External Economies of Scale

Question 1

What are the two reasons why countries specialize and trade?

Answer 1

1. Countries differ either in their resources or in their technology and specialize in the things they do relatively well
2. Economies of scale make it advantageous for each country to specialize in the production of only a limited range of goods and services

Question 2

Which assumption do not hold in external economies of scale?

Answer 2

Perfect competition

Question 3

Which assumption do hold in external economies of scale?

Answer 3

Imperfect competition

Question 4

What is oligopoly?

Answer 4

If there are few large firms in a market

Question 5

What is economies of scale?

Answer 5

It can also be called increasing returns. It is when production is more efficient, the larger the scale at which it takes place. Ex.. doubling the input to an industry will more than double the industry’s output

Question 6

How can two countries take advantage of economies of scale?

How would that benefit the world economy?

Answer 6

Each must concentrate on producing only a limited number of goods. If each country produces only some of the goods, then each good can be produced at a larger scale than would be the case if each country tried to produce everything. As a result, the world economy can produce more of each good.

Question 7

How can external economies of scale benefit the consumers?

Answer 7

It leads to an increase in the variety of goods available

Question 8

How is the production increase achieved?

Answer 8

It depends on the market structure. Either by more production or an increase in number of firms producing.

Question 9

What is external economies of scale?

Answer 9

When the cost per unit depends on the size of the industry but not necessarily on the size of any one firm
–> Increase in number of firms

Question 10

What is internal economies of scale?

Answer 10

When the cost per unit depends on the size of an individual firm but not necessarily on that of the industry. –> Increase in production in a specific firm

Question 11

What are the different implications for each structure of industries in external and internal economies of scale?

Answer 11

• An industry where economies of scale are purely external (that is, where there are no advantages to large firms) will typically consist of many small firms and be perfectly competitive
• Internal economies of scale, by contrast, give large firms a cost advantage over small firms and lead to an imperfectly competitive market structure.

Question 12

According to Alfred Marshall, what are the 3 reasons why a cluster of firms may be more efficient than an individual firm in isolation?

Answer 12

• the ability of a cluster to support specialized suppliers
• the way that a geographically concentrated industry allows labor market pooling
• the way that a geographically concentrated industry helps foster knowledge spillovers.

Question 13

What does specialised suppliers mean?

Answer 13

Silicon Valley study: Key inputs are cheaper and more easily available because there are many firms competing to provide them, and firms can concentrate on what they do best, contracting out other aspects of their business

“You want to be close to an industry that uses the input you produce”

Question 14

What does labor market pooling mean?

Answer 14

The way that a cluster of firms can create a pooled market for workers with highly specialized skills.

Advantages:
• the producers are less likely to suffer from labor shortages
• the workers are less likely to become unemployed

If the industry is concentrated in a single city, low labor demand from one firm will be offset by high demand from the other

Question 15

What does knowledge spillovers mean?

Answer 15

An important source of technical know-how, however, is the informal exchange of information and ideas that takes place at a personal level.
And this kind of informal diffusion of knowledge often seems to take place most effectively when an industry is concentrated in a fairly small area, so that employees of different companies mix socially and talk freely about technical issues.
Marshall: If one man starts a new idea, it is taken up by others and combined with suggestions of their own; and thus, it becomes the source of further new ideas

Question 16

Will a bigger industry generate weaker or stronger external economies of scale?

Answer 16

Stronger, due to the assumption: The larger the industry, the lower the industry’s costs.

Question 17

How does demand and supply look in an external economies and market equilibrium without international trade?

Answer 17

• Demand: Downward sloping
• Supply: Upward sloping
• In the case of external economies of scale: Forward-falling supply curve: The larger the industry´s output, the lower the price at which firms are willing to sell, because their average cost of production falls as industry output rises.
  (Fig. 7.1)

Question 18

If it is impossible to trade, you have two countries producing the same and production has external economies of scale. Country 1 has a lower price than country 2. How does the graphs of each country look?

