Question

Trade in the presence of external scale economies leads to prices that are lower than the prices in only one of the trading partners before trade. True or False? Justify your answer with an appropriate diagram

Answer 1

What are 'External Economies Of Scale?

External economies of scale imply that as the size of an industry grows larger or more clustered, the average costs of doing business within the industry fall. This may occur due to increased specialization or training of workers, faster innovation or shared supplier relationships. These factors are typically referred to as positive externalities; industry-level negative externalities are called external diseconomies.

• BREAKING DOWN 'External Economies Of Scale'

External economies of scale also refer to how an industry might experience a downward-sloping supply curve, at least within a given range. Economies of scale, whether external or internal, refer to factors that drive down average production costs as output volume increases. However, there is a limit to the realizable economies of scale based on any given factor. This occurs whenever the added costs of complexity associated with a larger output volume exceed the benefits of greater scaling.

• Industry-level Scaling

Unlike internal economies of scale, which occur at the firm level, an external economy of scale manifests at an industry-wide level. The key characteristic of external economies is that individual firms have no direct control over their development, which means they cannot exclude competitors from benefiting also. British economist Alfred Marshall is frequently credited with distinguishing between external and internal economies of scale.

There are many reasons such scaling may occur. For example, one firm might determine that California is a particularly good location for year-round film-making. More firms may then decide to move operations to California to take advantage of the specialized labor and infrastructure already in place thanks to the success of the first firm. As more and more firms succeed in the same area, new entrants can take advantage of even more localized benefits.

Businesses in the same industry tend to cluster in specific regions. For example, new movie producers to locate to Hollywood because there are more camera operators, actors and actresses, costume designers and screenwriters in the area. Successive firms can realize greater cost advantages in such areas.

• Scaling Across Industries

If two or more separate industries are incidentally beneficial to one another, there can be external economies of scale across the entire group. This is sometimes called "agglomeration economies," and is similar to the business governance concept of synergy.

Concepts such as external economies of scale or agglomeration economies may help explain why growth does not spread evenly across a country or set of countries. These concepts might also explain why urban areas can grow fast enough to support larger populations. Major innovations, such as the automobile or the internet, result in wide-spread agglomeration benefits.

(a) The economic rationale for trade agreements

There has long been a solid argument in favour of

free trade based on economic efficiency. Based on

this premise, there is no need for trade agreements

since governments intent on maximizing national

welfare would consider any deviation from free

trade as a self-defeating choice. Notwithstanding

this well-known argument, unilateral trade policies

that inefficiently restrict trade flows do occur and

trade agreements that aim to limit such unilateral

actions are in place.

Economists have identified several rationales for

the existence of trade agreements, such as those

embodied in the WTO, and its antecedent, the

General Agreement on Tariffs and Trade (GATT).

Two main approaches can be distinguished.1 The

first states that in the absence of a trade agreement,

a country may be tempted to manipulate the

terms-of-trade (i.e. the price of its exports relative

to its imports) in order to increase its national

income at the expense of its trading partners. The

second approach stresses the economic and political

difficulties that governments face in setting trade

policy. As discussed below, trade agreements allow

governments to escape terms-of-trade conflicts and/

or to resist pressures from the private sector and

special-interest groups urging the government to

deviate from a liberal trade policy.

i) The traditional approach to trade agreements

The main logic of the terms-of-trade (or traditional)

approach is that countries that have market power

(i.e. that can influence their terms-of-trade) cannot

resist the temptation to act in their own interests.

Johnson (1954) analyzes a situation where each

country sets trade policy in an attempt to improve

its terms-of-trade and increase national income. The

resulting “non-cooperative equilibrium” (known as

Nash equilibrium) is inefficient as the unilateral

actions of countries cancel out one another. More

restrictive trade policies by all countries have little

net effect on the terms-of-trade, but lead to a

contraction of trade volumes which reduces overall welfare.

ii) The commitment approach to trade

agreements

While the traditional approach to trade agreements

emphasizes an international source of inefficiency

in trade policy (i.e. the temptation of countries

to act in a non-cooperative manner), commitment through which time-inconsistent trade policy may

lead to inefficiencies (a partial list includes Staiger

and Tabellini, 1987; Matsuyama, 1990 and Amin,

2003). In these models, the government wishes to

use discretionary trade policy to increase social

welfare (for example, in response to unexpected

events, or to allow temporary protection to an

infant industry, etc.). However, the use of trade

policy changes the behaviour of participants in the

economy. If agents anticipate the policy that the

government will implement, they can react to it in a

way that will reduce the impact that it has on them.

This implies that the government will not be able to

use discretionary trade policy as intended, and this

results in a socially inefficient trade policy.

