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1. http://blogs.ft.com/ft-long-short/2013/02/14/no-excuses-for-britains-dire-exports/?http://blogs.ft.com/ft-long-short/2013/02/14/no-excuses-for-britains-dire-exports/?

2. Paul Krugman • http://www.nobelprize.org/nobel_prizes/economics/laureates/2008/press.html

3. Increasing Returns to Scale • Why do developed countries trade with one another? Or similarly, why do less-developed countries trade with one another? Krugman (1979, 1980) • Previous models have a hard time with that question. • Most trade occurs between developed countries.

4. Preview • Types of economies of scale • Economies of scale and market structure • The theory of external economies • External economies and international trade • Dynamic increasing returns • International trade and economic geography

5. Introduction Countries specialize and trade for two reasons: • Countries differ in either their resources or technology (till now we considered models in which trade was based on comparative advantages) • Economies of scale (or increasing returns)

6. Introduction • The models of comparative advantage thus far assumed constant returns to scale: • When inputs to an industry increase at a certain rate, output increases at the same rate. • If inputs were doubled, output would double as well.

7. Introduction (cont.) • But there may be increasing returns to scale or economies of scale: • A larger scale is more efficient: the cost per unit of output falls as a firm or industry increases output.

8. Relationship of Input to Output for a Hypothetical Industry

9. Introduction (cont.) • Increasing Return to Scale is a force for specialization (and, therefore, gains from trade)

10. Introduction (cont.) • International trade permits each country to produce a limited range of goods without sacrificing variety in consumption. • We assume “love-of-variety” • With trade, a country can take advantage of economies of scale to produce more efficiently than if it tried to produce everything for itself.

11. Economies of Scale and Market Structure • Where do economies of scale come from? • Economies of scale could mean either that larger firms or a larger industry would be more efficient.

12. Economies of Scale and Market Structure • External economies of scale occur when cost per unit of output depends on the size of the industry. • Internal economies of scale occur when the cost per unit of output depends on the size of a firm.

13. Economies of Scale and Market Structure (cont.) • Both external and internal economies of scale are important causes of international trade. • They have different implications for the structure of industries: • An industry where economies of scale are purely external will typically consist of many small firms and be perfectly competitive. • Internal economies of scale result when large firms have a cost advantage over small firms, causing the industry to become imperfectly competitive.

14. The Theory of External Economies • First: external economies • Many modern examples of industries that seem to be powerful external economies: • In the United States, the semiconductor industry is concentrated in Silicon Valley, investment banking in New York, and the entertainment industry in Hollywood. • (So geographic concentration is often a sign that an external economy exists)

15. The Theory of External Economies (cont.) • In developing countries such as China, external economies are pervasive in manufacturing. • One town in China produces most of the world’s underwear, another nearly all cigarette lighters (again, geography). • External economies played a key role in India’s emergence as a major exporter of information services. • Indian information services companies are still clustered in Bangalore.

16. The Theory of External Economies (cont.) • Special Economic Zones (SEZs) attempt to exploit external economies. What are SEZs? • Designated areas in countries that possess special economic regulations that are different from other areas in the same country. Moreover, these regulations tend to contain measures that are conducive to foreign direct investment. Conducting business in a SEZ usually means that a company will receive tax incentives and the opportunity to pay lower tariffs.

17. The Theory of External Economies (cont.) • For a variety of reasons, concentrating production of an industry in one or a few locations can reduce the industry’s costs, even if the individual firms in the industry remain small. • External economies may exist for a few reasons:

18. Why do External economies exist? • Specialized equipment or services may be needed for the industry, but are only supplied by other firms if the industry is large and concentrated. • For example, Silicon Valley in California has a large concentration of silicon chip companies, which are serviced by companies that make special machines for manufacturing silicon chips. • These machines are cheaper and more easily available there than elsewhere. • Stanford and UC Berkeley provide labor.

