Topic 7: Economies of Scale

Question 1

What is the difference between external and internal economies of scale?

Answer 1

Internal means it is the firms own production that decreases cost.

External is when it is the market production that decreases each firms cost.

Question 2

What reasons are there for internal economies of scale?

Answer 2

• Large fixed costs/overheads.
• Research.
• Learning by doing.
• Other reasons.

Question 3

What reasons can there be for external economies of scale?

Answer 3

• The industry is large enough to support a pool of skilled labour.
• The industry is large enough to support specialized input suppliers.
• Knowledge spillovers.

Question 4

Show a diagram explaining how with external economies of scale, a higher cost producer ‘first in’ can beat out a lower cost country.

Answer 4

As country D initially provides the whole market, it produces at AC₂.

Even though country C is a cheaper producer, it would start producing at AC₃, a higher price. This means it will never start producing by itself.

Question 5

Show an import ban which would allow a lower cost country to enter in a market with external economies of scale, assuming the previus producer maintains its cost.

Answer 5

Here AC₄, the new producers price under the protection is lower than AC₂, the established producers cost, so it can enter the market and move to AC₅.

Question 6

Show an import ban which fails to allow a lower cost producer entry into a market with external economies of scale.

Answer 6

Question 7

Show how a lower cost producer could be supported into a market with external economies of scale through subsidies.

Answer 7

The minimum subsidy is the one which brings the average cost down to the existing producer. Note that once firms continue to expand, the volume and cost of the subsidies will increase.