Chapter 7: External Economies of Scale and the International Location of Production


  • Until now we have assumed that markets are perfectly competitive
  • When there are increasing returns…large firms may have an advantage over small ones so monopolies and oligopolies are created
  • Economies of scale don’t have to lead to imperfect competition if they are external economies
  • External economies: apply at the level of industry rather than one single firm


  • Economies of scale = increasing returns meaning production is more efficient the larger the scale at which it takes place
  • Double inputs will more than double the production
  • We should look at average input… i.e.
  • Output = 5 average labour input = 2
  • Output = 25 average labour input = 1.2
  • As output increases… average input decreases
  • Economies of scale provide an incentive for international trade
  • International trade makes it possible for each country to produce a restricted range of goods and to take advantage of economies of scale without sacrificing variety in consumption

Market structure

  • External economies of scale – when the cost per unit depends on the size of the industry but not necessarily on the size of any firm
  • Internal economies – opposite of external economies
  • Said to be external economies of scale if the efficiency of firms is increased by having a larger industry even though the firm is the same size as before
  • Said to be internal economies of scale if firm is more efficient if its output is larger
  • In external economies (where there are no advantages to large firms) it will consist of small firms and will be perfectly competitive
  • In internal economies (where large firms have a cost advantage) there will be an imperfectly competitive market

Specialized Suppliers

  • Clusters are better for production i.e. Silicon Valley and easier barriers to entry

Labour Market Pooling

  • Clusters help labour pooling – lower risk of unemployment and no shortage of skilled workers

Knowledge Spillovers

  • By mingling and face to face relations knowledge is transferable

External Economies

Market Equilibrium

  • Clusters are able to support specialized suppliers, provide a pooled labour market and facilitate knowledge spillovers in a way that a geographically dispersed industry cannot

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  • Bigger the better
  • External economies of scale – forward-falling supply curve – the larger the output the lower the price at which firms are willing to sell because their average cost of production falls as industry output rises
  • AC curve = forward-falling supply curve

International Trade

  • In the absence of trade, the price of buttons in china is lower than USA at equilibrium
  • Before trade china supplied buttons in china but after trade they supplied in the world market so more demand demand shifts to the right… and price decreases
  • New price in china is lower than initial autarky price of USA for buttons
  • Trade leads to button prices that are lower than the prices in either country before trade
  • In models without increasing returns… standard model = cloth is relatively cheap at home and expensive in foreign trade will raise cloth prices in home and reduce in foreign
  • In external economies of scale international trade make it possible to concentrate the world production in a single location and so reduce costs by reaping the benefits of stronger external economies

Patterns of Trade

  • Comparative advantage (bottoms in china becasue they are labour intensive and china has lower labor costs so it makes sense)
  • Historical contingency – maybe at some point in history they were leading but they have retained their power even though now it could go to someone else (i.e. Vietnam can make buttons for cheaper than china but since china is already established… it retains power)
  • Sometimes sheer accident plays a key role in industrial concentration
  • Suppose the economies are external then in button industry, each country consists of small perfectly competitive firms and so it will drive the price down to its average cost

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