Answer 18

Look at graph 7.2

Price on the y-axis, Production of good on the x-axis. D is downward sloping and supply is upward sloping.

Question 19

If it is possible to trade, you have two countries producing the same and production has external economies of scale. Country 1 has a lower price than country 2. How does the graphs of each country look? What will happen?

Answer 19

Look at graph 7.3

Here country 1 will expand the production, country 2 will stop. It increases output in country 1 and decreases the costs. Country 1 will supply the whole market.

Question 20

What happens to the prices of the good in the case of international trade?

Answer 20

International trade leads to prices being BOTH smaller than the prices of both countries before they started trading.

Question 21

Why can country 1 have lower production costs than country 2 before starting trading?

Answer 21

• Comparative advantage. We believe there are differences in technology and resources.
• Historical contingency: Something gives a particular location an initial advantage in a particular industry, and this advantage gets “locked in” by external economies of scale even after the circumstances that created the initial advantage are no longer relevant

Question 22

What are the consequences of historical determining the location of the industry?

Answer 22

Industries aren´t always located in the “right” place

Question 23

We assume the Vietnamese cost curve lies below the Chinese curve because, say, Vietnamese wages are lower than Chinese wages. Explain the case of an already established advantage.

Answer 23

Look at fig. 7.4.

At any given level of production, Vietnam could manufacture buttons more cheaply than China. Even though that is true, it is still China who ends up producing them, since they get established first.

Question 24

How can a country be worse off in internal trade due to external economies of scale?

Answer 24

Look at fig. 7.5.

Here Thai imports watches from Swiss, which supplies the world market at P1. It is low enough to block entr y of Thai. If Thai blocked international trade, they would be able to supply the domestic market at a lower price(P2) than the world market price (P1).

Question 25

What is dynamic increasing returns in regards to learning?

Answer 25

When external economies arise from the accumulation of knowledge: When a firm improves its product or production techniques through experience other firms are seeing and following.

Question 26

What does industry costs depend on in the learning curve?

Answer 26

Experience!

Explain fig. 7.6. It is downward sloped because the effect on costs of the experience gained through knowledge.

Question 27

What is dynamic increasing returns?

Answer 27

When costs fall with cumulative production over time rather than with the current rate of production.

Question 28

What does the infant industry argument imply?

Answer 28

It can justify protectionism when: A country could have low enough costs to produce a good for export if it had more production experience, but given the current lack of experience, the good cannot be produced competitively. Such a country might increase its long-term welfare either by encouraging the production of the good by a subsidy or by protecting it from foreign competition until the industry can stand on its own feet.

Question 29

What is interregional trade?

Answer 29

Trade that takes place between regions within countries.

Question 30

Name 2 examples of tradable industries and 2 examples of nontradable industries.

Answer 30

Tradable: Aircraft manufacturing & Software publishing.

Nontradable industries: Ready-mix concrete manufacturing and tax preparation services

Question 31

What determines the location of tradable industries?

Answer 31

• Natural resources
• External economies: Why are so many advertising agencies located in New York? The answer is because so many other advertising agencies are located in New York

Question 32

What explains how a particular region develops the external economies that support an industry?

Answer 32

Historical events

Question 33

Are the forces driving interregional trade really all that different from those driving international trade?

Answer 33

No

Question 34

What is economic geography?

Answer 34

In recent years, there has been a growing movement among economists to model interregional and international trade.
- Also, the rise of cities and economic interaction across space

Question 35

What are the main characteristics of internal returns to/ economies of scale?

Answer 35

Internal returns to/economies of scale are normally associated to activities where the startup
cost involves a large expenditure in fixed cost, and the number of firms is relatively small.

Question 36

What are the main characteristics of external economies of scale?

Answer 36

External economies of scale normally involve many firms, and they are linked to one or
several of the following three reasons: access to specialized suppliers, labour market pooling,
and knowledge spillovers.

