Deck 6: External Economies of Scale and the International Location of Production

Question 1

For each of the following examples, explain whether it is a case of external or internal economies of scale:
a. A number of firms doing contract research for the drug industry are concentrated in southeastern South Carolina.
b. All Hondas produced in the United States come from plants in Ohio, Indiana, or Alabama
c. All airframes for Airbus, Europe's only producer of large aircraft, are assembled in Toulouse, France.
d. Cranbury, New Jersey, is the artificial flavor capital of the United States.

Answer 1

Internal economies of scale:
Internal economies are those economies in production which occur to the firm itself when it expands its output or enlarge its scale of production.
External economies of scale:
External economies refer to all those benefits which accrue to all the firms operating in a given industry. External economies of scale increase the productivity of an entire industry, geographical area or economy. External factor are outside the control of a particular company. Generally, these economies accrue due to the expansion of industry and other facilities expanded by the Government. 
a)When a number of firms doing contract research for the drug industry are concentrated in southeastern South Carolina, it is external economies of scale as costs decreases due to size of the industry and its concentration in a locality.
Thus, it is an external economy of scale.
b)It is an outsourcing from the company's own plant in the company b.Thus, it is an internal economy of scale.
c)All airframes for Airbus, the only producer of large aircraft in the continent are assembled in Toulouse; France is the internal economy.
Thus, it is an internal economy of scale.
d)Cranbury, NJ is the artificial flavor capital of the country U is the external economies of scale as there are many firms in that locality.
Thus, it is an external economy of scale.

Question 2

It is often argued that the existence of increasing returns is a source of conflict between countries, since each country is better off if it can increase its production in those industries characterized by economies of scale. Evaluate this view in terms of the external economy model.

Answer 2

The existence of increasing returns in any country can be due to external economies of scale or internal scale of economies.
In the external economies of scale, the per unit cost of output depends on the industry size. While, in the case of internal economies of scale the per unit cost of output depends on the firm size.
In today's world, the major economies around the globe have experienced growth due to external economies of scale. There are many countries which are in conflict because countries are favoring the concentration of production of an industry in just few locations.
The countries are favoring external economies due to:
1. Specialized equipment or services: The availability of specialized cheaper and accessible machinery improves the production process.
2. Labor pooling: When the countries are concentrated in a specific region, it may attract a pool of workers which reduces the hiring cost and employee search cost.
3. Knowledge Spillover: The exchange of knowledge between workers is easy when a concentrated and large industry exists.
There are conflicts between the countries as the trade based on the external economies has an ambiguous effect on the nation's welfare.
There is a possibility that a country is worse off with trade: A country may be better off if it produces all the goods and services on its own rather than importing from other countries. The countries experiencing the external economies of scale can always produce different goods and services at a lower cost and thus sell the goods at a lower price level in the world market. This makes the survival of the other country's industries difficult.
The pattern of trade may exist due to historical accidents: It is argued that the countries which start as a large producer in certain industries may continue to remain a large producer even though the other country can produce the same good at a cheaper price.
Thus, a major reason behind the conflict for the trade based on external economies of scale is for the fact, that the external economies does not guarantee that the right country will produce a good.

Question 3

Give two examples of products that are traded on international markets for which there are dynamic increasing returns. In each of your examples, show how innovation and learning-by-doing are important to the dynamic increasing returns in the industry.

Answer 3

The most important products which are traded internationally and experience dynamic increasing returns are Software services and Motion pictures. In both the sectors continuous innovation helps in reducing the cost for cumulative output rather than current output. It is also a process of continuous learning-by-doing; especially filmmaking. The experience gained through production effects the cost. When individual firms in software sector and filmmaking improves its products or production techniques through experience, other firms are likely to imitate the firm and benefit from its knowledge. This spillover of knowledge gives rise to a situation in which production costs of individual firm falls as the industry as a whole gathers experience.

Question 4

Evaluate the relative importance of economies of scale and comparative advantage in causing the following: a. Most of the world's aluminum is smelted in Norway or Canada.
B) Half of the world's large jet aircraft are assembled in Seattle.
C) Most semiconductors are manufactured in either the United States or Japan.
D) Most Scotch whiskey comes from Scotland.
E) Much of the world's best wine comes from France.

Question 5

Consider a situation similar to that in Figure , in which two countries that can produce a good are subject to forward-falling supply curves. In this case, however, suppose the two countries have the same costs, so that their supply curves are identical.
a. What would you expect to be the pattern of international specialization and trade? What would determine who produces the good?
b. What are the benefits of international trade in this case? Do they accrue only to the country that gets the industry?
Figure
Trade and Prices
When trade is opened, China ends up producing buttons for the world market, which consists both of its own domestic market and of the U.S. market. Output rises from Q 1 to Q 2 , leading to a fall in the price of buttons from P 1 to P 2 , which is lower than the price of buttons in either country before trade

Question 6

It is fairly common for an industrial cluster to break up and for production to move to locations with lower wages when the technology of the industry is no longer rapidly improving-when it is no longer essential to have the absolutely most modern machinery, when the need for highly skilled workers has declined, and when being at the cutting edge of innovation conveys only a small advantage. Explain this tendency of industrial clusters to break up in terms of the theory of external economies.

Question 7

Recently, a growing labor shortage has been causing Chinese wages to rise. If this trend continues, what would you expect to see happen to external economy industries currently dominated by China? Consider, in particular, the situation illustrated in Figure How would change take place?
Figure
The Importance of Established Advantage The average cost curve for Vietnam, AC Vietnam , lies below the average cost curve for China, AC China. Thus Vietnam could potentially supply the world market more cheaply than China. If the Chinese industry gets established first, however, it may be able to sell buttons at the price P 1 , which is below the cost C 0 that an individual Vietnamese firm would face if it began production on its own. So a pattern of specialization established by historical accident may persist even when new producers could potentially have lower costs.

Question 8

In our discussion of labor market pooling, we stressed the advantages of having two firms in the same location: If one firm is expanding while the other is contracting, it's to the advantage of both workers and firms that they be able to draw on a single labor pool. But it might happen that both firms want to expand or contract at the same time. Does this constitute an argument against geographical concentration? (Think through the numerical example carefully.)

Question 9

Which of the following goods or services would be most likely to be subject to (1) external economies of scale and (2) dynamic increasing returns? Explain your answers. a. Software tech-support services
B) Production of asphalt or concrete
C) Motion pictures
D) Cancer research
E) Timber harvesting