Question

Suppose there exists external economies of scale in an industry located in country X. If country X moves from free trade to autarky, it necessarily loses welfare. Explain in detail, using any relevant diagrams, whether the above statement is true, false or uncertain.

Answer 1

The statement is true.

We will explain it with the help of the following diagram.

Initially there is free trade. The Supply in free trade is shown by Supply (open). The demand is the domestic demand. The equilibrium point is E1, the price is P1 and quantity is Q1. The total welfare in this state is the area of the triangle AE1B.

Now the country moves to Autarky. Autarky is the state of complete self-dependence. So the country will not trade with anyone else. it is given that there are external economies of scale. This means that local industry is not as efficient in producing the product as external. This will result in decrease of supply. The supply curve shifts to the left and is shown as Supply (autarky). E2 is the new equilibrium point with price P2 and quantity Q2. The price is higher and quantity is lower. The total welfare now is the area of the triangle AE2C.

The thing to be noted is that the demand curve will not move. This means is that the new welfare area triangle will always be a subset of earlier welfare triangle (when economy was open). This means this new triangle will always have area lesser than the original and that means that the new welfare will always be lower.

Hence, there will necessarily be loss of welfare from economy moves from open to autarky and there are external economies of scale.