Question

This question deals with external economies of scale.

a) How does external economies of scale potentially justify infant industry protection? Use a diagram to help you answer this.

b) Suppose that Germany and India can both produce shirts, but India has a lower average cost curve. Germany has the head start in world production of shirts, beginning as the world's only supplier of shirts. Even though Germany has the head start advantage, India can still enter production of shirts. Draw the AC curves and world demand curve of this scenario, making sure to label the initial world price and quantity produced, as well as each AC curve.

Answer 1

a) Economies of scale occur when output increases more than the increase in input and cost per unit is low; in external economies of scale cost per unit depends on the size of the industry. There is a large number of firms competing in perfectly competitive market structure. The reasons for exhibiting external economies of scale are labor pooling, specialized equipment, and knowledge spillover. It benefits the world economy in terms of gaining a comparative advantage and leads to concentration of industry.Dynamic increasing returns depends on the initial advantage which justifies protection so that they gain experience from knowledge spillover and incurs a learning curve; a temporary protection is required; which is infant industry argument.

b)

External economies of scale give major emphasis to the history and accident in determining the role of international trade.i.e. a country starting with a large advantage may retain that advantage even if another country could potentially produce the same good more cheaply. In the given example, Germany has a head start advantage as world's only supplier of shirts. India can still enter but Germany will retain its comparative advantage being the potential large producers even if another region can produce more cheaply.