Question 37

Almost all Hermes products are manufactured in France: External or internal economies of scale?

Answer 37

Here it is external economies of scale, since they here have clustered the firms in France, due to specialization, market pooling and knowledge spillovers. They are excellent in working with leather.

Question 38

Apple has its displays mainly made in Japan and some made in Korea: External or internal economies of scale?

Answer 38

The electronic devices industry is located in few countries around the world. Japan and Korea are two of the most prominent. This suggest something more related to external economies of scale and its factors than to internal economies of scale. The labor market pooling and the access to specialized suppliers seem two plausible reasons.
Nevertheless I wouldn’t discard internal economies of scale. I found that “its displays are mainly made in Japan by Japan Display and Sharp, and some are still made in South Korea by LG Display”. Hence, it can suggest the presence of internal returns to scale, if those displays are made in few plants.

Question 39

All Toyota Land Cruiser and Prius sold in the United States market are assembled in Japan: External or internal economies of scale?

Answer 39

Here it is internal economies of scale, since it requires large investments in it and the high fixed costs when creating a new assembly plant. The automobile industry is a typical example of internal economies of scale.

Question 40

Gerber used to be an American-owned company, now a subsidiary of the Nestlé Group, headquartered in Fremont, Michigan: External or internal economies of scale?

Answer 40

From Gerber webpage: “Nearly 190 food products are now labeled in 16 languages and distributed to 80 countries. Always dedicated to the health of its young consumers, Gerber has maintained one of the world’s largest private research facilities dedicated exclusively to infant nutrition”.
This can suggest internal economies of scale.
There is only one firm and one type of good (i.e., infant products). It has a large volume of production and the “largest private research facilities dedicated exclusively to infant nutrition” would suggest a large fixed cost to create those facilities.

Question 41

It is often argued that the existence of increasing returns is a source of conflict between countries, since each country is better off if it can increase its production in those industries characterized by economies of scale. Evaluate this view in terms of the external economy model.

Answer 41

Look at fig. 7.5 (P. 190): It explains the conflict between countries. Imagine that all watches are concentrated in SWISS. Thai has a barrier to enter the market. If Thai locally specialized and fulfill the domestic demand, then the eq. will be at point 2, where the price is smaller than the world price. Then it would be better to close your economy to import of watches, since they can produce and sell watches cheaper themselves. Therefore, their welfare AND TOT can be improved without international trade.

Conflict: If Thai closes their market, then Swiss will react in some way with some retaliatory policies.

So, external economies of scale can make conflicts with internal trade.

Question 42

Give two examples of products that are traded on international markets for which there are dynamic increasing returns. In each of your examples, show how innovation and learning-by-doing are important to the dynamic increasing returns in the industry.

Answer 42

Two industries characterized by dynamic increasing returns are biotechnology and aircraft design.
• Biotechnology is an industry in which innovation fuels new products, but it is also one where learning how to successfully take an idea and create a profitable product is a skill set that may require some practice.
• Aircraft design requires innovations to create new planes that are safer or more cost efficient, but it is also an industry where new planes are often subtle alterations of previous models and where detailed experience with one model may be a huge help in creating a new one.

Question 43

Most of the world’s gold is produced in South Africa or Tanzania: : Compare economies of scale and CA

Answer 43

CA: Here it could be mainly due to the comparative advantage since they have different technology and resources. For instance, you need mines with gold which they have, which there could be a scare in.
EOS: If there are many mines, but only some of them are profitable then it is internal economies of scale in the gold mining. It is because there are high fixed costs connected to having a mine.

Question 44

Half of the world’s production of uranium comes from just ten mines in six countries: Compare economies of scale and CA

Answer 44

CA: Here it could also be due to the comparative advantage since you need the natural resource (The mines) for producing this product.
EOS: If there are many mines, but only some of them are profitable then it is internal economies of scale in the uranium mining. It is because there are high fixed costs connected to having a mine.

