EC 340

Lecture 3 - Trade and Economies of Scale

from last time
trade facts
shifts in demand
external economies
monopolistic competition
gains and losses from opening up trade

From Last Time

Trade Facts

  1. Over the last 30 years, a rising share of world trade has been in knowledge intensive products.
  2. Comparative advantage in knowledge intensive products shifts rapidly.
  3. Trade between industrial countries rose from 45% to 55% of world trade.
  4. Intra-industry trade has grown fastest.

Shifts in Demand

Income growth shifts demand toward luxuries, and knowledge-intensive goods and product variety are both luxuries.

External Economies

If demand were the whole story, the relative price of luxuries should have risen, but it hasn't.

Economies of scale exist when an x% increase in all inputs leads to a more than x% increase in output. With economies of scale, average costs drop as output increases. Therefore, when demand increases, price can actually fall.

One source of economies of scale is external economies. These are the productivity gains and cost reductions that an individual firm reaps from the expansion of other firms in the same industry. In a knowledge-intensive industry, new knowledge is available to every firm either as direct information or as knowledge carried by skilled workers changing firms, e.g. New York's garment district, Silicon Valley.

With external economies, the more an industry expands its scale of production, the lower each firm's costs fall. When industry output rises, average costs for all firms fall.

external economiesInitially the industry is at point A when new export business increases demand. The price initially rises causing firms to produce more output. This is when the external economies kick in. The expansion of output lowers costs and shifts the industry supply curve to the right. Producers surplus has risen so domestic producers gain. The price falls so consumers benefit and foreign producers lose.
The idea is that the country gained access to export markets and external economies magnified its success. The first country to gain access to new markets and supply them captures a big expansion of exports and lowers its costs. Comparative advantage can be acquired from historical luck or government policy.

Monopolistic Competition

Internal economies occur when expanding the firm's own scale of operation cuts only its average costs. Internal economies tend to lead to imperfect competition.

characteristics of monopolistic competition

  1. many buyers and sellers
  2. different products
  3. free entry and exit
  4. perfect information
In a monopolistically competitive market, firms use product differentiation more than price to compete. Toothpaste is basically toothpaste, but consumers are convinced that Crest is different than Aim. So, the makers of Crest have a monopoly in the market for Crest while the makers of Aim have a monopoly in the market for Aim. In the short run, monopolistic competitors can earn economic profits. They produce the quantity of output at which MR = MC.

monopolistic competition in the short run
Entry into the market causes the demand curve for all other competitor's products to decrease. New products are introduced as long as economic profits are positive. In the long run, free entry and exit allows only for normal profits. monoplostic competition in the long run

Suppose an export market opens up so that the demand curve shifts up to the right. The firm is able to earn above-normal profits which attract new firms. The demand curve shifts down to the left and the firm ends up at point B. The price has fallen so consumers gain and foreign producers lose. There is no long run change in profits so there is only a temporary gain for domestic 
under monopolistic competition

Economies of scale do not determine comparative advantage but do translate any comparative advantage into lower prices and a greater expansion of output and trade.

Gains and Losses from Opening Up Trade

competitionexternal economiesmonopolistic competition
Exporting Countrygaingaingain
producersgaingaintemporary gain
Importing Countrygaingaingain
Whole Worldgaingaingain

David A. Latzko
318 COB
Department of Business and Economics
Wilkes University
Wilkes-Barre, PA 18766
phone: (717) 408-4718
fax: (717) 408-4917