1. Introduction. Economies of Scale, Imperfect Competition, and International Trade KOM, Chap 7 and 8

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1 Economies of Scale, Imperfect Competition, and International Trade KOM, Chap 7 and 8 Introduction and types of economies of scale External economies of scale and trade Monopolistic competition Monopolistic competition and trade Inter-industry trade and intra-industry trade 1. Introduction When defining comparative advantage, the Ricardian model and the Heckscher-Ohlin model both assume constant returns to scale: If all factors of production are doubled then output will also double. But a firm or industry may have increasing returns to scale or economies of scale: If all factors of production are doubled, then output will more than double. Larger is more efficient: the cost per unit of output falls as a firm or industry increases output. Mutually beneficial international trade can arise as a result of economies of scale. 1

2 Two sources of economies of scale: 1. External economies of scale occur when cost per unit of output depends on the size of the industry. External economies of scale may result if a larger industry allows for more efficient provision of services or equipment to firms in the industry. Many small firms that are competitive may comprise a large industry and benefit from services or equipment efficiently provided to the large group of firms. Agglomeration benefits: Watch industry in Switzerland, software industry in the Silicon Valley, the biotechnology industry around Boston, the banking industry in London or New York 2. Internal economies of scale occur when the cost per unit of output depends on the size of a firm. Internal economies of scale result when large firms have a cost advantage over small firms, which leads to an imperfectly competitive market. Toyota and the car industry, Dell and the computer industry, Boeing and the aircraft industry. Both types are important for international trade but they have different implications for market structures 2. External Economies of Scale Many modern examples of industries that seem to be powerful external economies: In the US, the semiconductor industry is concentrated in Silicon Valley, investment banking in NYC, and the entertainment industry in Hollywood. In developing countries such as China, external economies are pervasive in manufacturing. One town in China produces most of the world s underwear, another nearly all cigarette lighters. External economies played a key role in India s emergence as a major exporter of information services. Indian information services companies are still clustered in Bangalore. 2

3 For a variety of reasons, 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. External economies may exist for a few reasons: 1. Specialized equipment or services may be needed for the industry, but are only supplied by other firms if the industry is large and concentrated. The Silicon Valley has a large concentration silicon chip companies; they are serviced by companies making special machines for producing silicon chips. These machines are cheaper/more easily available for Silicon Valley firms than for firms elsewhere. 2. Labor pooling: a large and concentrated industry may attract a pool of workers, reducing employee search and hiring costs for each firm. 3. Knowledge spillovers: workers from different firms may more easily share ideas that benefit each firm when a large and concentrated industry exists. External economies represented by decreasing average cost at the industry level. The supply curve is forward-falling: the larger the industry s output, the lower the price at which the firms are willing to sell. Prior to international trade, equilibrium prices and output for each country is at point 1. 3

4 What will happen when the countries open up the potential for trade in buttons when China has lower costs? 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 button production will be concentrated in China. How does this concentration of production affect prices? Chinese button prices were lower than U.S. button prices before trade. Because China s supply curve is forward-falling, increased production as a result of trade leads to a button price that is lower than the price before trade. Trade leads to prices that are lower than the prices in either country before trade! Very different from the implications of models without increasing returns: the effect of trade is to reduce prices everywhere! 4

5 Examples: the watch industry; Silicon Valley (thanks to two graduate students named Hewlett and Packard) What might cause one country to have an initial advantage from having a lower price? One possibility is comparative advantage (technology and/or resource advantage). 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. Even if Thai watchmakers could produce at lower unit cost than Switzerland, the Thai (or for that matter any other country) watch industry may not emerge if Switzerland has enough of a head start. No guarantee that the country with the lowest cost will produce a good that is subject to external economies. 5

6 It is possible that a country is worse off with trade than it would have been without trade: Suppose Thailand stops importing Swiss watches and builds an industry to satisfy Thai demand (D_Thai). It could get a lower price than by importing Swiss watches. Thus protecting the Thai market, reverting to autarky in watches can lead to a lower price of watches in Thailand than under free trade. However, cases like this are not easy to identify. Many countries have failed with this type of policy. For the world, it ii better to have concentrated production but not necessarily for a country. 3. 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 imply dynamic external economies of scale. 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. 6