Question 45

Most beef meat comes from either Australia or Argentina: Compare economies of scale and CA

Answer 45

CA: Here they could have more resources for doing this than other countries, in labor and capital. Ex. if cattle is land intensive, it is possible that they are land abundant countries who concentrate their production.
EOS: If there are high fixed cost connected with having beef farms, then internal economies of scale could be the reason. (He does not believe in EOS here)

Question 46

Most Champagne comes from France. Compare economies of scale and CA

Answer 46

CA: France has comparative advantage today in Champagne, due to the environment and the grapes they have.

Question 47

Much of the world’s coffee beans comes from Brazil. Compare economies of scale and CA

Answer 47

CA: Brazil could have comparative advantage since they have the environment to produce these. It is difficult to reproduce it other places.

Question 48

Consider a situation similar tool that in Figure 7-3, in which two countries that can produce a good are subject to forward-falling supply curves. In this case, however, suppose the two countries have the same costs, so that their supply curves are identical.
a. What would you expect to be the pattern of international specialization and trade? What would determine who produces the good?

Answer 48

The first entering the market will produce the good. No one of them is better than the other. It is random who goes internally first.
The country that moves first will have a cost advantage over the other country because it is producing a larger quantity of the good. That country will produce the entire output of the good and export to the second country

Question 49

It is fairly common for an industrial cluster to break up and for production to move to locations with lower wages when the technology of the industry is no longer rapidly improving—when it is no longer essential to have the absolutely most modern machinery, when the need for highly skilled workers has declined, and when being at the cutting edge of innovation conveys only a small advantage. Explain this tendency of industrial clusters to break up in terms of the theory of external economies.

Answer 49

The three forces driving external economies of scale are access to specialized suppliers, labor market pooling, and knowledge spillovers. As these forces weaken, so too do the cost advantages of geographic clustering. The location of production becomes increasingly driven by factor costs (i.e., wages in less developed countries) when industries move away from external economies of scale toward traditional constant returns to scale.
So, the only solution is to reduce the AC, so move to a country with lower wages. It is done through off shoring, so focusing on the internal economies of scale.

Question 50

Recently, a growing labor shortage has been causing Chinese wages to rise. If this trend continues, what would you expect to see happen to external economy industries currently dominated by China? Consider, in particular, the situation illustrated in Figure 7-4. How would change take place?

Answer 50

If all production is concentration in China, then Viet will not enter the market, since P1 is lower than the initial costs for Viet companies.
An increase in wages in China affects the average costs. It can increase the AC in China by an upward shift in the ACC. Despite this, it is still cheaper to produce in China. If they continue to increase for longer, then the price of China will at some point be larger than the costs of Vietnam. Conclusion: The production will in the end move to Vietnam (When P1 for China is higher than C0 for Viet)

Question 51

Do the labor market pooling example on page 183. Show when both have high demand, both have low demand, one has high demand and the other has low demand.
There are 2 firms.
-If there are high demand, they both hire 150 workers
-If there are low demand, they both hire 50 workers
-The total labor suppliers are 200 workers
The results will be linked to employment and location (Same or different cities). Also, the effect of workers and firms. Worst case for workers in unemployment. Worst case for firms is to have a scare of labor.
If they are in different cities, there are 100 in each and they cannot migrate.
Is concentration better or worse for the workers and the companies?

Answer 51

Case B: 1 has high demand, 2 has low demand
Workers:
• Same city: 0 is unemployed
• Different cities: 0 unemployed in City 1, 50 unemployed in City 2
Firms:
• Same city: 0 is unemployed
• Different cities: Company 1 is missing 50 people; Company 2 is missing 0.
Here it is best for the workers and for the firms to be concentrated in the same city by labor market pooling.
In the case of high or low demand of both, it does not matter if they are concentrated or not.