ExternalEconomiesofScale(2/8/2012)

Econ390001

Equations returnstoscale o F(aK,aL)=aF(K,L) constantreturnstoscale o F(aK,aL)>aF(K,L) increasingreturnstoscale Definitions constantreturnstoscaleincreasesinoutputareproportionaltoincreasesininputs increasingreturnstoscaleincreasesinoutputaremorethanproportionaltoincreasesininputs o a.k.a.economiesofscale externaleconomiesofscalecostperunitofoutputdependsonthesizeoftheindustry internaleconomiesofscalecostperunitofoutputdependsonthesizeofafirm specializedsuppliersasinglefirmwouldnotbealargeenoughmarkettosupportspecialized equipmentorsupportservices,butanentireindustryconcentratedinonelocationislargeenough laborpoolingalargeandconcentratedindustrymayattractapoolofworkers,reducingemployee searchandhiringcostsforeachfirm knowledgespilloversworkersfromdifferentfirmsmaymoreeasilyshareideasthatbenefiteachfirm whenalargeandconcentratedindustryexists forwardfallingsupplycurveaveragecostofproductionfallsasindustryoutputrises o a.k.a.downwardslopingsupplycurve dynamicincreasingreturnstoscaleaveragecostsfallascumulativeoutputovertimerises o a.k.a.dynamiceconomiesofscale o c.f.:increasingreturnstoscaleaveragecostsfallascurrentoutputrises infantindustryargumenttemporaryprotectionofindustriesallowsthemtogainexperienceandthus economiesofscale economicgeographythestudyofinternationaltrade,interregionaltradeandtheorganizationof economicactivityinmetropolitanandruralareas

externaleconomiesofscale(beforetrade)

externalEoS(aftertrade)

headstartcountryblockslowercost

Thailandbetterinautarky

learningcurve

Principles Returnstoscaleofmodelsstudied: o Constantreturnstoscale Ricardianmodel specificfactorsmodel HeckscherOhlinmodel standardtrademodel o Increasingreturnstoscale Externaleconomiesofscalemodel thislecture(KrugmanCh.7) Internaleconomiesofscalemodel nextlecture(KrugmanCh.8) Increasingreturnstoscale: o Doublinginputsmorethandoublesoutput. o Averagecostfallsasoutputrises(moreefficient). Mutuallybeneficialtradecanariseasaresultofeconomiesofscale. o Eachcountrycanproducealimitedrangeofgoods(takingadvantageofeconomiesofscaleto producemoreefficiently)withoutsacrificingvarietyinconsumption. Economiesofscale: o Externaleconomiesofscale Costperunitofoutputdependsonthesizeoftheindustry. Typicallyconsistsofmanyperfectlycompetitivesmallfirms. o Internaleconomiesofscale Costperunitofoutputdependsonthesizeofafirm. Typicallyconsistsofimperfectlycompetitivelargefirms. Externaleconomiesofscaleexamples o SiliconValley,CA,USA semiconductors o Hollywood,CA,USA entertainment o NewYorkCity,NY,USA investmentbanking o Qiaotou,China buttons Reasonsforexternaleconomiesofscale o specializedsuppliers o labormarketpooling o knowledgespillovers ExternaleconomiesofscalecanberepresentedbyadecliningACcurve(downwardslopingsupply).

Internationaltrade o Beforeinternationaltradeequilibriumpricesandoutputforeachcountryareattheintersection ofdomesticsupplyanddomesticdemand. o Aftertradeindustryexpandsinthelowercostcountyandcontractsinthehighercostcountry. Astheindustryexpandsinthelowercostcountry,itscostsfallanditspricesfall. Astheindustrycontractsinthehighercostcountry,itscostsriseanditspricesrise. o Thelowercostcountrygetsalltheindustryproduction. o Tradeleadstopricesthatarelowerthaneithercountrysautarkyprices. Inthestandardtrademodel(withconstantreturnstoscale)relativepricesconverge: theeffectoftradeistoraisepricesintherelativelycheapcountryandreducethemin therelativelyexpensivecountry. Withexternaleconomies(increasingreturnstoscale)tradereducespriceseverywhere. Whatcausesinitialpriceadvantages? o comparativeadvantage differencesintechnology&resources o historicalaccidents startaslargeproducers Determiningthecountryofindustryconcentration o ThecountrywiththelowestpotentialACcurvemaynotgettheindustry. o Anothercountrymaygetaheadstartbyhistoricalaccident. o WhenthecountrywiththelowerACcurveconsidersenteringthemarket,thecostforitsinitial productionwillbefarabovetheworldprice.Thereforeitwillnotentereventhoughifit producedalltheindustryfortheworlditspricewouldbecheaperthanthecurrentworldprice. Welfareconsiderations o Therewillbegainstotheworldeconomybyconcentratingindustrieswithexternaleconomies. o Butwithexternaleconomiesofscaleitistheoreticallypossibleforacountrytobebetterofin autarkythanwithtrade. AcountrywithalowerACcurvethatisblockedfromprofitablyproducingbyacountry thatgotaheadstart(establishingalowworldprice)couldproducecheaperinautarky givenanopportunitytoachieveeconomiesofscale. Inpracticeitisveryhardtoexanteidentifyindustriesthatwouldhavealowercostthan theworldsiftradewereblocked. Dynamicincreasingreturnstoscale o Dynamicincreasingreturnstoscalecanariseifproductioncostdependsontheaccumulationof knowledgeandexperience. o Thelearningcurveisagraphicalrepresentationofdynamicincreasingreturnstoscale. o Likeexternaleconomiesofscale,dynamicincreasingreturnstoscalecanlockinaninitial advantageinanindustry. Thiscanbeusedtojustifyprotectionismthroughtheinfantindustryargument. Temporaryprotectionoftenpersistsformany,manyyears. Itishardtoidentifyexantewhen(dynamic)externaleconomiesofscalereallyexist. Economicgeography o Externaleconomiesmaybeimportantforinterregionaltradewithinacountry. entertainmentinHollywood,CA financialfirmsinNewYorkCity,NY o Somenontradablegoodslikenewspapersandhaircutsmustbesuppliedlocally. o Ifexternaleconomiesexist,thepatternoftrademaybeduetohistoricalaccidents.