade

•Economies of Scale: A situation where the cost per unit of production


decreases as the scale of output increases. This plays a critical role in
shaping international trade patterns.

•Types of Economies of Scale:


• Internal Economies of Scale: Cost reductions that occur within a
firm as it increases its production. Larger firms benefit more than
smaller ones, potentially creating monopolies or oligopolies.
• External Economies of Scale: Cost reductions that occur outside
the firm, at the industry level, where all firms benefit from the
industry's overall growth, not just individual expansion.
Relevance to International Trade:

External economies of scale create a different basis for


international trade compared to models like comparative
advantage. These economies explain why industries might cluster
in specific countries, leading to a pattern of trade that can persist
due to the advantages created by geographic concentration.
Economies of Scale and Market Structure
•Internal vs. External Economies:
• Internal Economies: Firms become more efficient individually as their scale
increases. This can lead to fewer firms and less competition, possibly resulting
in monopolistic or oligopolistic market structures.
• External Economies: In contrast, external economies allow many small firms
to coexist because they benefit collectively from industry-wide efficiencies,
such as shared labor markets and supplier networks.
•Features of External Economies:
• Industry Clusters: External economies often lead to geographic clustering of
firms in specific regions or cities. Examples include Silicon Valley (tech
industry) and Hollywood (film industry).
• Competitive Nature: Despite the clustering, firms in industries benefiting from
external economies of scale tend to remain competitive because the benefits
are shared, not monopolized by any one firm.
The Sources of External Economies of Scale

a. Specialized Suppliers:
•In industrial clusters, suppliers of inputs specialize in serving that industry,
improving efficiency. For example, a cluster of technology firms creates a
demand for highly specialized components, which leads to the development
of nearby suppliers that cater specifically to those needs.

•Example: In the tech industry, proximity to specialized chip manufacturers


and component suppliers allows for rapid prototyping and efficient
production processes.
b. Labor Market Pooling:
•A clustered industry benefits from a shared labor market, where workers with
specialized skills are readily available. This reduces the risk of labor shortages
and makes it easier for firms to hire or replace workers.
•Example: In finance, New York City has a deep pool of professionals with
expertise in banking and finance, making it the go-to location for financial
firms.

c. Knowledge Spillovers:
•Innovations and knowledge can spread more easily when firms are located
near each other. Ideas, new processes, and techniques are often shared
informally through personal interactions and networking within these clusters.
•Example: In Silicon Valley, tech firms benefit from a culture of sharing and
collaboration, which accelerates innovation.
External Economies and Market Equilibrium
•Market Equilibrium under External Economies:
• External economies create a situation where an industry can achieve lower costs
simply by increasing the overall scale of production in a region. This leads to a
forward-falling supply curve, where increased output leads to lower prices.
• This phenomenon explains why a country may dominate an industry even though
it doesn’t have an inherent comparative advantage. Once established, a cluster of
firms drives prices down, preventing other regions from competing effectively.

•Lock-In Effect:
• Once a country develops an industrial cluster in a particular sector, the benefits
of external economies tend to "lock in" the industry in that region, making it
difficult for other countries to displace the established cluster, even if they have
better factor endowments.
• Example: Despite China’s cheaper labor, Hollywood remains the center of film
production due to knowledge spillovers and specialized suppliers.
Dynamic External Economies and Learning Curves
•Dynamic External Economies:
• These economies are related to the concept of the learning curve,
where firms (and industries) reduce costs over time as they gain
experience in production. This means that a country with an
established industry will have a cost advantage simply due to its
cumulative experience.
•Learning Curve Implications for Trade:
• Industries with steep learning curves can maintain a competitive
advantage even in the face of new entrants with lower costs. This
explains why early starters in an industry often maintain
dominance.
• Example: Japan’s early dominance in consumer electronics (e.g.,
televisions and cameras) allowed its firms to maintain a
Dynamic External Economies and Learning Curves

•Dynamic External Economies:


