Chapter 6
Scale Economies, Imperfect Competition, and Trade
Scale Economies
• With constant returns to scale, input use and total
cost rise in the same proportion as output
increases.
– Because total cost and output go up by the same
proportion, average cost (cost divided by the number
of units produced) is constant (or steady).
• With scale economies, output quantity goes up by
a larger proportion than does total cost, as output
increases.
– If output quantity expands faster than total cost
increases, then the average cost of producing a unit of
output decreases as output increases.
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Scale Economies
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Internal Economies of Scale
• In internal economies of scale the size of the
individual firm matters, i.e. larger firms have a
cost advantage over smaller firms.
• Scale economies that are internal to the firm
can drive an industry away from perfect
competition, because they drive individual
firms to be larger than the (very) small firms
that populate perfectly competitive industries.
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Internal Scale Economies
If scale economies are modest or moderate, there is
room in the industry for a large number of firms
• For products that are differentiated, a mild form
of imperfect competition called monopolistic
competition exists, where a large number of
firms compete vigorously with each other in
producing and selling varieties of the basic
product.
If a few large firms dominate the global industry,
perhaps because of substantial scale economies,
then we have an oligopoly.
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External Scale Economies
• External scale economies are based on the size of
an entire industry within a specific geographic
area.
– The average cost of the typical firm producing the
product in this area declines as the output of the
industry (all the local firms producing this product)
within the area is larger
• Types of external economies of scale:
– Clustering of the production of some products in
specific geographic areas due to a specialized supply
of resources such as labor, equipment and support
services
– Greater knowledge spillover among the firms in the
cluster
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Intra-Industry Trade
• Net trade for an industry is the difference
between exports and imports of the industry’s
product(s).
• Inter-industry trade: a country exports products
in some industries and imports products in other
industries. For each industry, net trade is either
(almost) all exports or (almost) all imports.
• Intra-industry trade (IIT): two-way trade in which
a country both exports and imports the same or
very similar products (products in the same
industry).
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Measuring Intra-Industry Trade
• IIT is the part of total trade in the product
(exports plus imports) that is not net trade
(IIT) = (X + M) – │X – M │
where X is the value of exports and M is the
value of imports of the product
• Intra-industry trade for a product is equivalent
to twice the value of the smaller of exports or
imports.
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How Important is Intra-Industry
Trade?
The relative importance of IIT as a share of total
trade in the product can be expressed as:
IIT share =
𝐼𝐼𝑇
Total trade
=
(𝑋 + 𝑀 ) – │𝑋 – 𝑀 │
𝑋+𝑀
=1-
│𝑋 – 𝑀 │
(𝑋+𝑀 )
IIT is more important for trade in manufactured
products than it is for trade in agricultural products
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Intra-Industry Trade for the United
States, Selected Products, 2012
U.S. Exports (X) $million U.S. Imports (M) ($millions) Total Trade (X+M) ($millions) Net Trade (X-M) ($millions)
Intra-Industry Trade ($millions)
IIT Shares (%)
1,723
1,962
3,684
(−)239
3,445
93.5
3,710
3,058
6,768
(+)651
6,117
90.4
308
512
(−)103
410
79.9
33,483
27,490
60,973
(+)5,993
54,979
90.2
53,901
149,142
203,042
(−)95,241
107,802
53.1
Books and brochures
(89219)
323
134
456
(+)189
267
58.6
Photographic
cameras(88111)
2,414
1,712
4,126
(+)701
3,425
83.0
Perfumes(55310)
Cosmetics(55320)
Clothes washing machines 205
(77511)
Microcircuits (77640)
Automobiles(78120)
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Average Percentage Shares of IntraIndustry Trade in the County’s Total Trade
in Nonfood Manufactured Products
Country
United States
Canada
Japan
Germany
France
United Kingdom
1989
55.3
2005
58.3
54.3
27.8
62.6
71.3
69.0
63.2
41.2
67.5
73.9
71.7
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2012
63.6
55.4
38
67.2
71.5
71.6
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What Explains Intra-Industry Trade?