19. Why do External economies exist? (cont.) • Labor pooling: a large and concentrated industry may attract a pool of workers, reducing employee search and hiring costs for each firm. One engineer from the Silicon Valley said: “it wasn’t that big a catastrophe to quit your job on Friday and have another job on Monday…You didn’t even necessarily have to tell your wife. You just drove off in another direction on Monday morning”

20. Why do External economies exist? (cont.) • Knowledge spillovers: workers from different firms may more easily share ideas that benefit each firm when a large and concentrated industry exists. • In the modern economy knowledge is a very important input. For some industries (e.i. innovative industries) is even more important than factors of production like labor, capital, and raw materials. • Important source of technical know-how is the informal exchange of information and ideas that takes place at a personal level • when an industry is concentrated in a small area employees of different company mix socially and talk freely about technical issues • it is easier for companies in the Silicon Valley area to stay near the technological frontier than it is for company elsewhere

21. External Economies and Market equilibrium • Represent external economies simply by assuming that the larger the industry, the lower the industry’s costs. • There is a forward-falling supply curve (without economies of scale the supply curve would be upward sloping): the larger the industry’s output, the lower the price at which firms are willing to sell. • Without international trade, the unusual slope of the supply curve doesn’t matter much.

22. External Economies Before Trade

23. External Economies and International Trade • Prior to international trade, equilibrium prices and output for each country would be at the point where the domestic supply curve intersects the domestic demand curve. • Suppose Chinese button prices in the absence of trade would be lower than U.S. button prices.

24. External Economies and International Trade (cont.)

25. External Economies and International Trade (cont.) • What will happen when the countries open up the potential for trade in buttons? • The Chinese button industry will expand, while the U.S. button industry will contract. • As the Chinese industry’s output rises, its costs will fall further; as the U.S. industry’s output falls, its costs will rise. • In the end, all button production will be in China.

26. External economies, Output, and Prices • How does this concentration of production affect prices? • Trade leads to prices that are lower than the prices in either country before trade!

27. External Economies and International Trade (cont.) • In the standard trade model relative prices converge as a result of trade. • With external economies, by contrast, the effect of trade is to reduce prices everywhere.

28. Trade and Prices

29. External Economies and the Pattern of Trade • What might cause one country to have an initial advantage from having a lower price? • One possibility is comparative advantage due to underlying differences in technology and resources. • If external economies exist, however, the pattern of trade could be due to “historical accidents”: • Countries that start as large producers in certain industries tend to remain large producers even if another country could potentially produce more cheaply.

30. External Economies and the Pattern of Trade (cont.) • A tufted blanket, crafted as a wedding gift by a 19th-century teenager, gave rise to the cluster of carpet manufacturers around Dalton, Georgia. • Silicon Valley may owe its existence to two Stanford graduates named Hewlett and Packard who started a business in a garage there. • Los Angeles became the centre of the early film industry when film were shot outdoors and needed good weather • An historical contingency gives a particular location an historical advantage in a particular industry, and this advantage gets “locked in” by external economies of scale even after the circumstances that created the initial advantage are no longer relevant.

31. Example: The Mining Town of Antofagasta, Chile “Increasing returns, comparative advantage, and history: the formation of the mining city of Antofagasta”, Fernandez and Atienza(2011) Published in: Urban Geography, 32-5

32. Example: The Mining Town of Antofagasta, Chile (cont.) “…this study analyzes the case of Antofagasta, a major city located in the Atacama Desert of northern Chile. Today, this urban agglomeration which did not even exist 150 years ago, is the fourth-largest city in the country, with a population of about 350,000, and South America’s leading mining city, with exports of U.S. $68,572 million in 2008 (National Customs Service, 2008).’’

33. Example: The Mining Town of Antofagasta, Chile (cont.) “Natural resource endowment is a necessary but insufficient condition to explain the formation of a durable mining city. This article focuses on the dynamic and endogenous factors that give rise to increasing returns to scale as a key element in understanding the formation and sustainability of this type of urban agglomeration.”

34. External Economies and the Pattern of Trade (cont.) • Assume that the Vietnamese cost curve lies below the Chinese curve because Vietnamese wages are lower than Chinese wages. • At any given level of production, Vietnam could manufacture buttons more cheaply than China. • Vietnam will not supply the world marketif China, for historical reasons, established its button industry first. • No guarantee that the “right’’ country will produce a good that is subject to external economies.