• These economies are related to the concept of the learning curve, where
firms (and industries) reduce costs over time as they gain experience in
production. This means that a country with an established industry will
have a cost advantage simply due to its cumulative experience.
•Learning Curve Implications for Trade:
• Industries with steep learning curves can maintain a competitive advantage
even in the face of new entrants with lower costs. This explains why early
starters in an industry often maintain dominance.
• Example: Japan’s early dominance in consumer electronics (e.g., televisions
and cameras) allowed its firms to maintain a competitive edge over
newcomers due to the experience gained in the industry.
External Economies and the Pattern of Trade
•Historical Accidents:
• The location of an industry is often determined by historical events or
"accidents" that allow a region to develop external economies. Once
established, these industries become difficult to dislodge.
• Example: The button industry in Qiaotou, China, developed due to a
historical accident when three brothers began collecting and producing
buttons. Today, this region accounts for 60% of the world's button
production.
•Self-Reinforcing Patterns:
• Over time, the initial advantages created by external economies can
become self-reinforcing, making it even harder for other regions to
compete. The geographical concentration of industries, such as finance
in London or textiles in Bangladesh, persists over time because of the
cumulative benefits of external economies.
Trade and Welfare with External Economies

•Trade Benefits:
• External economies can generate substantial welfare gains through trade by allowing
countries to specialize in industries where they enjoy a cost advantage due to external
economies, rather than comparative advantage alone.
•Welfare Challenges:
• However, external economies can also lead to suboptimal outcomes, such as when a
country locks in the wrong industry due to historical accidents or fails to develop a
potentially more efficient industry because of the early dominance of another region.
•Policy Implications:
• Governments may need to consider protecting or nurturing certain industries (via
tariffs, subsidies) to allow them to develop external economies and remain competitive
globally. This forms the basis of the infant industry argument.
• Example: South Korea used protectionist policies to nurture its steel and electronics
industries in the early stages, allowing these sectors to develop external economies and
later compete globally.
• Economic geography examines international and interregional trade
and the organization of economic activity in metropolitan and rural
areas.
• What determines the location of tradable industries?
• In some cases, natural resources play a key role. For example,
Houston is a center for the oil industry because east Texas is
where the oil is.
• In the case of interregional trade, labor and capital are much more
mobile than in the case of international trade.
• Resources tend to move where the industries are rather than the
other way round, see Silicon Valley.
• In such case, the patterns of trade are m`uch more influenced by
external economies and historical accidents.
Discussion Questions:
1.What are the main differences between internal and external economies
of scale?
2.How do knowledge spillovers and labor market pooling contribute to
industrial clustering?
3.What are the policy implications for developing countries aiming to
establish industries benefiting from external economies?
External Economies of Scale and the International Location of Production
Case Study: Consider the following scenario.
In the late 1990s, Shenzhen, China, began to emerge as a hub for electronics
manufacturing. Initially, firms from Taiwan and Hong Kong set up factories in
Shenzhen due to its proximity to these regions, along with cheaper labor and
land costs. Over time, more companies moved to the region, creating a
concentrated cluster of electronics manufacturers. Today, Shenzhen is known
as the "Silicon Valley of Hardware," hosting some of the largest electronics
firms in the world, including Huawei and DJI.
This cluster now benefits from specialized suppliers, a large pool of skilled
labor, and frequent knowledge sharing between firms. As a result, even
though other countries have tried to compete by offering lower labor costs,
Shenzhen remains the global center for electronics production.
Question:
1.Identify the key sources of external economies of scale that have
contributed to the success of Shenzhen as an electronics manufacturing hub.
2.Explain how historical accidents or early developments in Shenzhen's
growth may have contributed to its long-term success as an industrial cluster.
3.Discuss the challenges faced by competing regions (such as Vietnam or
India) that try to replicate Shenzhen’s success. Why might these regions
struggle to displace Shenzhen’s dominance in the global electronics market
despite potentially lower labor costs?
4.Evaluate the role of government policy in nurturing the development of
external economies of scale in Shenzhen. What specific actions could a
government take to support such industrial clusters in their early stages?

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