• Some measured IIT reflects trade driven by
comparative advantage
• Product differentiation: many different types
and varieties of a product may exits
• Transportation cost and geographical location
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Monopolistic Competition and Trade
Monopolistic competition describes an industry with the
following characteristics:
• A large number of firms each producing a variant of a
product that consumers view as unique. The product
differentiation may be based on branding, physical
characteristics, quality, effectiveness, or anything else
that matters to consumers.
• Each firm has some degree of monopoly power based
on its established production of its unique variety.
• There is ease of entry and exit of firms in the long run
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The Market with No Trade
The three key characteristics of monopolistically
competitive market for small compact cars with no trade in
the U.S. are:
• Differentiation: The price that a firm can charge
decreases as the number of models available in the
market increases. The price curve (P) is downward
sloping
• Internal scale economies: Crowding of models reduces
the ability for the firm to achieve scale economies. The
unit cost curve (UC): an upward sloping curve
• Ease of entry and exit from market: In the long
run, a typical firm earns zero economic profits on
its model
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The U.S. Market for Compact Cars, No
Trade
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Opening to Free Trade
If the world is now open to trade,
1. Domestic automobile company, for example
Ford, can export their models to foreign
consumers.
2. Foreign automakers in the rest of the world
can export their models to the United States
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Markets for Compact Cars, No Trade and
Free Trade
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Basis for Trade
• In this setting the basis for trade is product
differentiation.
• The basis for exporting is the domestic
production of unique models for foreign
consumers
• The basis for importing is the demand by
domestic consumers for unique models produced
by foreign firms.
• Intra-industry trade in differentiated products can
be large, even between countries that are similar
in their general production structure
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Net Trade and Intra-Industry Trade
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Gains from Trade
• A major additional source of national gains
from trade is the increase in the number of
varieties of products available to consumers
through imports
• Another source of gains from trade arises
from increased competition between
domestic and foreign firms and lower prices of
domestic varieties.
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Gains from Trade
• Unlike the H-O model, the opening up of trade
has little impact on the domestic distribution
of factor incomes if the additional trade is
intra-industry.
• Gains from greater variety can offset any
losses in factor income resulting from interindustry shifts in production that do occur.
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Global Oligopoly
In an oligopoly market a small number of firms
dominate total production of a product.
Examples:
– Boeing and Airbus account for nearly all the
world’s production of large commercial aircrafts
– Sony, Nintendo, and Microsoft design and sell
most of the world’s video game consoles.
– Companhia Vale de Rio Doce (CVRD), Rio Tinto,
and BHP Billiton mine more than half of the
world’s iron ore
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Oligopoly, Scale Economies, and Trade
• If substantial scale economies exist over a
large range of output, then production of a
product tends to be concentrated in a few
large facilities in a few countries to take
advantage of the cost-reducing benefits of the
scale economies.
• Countries that have these production
locations export the product.
• Other countries import the product.
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Oligopoly Pricing
• Each firm in an oligopoly is competing with a
few other large firms, so any action it takes
will provoke reactions from rivals
– Prisoner’s dilemma
– Cartels
• If the oligopoly firms can restrain their price
rivalry, then the exporting countries benefit
from the higher export prices and better
terms of trade.
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External Scale Economies
• External Scale Economies (also called
agglomeration economies) exist when the
expansion of the entire industry’s production
within a geographic area lowers the long-run
average cost for each firm in the industry in
the area.
• Production tends to be concentrated in a
small number of locations, and countries with
these locations export the product.
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External Economies Magnify and
Expansion in a Competitive Industry
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Problem 11: Data for Japanese exports and imports,
2012
Japanese
Exports($millions)
Product
Japanese
Imports($millions)
Perfumes(55310)
3
234
Cosmetics(55320)
1,291
1,183
3
967
Microcircuits (77640)
27,997
17,456
Automobiles(78120)
97,276
10,882
Photographic cameras (88111)
11
26
Books and brochures (89219)
96
251
Clothes washing machines (77511)
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