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Chapter 6
Scale Economies, Imperfect Competition, and Trade
Overview
Standard trade theory presented in Chapters 3-5 is based on perfect competition, with constant
returns to scale at the level of the individual firm and constant or increasing cost of expanding
production at the level of the industry. Comparative advantage predicts that countries will trade
with other countries that are different (the source of the comparative cost differences) and that
each country will export some products and import other, quite different products. While much
international trade conforms to these patterns, a substantial amount does not. Most obviously,
industrialized countries trade a lot with each other, and in much of their trade each is exporting
and importing similar products.
This chapter looks at three theories of trade based on market structures that differ from the
standard theory. Each of these theories includes a role for scale economies, so that unit costs tend
to decline as output increases. The first section of the chapter defines and examines scale
economies, and it explains the difference between scale economies that are internal to the
individual firm, and scale economies that are external to the firm but apply to a cluster of firms
in a geographic area.
The next section of the chapter defines intra-industry trade (IIT), in which a country both exports
and imports the same product or very similar product varieties. It explains how IIT is measured
for an individual product, with examples shown in Figure 6.2. The importance of IIT in a
country’s overall trade is the weighted average of the IIT shares for each of the individual
products. Figure 6.3 provides originalestimates of the overall importance of IIT.
The remainder of the chapter presents the three additional trade theories. The first is based on
monopolistic competition. While there may be a number of explanations of intra-industry trade,
product differentiation seems to be the major one. The market structure of monopolistic
competition is useful for analyzing the role of product differentiation. Each producer faces a
downward-sloping demand curve for its product variety. If scale economies (internal to the firm)
are moderate (relative to the size of the total market for all varieties of this product), then easy
entry drives each firm to earn zero economic profit (the average cost curve is tangent to the
demand curve). If a monopolistically competitive national market is opened to international
trade, then domestic consumers have access to additional varieties of the product—those that can
be imported. Domestic producers have access to additional buyers—foreigners who prefer their
varieties. Product differentiation in this monopolistically competitive global market is the basis
for intra-industry trade, as some varieties are imported while others are exported. (The box on
“The Gravity Model of Trade” examines an empirical approach that is consistent with trade
based on product differentiation and monopolistic competition. It discusses some of the key
findings about national economic size, geographic distance, and other impediments to trade.)
With this kind of trade based on product differentiation and monopolistic competition, an
additional source of gains from trade for the country is the increase in varieties that become
available. Furthermore, trade may also lead to lower prices for the domestic varieties. These
benefits accrue to consumers generally. The implications of trade for the well-being of different
groups in the country are also modified. First, if most trade is intra-industry, then there may be
little pressure on factor prices caused by inter-industry shifts in factor demand. Second, the gains
from increased variety reduce the loss to factors that suffer income losses due to
Stolper-Samuelson effects. Some may believe they are better off even though they appear to lose
income. In addition, increased international competition drives national production toward
domestic firms with lower costs, a process of restructuring within the national industry.
The second theory is global oligopoly. In some industries, a few large firms account for most
global sales, perhaps because internal scale economies are large. Although we do not have a
single dominant full theory of oligopoly, we can make several observations about oligopoly and
trade. First, scale economies tend to concentrate production in a few production sites. When they
were chosen by the firms, these may have been the lowest-cost sites. Over time production tends
to continue in these sites, even though they may not remain the lowest cost sites if all sites could
achieve the same production scale.
Second, in an oligopoly each large firm should recognize interdependence with the other large
firms—its actions and decisions are likely to elicit responses from the other firms. Competition
then resembles a game, but it is still not clear how the firms should play the game. If they
compete aggressively, then they may earn only normal profits. They may be caught in the
prisoners dilemma of competing aggressively, unless they can find some way to cooperate. If
instead they restrain their competitive thrusts, then they may be able to earn high profits.
The fact that oligopoly firms can earn high profits means that it matters where these firms are
located (or who owns them). The high profit earned on export sales creates another source of
national gains from trade for the exporting country, in the form of better terms of trade, at the
expense of foreign buyers of the imports.
Our third theory is based on scale economies that are external to the individual firm but arise
from advantages of having a high level of production in a geographic area. With external scale
economies (also called agglomeration economies), an expansion of demand (such as that caused
by increased exports) can result in a lower unit cost for all producers in the area and a lower
product price. With free trade production tends to be concentrated in one or a few locations. In
the shift from no trade to free trade, production in some locations would increase so that their
unit costs and prices fall, while production in other locations would decrease or cease. It is not
easy to predict which locations become dominant—luck, a large domestic market, or government
policy may be important. The importing countries gain from trade, even if local production
ceases, because consumers benefit from the lower prices of the imported product. A key
difference from the standard model is that with external scale economies consumers in the
exporting country also gain surplus as trade leads to lower costs and prices, because production
is concentrated in few locations that can better achieve the external economies.
The chapter concludes with a summary that pulls together the sweep of the analysis of
international trade covered in Chapters 2-6.
Tips
The analysis in the text of the chapter is at the level of the market and uses the graph with the
price curve and the unit cost curve. The analysis of the individual firm in a monopolistically
competitive market is in a concise Extension box. An instructor has the option to omit this box
from the assigned required reading—students will still be able to follow the discussion in the
text. If you omit the extension box, also omit end of chapter question 10.
The link of global oligopoly to trade policy—often called strategic trade policy—is presented in
Chapter 11. An analysis of global cartels is presented in Chapter 14.
The country assignment included as a Suggested Assignment for Chapter 5 includes a question
referring to the country's intra-industry trade. If appropriate, you could ask a more specific
question, which might include calculations of the intra-industry trade shares for individual
products using the formula in the text, or the calculation for the country of the weighted average
of these IIT shares.