B. The economic rationale for flexibility in trade agreements:

The discussion about the economic rationales for

trade agreements highlights the main potential

costs of introducing flexibility into the multilateral

trading system. First, since a trade agreement allows

signatories to cooperate with each other through

low trade barriers, flexibilities may undermine what

the agreement achieves. In the words of Ethier

(2002), contingency measures constitute unilateral

behaviour in the multilateral trading system. The

use of such unilateral measures is costly as it may

reduce international trade flows and diminish the

efficiency gains from more open trade.

Second, as rigid government commitments increase

the credibility of trade policy and reduce the

likelihood of inefficient policies, relaxing such rigid

commitments may harm governments’ credibility

and reduce national and global welfare. For instance,

if governments are not fully committed to free trade

and can use contingency measures, there may not

be an efficient allocation of resources between

sectors as firms may anticipate that governments

will use such measures in the future and may adjust

their behaviour accordingly. This mis-allocation of

resources represents a welfare loss, which is the cost

in terms of credibility of introducing trade policy

flexibility in a trade agreement.

If such risks exist, how can we justify the existence

of flexibilities – such as contingency measures

– in the multilateral trading system? In general,

in the presence of uncertainty regarding future

developments, flexibilities facilitate deeper

government commitments, contribute to the

overall stability of the system and help to reduce

domestic opposition to signing a trade agreement.

The evolution of safeguards provisions within the

GATT/WTO system illustrates the interaction

between commitments and flexibilities in trade

agreements.

Two main approaches have emerged in the literature.

The logic of the first is that that cost of flexibilities

in trade agreements has to be assessed against the

benefits of allowing governments some degree of

discretion in setting their trade policy. The second

approach stresses the limits of trade cooperation

due to the contractual costs of trade agreements,

difficulties in predicting future events, or political

constraints to the regulation of domestic policies. As

a result of these limitations, governments may prefer

to sign a trade agreement that allows some policy

discretion. While there are important overlaps

between these two points, the differences between

these two arguments justify separate discussions.

• Example of internal economies of scale

Technology - A larger firm may be able to adopt technologies of production that a smaller firm cannot. Large-scale businesses can afford to invest in expensive and specialist capital machinery.

• Example of external economies of scale

Transportation & Logistics - Better transportation and communication may develop because of the presence of larger firms.The Long Run Average Cost (LRAC) curve plots the average cost of producing the lowest cost method.

The Long Run Marginal Cost (LRMC) is the change in total cost attributable to a change in the output of one unit after the plant size has been adjusted to produce that rate of output at minimum LRAC.

As a result, the intersection of the LRMC and the LRAC is where the long run costs are at a minimum. The quantity produced is represented by a vertical dotted line at Minimum LRAC.

• Causes of Diseconomies of Scale

1. Workers

The primary cause of diseconomies of scale comes from the difficulty of managing an increasingly large workforce. At such a large scale, the firm could have thousands of workers; it becomes difficult to maintain the same level of quality and productivity. Employees in large organizations tend to be disassociated with the company’s goals.

2. Supply chain

At that scale, it also becomes difficult to coordinate information and the supply chain across factories and countries.

Examples of Diseconomies of Scale

1. Poor Communication

Larger firms often suffer poor communication because of an ineffective flow of information between departments, divisions or between head office and subsidiaries. For example, a large clothing brand may be less responsive to changing tastes and fashions than a much smaller boutique brand.

2. Coordination

Coordination also affects large firms with many departments and divisions and may find it much harder to coordinate its operations than a smaller firm. For example, a small manufacturer can more easily coordinate the activities of its small number of staff than a large manufacturer employing tens of thousands.

3. Management Inefficiency

‘X’ inefficiency is the loss of management efficiency that occurs when firms become large and operate in uncompetitive markets. Such loses of efficiency include overpaying for resources, such as paying managers salaries higher than needed to secure their services and excessive waste of resources.

4. Motivation

The low motivation of workers in large firms is a potential diseconomy of scale that results in lower productivity, as workers may feel they are just another cog in the machine.

5. Principal-Agent Problem

Large firms may experience inefficiencies related to the principal-agent problem. This problem is caused because the size and complexity of most large firms mean that their owners often have to delegate decision making to appointed managers, which can lead to inefficiencies.

6. Complacency

Some economists argue that with large and uncompetitive markets, firms tend to become complacent because of their size. For example: Kodak made advances in digital photography but chose to stick to their core business and this led to their decline.

In the long run, we assume that all factors of production are adjustable. This means a firm can grow or shrink in size. In the long run, i.e., in the diagram, can move up and down the Long Run Average Cost Curve.

The Long Run Average Cost (LRAC) curve plots the average cost of producing the lowest cost method.

The Long Run Marginal Cost (LRMC) is the change in total cost attributable to a change in the output of one unit after the plant size has been adjusted to produce that rate of the production at minimum LRAC.

As a result, the intersection of the LRMC and the LRAC is where the long run costs are at a minimum. The quantity produced is represented by a vertical dotted line at Minimum LRAC.

An increase in production beyond this point increases the LRAC because the Long Run Marginal Cost of producing that extra good is quite high.