35. The Importance of Established Advantage

36. External Economies and International Trade (cont.) • Trade based on external economies has an ambiguous effect on national welfare. • There will be gains to the world economy by concentrating production of industries with external economies. • It’s possible that a country is worse off with trade than it would have been without trade

37. Trade and Welfare with External Economies Suppose that: • Switzerland has been the first to enter the market • Thailand could produce watches more cheaply • Thailand imports watches from Switzerland, which is able to supply the world market (DWORLD) at a price P1

38. External Economies and Losses from Trade P1is low enough to block entry by Thai producers, who must initially produce the watches at cost C0 BUT if Thailand reverts to autarky, it would be able to supply its domestic market (DTHAI) at the lower price P2

39. External Economies and the Pattern of Trade (cont.) • This example shows that external economies potentially give a strong role to historical accident in determining who produces what, and may allow established patterns of specialization to persist even when they run counter to comparative advantages

40. Trade and Welfare with External Economies • External economies of scale lead to gains from trade over and above those from comparative advantages: the world is more efficient and thus richer • BUT no guarantee that the right country will produce a good subject to external economies  Trade based on external economies may leave a country worse off than it would have been in the absence of trade

41. Trade and Welfare with External Economies (cont.) • There is an incentive for Thailand to protect its potential watch industry from foreign competition, BUT in practice identifying cases like that of the last graph is far from easy! • Note that it’s still to the benefit of the world economy to take advantage of the gains from concentrating industries. • Overall, it’s better for the world that each industry with external economies be concentrated somewhere.

42. Dynamic Increasing Returns • “Increasing Returns and All That: A View from Trade”, Antweilerand Trefler (2002) Published in: American Economic Review, 92(1): 93-119.

43. Dynamic Increasing Returns (cont.) “Do scale economies help to explain international trade flows? Using a large database on output, trade flows and factor endowments, we find that allowing for the presence of increasing returns to scale in production significantly increases our ability to predict international trade flows. In particular, using trade data, we find that a third of all goods-producing industries are characterized by increasing returns to scale. Thus, scale economies are a quantifiable and important source of comparative advantage.”

44. Dynamic Increasing Returns (cont.) • So far, we have considered cases where external economies depend on the amount of current output at a point in time. • But external economies may also depend on the amount of cumulative output over time.

45. Dynamic Increasing Returns • Dynamic increasing returns to scale exist if average costs fall as cumulative output over time rises. • Dynamic increasing returns to scale imply dynamic external economies of scale.

46. Dynamic Increasing Returns (cont.) • Dynamic increasing returns to scale could arise if the cost of production depends on the accumulation of knowledge and experience, which depend on the production process over time. • A graphical representation of dynamic increasing returns to scale is called a learning curve.

47. The Learning Curve

48. The Learning Curve (cont.) • Curves are downward sloping because of the effect on costs of the experience gained through production. • Like ordinary external economies, dynamic external economies can lock in an initial advantage or head start in a n industry • L is the learning curve of a country that pioneered an industry • L* is that of a country that has lower inputs costs (e.i. low wages), but less production experience • Provided that the first country has a sufficiently large head start, the potentially lower costs of the second country may not allow the second country to enter the market • For example, if the first country has a cumulative output of QL units, its unit cost is C1, while the second country has never produced the good  the second country will have an initial start-up cost, C*0, that is higher than the current unit cost C1 of the established industry

49. Dynamic Increasing Returns (cont.) • Like external economies of scale at a point in time, dynamic increasing returns to scale can lock in an initial advantage or a head start in an industry. • Can be used to justify protectionism. • Temporary protection of industries enables them to gain experience: infant industry (or import-substitution) argument. • Problem: picking winners and knowing when to stop protecting.

50. International Trade and Economic Geography • Trade within a country may follow the same patterns as international trade. • External economies may also be important for interregional trade within a country. • Many movie producers located in Los Angeles produce movies for consumers throughout the U.S.