7 Home country with cumulated output Q L has a lower unit cost (C 1 ) than Foreign country with no experience in that production even if production costs are lower in that country. This can also provide a head start to a country! Temporary protection of industries enabling them to gain experience is called an infant industry protection. Many attempts and many failures. These forces exist at the regional level and explain a lot of interregional specialization and trade. 4. Internal Economies Scale and Monopoly Internal economies of scale exist when large firms have a cost advantage over small firms, causing the industry to become noncompetitive. Internal economies of scale imply that a firm s average cost of production decreases the more output it produces. Perfect competition that drives the price of a good down to marginal cost would imply losses for those firms because they would not be able to recover the higher costs incurred from producing the initial units of output. As a result, perfect competition would force those firms out of the market. Internal economies of scale implies imperfect competition. 7

8 A monopoly is an industry with only one firm. An oligopoly is an industry with only a few firms. p p m MC( Q m The monopoly case: MR( P( Q Profit=P(Q-C( The monopoly maximizes its profit when increasing its production and sales no longer increases profit or when Δπ ΔP( ΔC( = P( + Q = 0 ΔQ ΔQ ΔQ or MR( = MC( ΔP( Because < 0, MR ( < P( ΔQ p p m MC( Profit AC( P( MR( Q m Q Average cost is the cost of production (C) divided by the total quantity of output produced ( at a time. AC = C/Q Marginal cost is the cost of producing an additional unit of output. Suppose that costs are measured by C = F + cq, where F represents fixed costs, independent of the level of output. c represents a constant marginal cost: the constant cost of producing an additional unit of output Q. AC = F/Q + c :A larger firm is more efficient because average cost decreases as Q increases: internal economies of scale. 8

9 Typically the case for large firms in the automobile, aircraft, or the computer industries. 5. Monopolistic Competition Monopolistic competition is an environment where 1. Each firm can differentiate its product from the product of competitors. 2. Each firm ignores the impact of a change in its own price has on their rivals prices: even though each firm faces competition it behaves as if it were a monopolist. A firm in a monopolistically competitive industry is expected: to sell more the larger the total sales of the industry and the higher the prices charged by its rivals. to sell less the larger the number of firms in the industry and the higher its own price. 9

10 This is captured by: 1 S Q = S b( P P) Q = + SbP SbP n n S or Q = A BP with A = + SbP and B = Sb n Q is an individual firm s sales S is the total sales of the industry n is the number of firms in the industry b is a constant term representing the responsiveness of a firm s sales to its price P is the price charged by the firm itself P is the average price charged by its competitors Simplification: All firms are alike so that P = P. It follows that, in equilibrium, Q = S/n AC = F/Q + c = F(n/S) + c The larger the number of firms n, the higher AC for each firm since Q falls. The larger the total sales S, the lower AC for each firm because Q rises. n AC = F + c Curve cc S The greater the number of firms in the industry, the higher the AC If each firm faces the linear demand S Q = [ + SbP] SbP n Each firm s marginal revenue is ΔP( MR( = P( + Q ΔQ MR( = P Q bs When firms maximize profits, they set MR(=MC( or P Q/bS = c Thus P = c + Q/Sb Since Q=S/n, 1 P = c + Curve PP nb The larger the number of firms n in the industry, the lower the price each firm charges because of increased competition. 10

11 At point E, The number of firms is such that each firm has zero profits: price matches average cost. No new firm wants to enter or to exit the market. If the number of firms is greater than or less than n 2, then in industry is not in equilibrium: firms have an incentive to exit or enter the industry. Firms have an incentive to enter the industry when profits are greater than zero (price > average cost). Firms have an incentive to exit the industry when profits are less than zero (price < average cost). Automobile industry when we look at the brand level, pop/rock music industry. 6. Monopolistic Competition and Trade Trade increases market size (S rises); hence it decreases AC in an industry described by monopolistic competition. CC: PP: Trade has two effects: n AC = F + c S 1 P = c + nb 1. It increases the number of firms/variety of goods (n rises) that consumers can buy 2. It decreases prices (p falls). Hence trade increases consumer s welfare. 11

12 Hypothetical example of gains from trade in an industry with monopolistic competition Domestic market before trade Foreign market before trade Integrated market after trade Industry sales 900,000 1,600,000 2,500,000 Number of firms Sales per firm 150, , ,000 Average cost 10,000 8,750 8,000 Price 10,000 8,750 8,000 But it is unclear whether firms will locate in the domestic or the foreign country. We cannot predict who is producing where and thus who is trading what! This is very different from the type of trade we had before as trade is not based on comparative advantage! Intra-industry trade refers to two-way exchanges of similar goods. Two new channels for welfare benefits from trade: Benefit from a greater variety at a lower price. Firms consolidate their production and take advantage of economies of scale. A smaller country stands to gain more from integration than a larger country. 12

13 About 25 50% of world trade is intra-industry. Most prominent is the trade of manufactured goods among advanced industrial nations, which accounts for the majority of world trade. 13