Chapter 7
External Economies of Scale
and the International Location
of Production
■ Chapter Organization
Economies of Scale and International Trade: An Overview.
Economies of Scale and Market Structure.
The Theory of External Economies.
Specialized Suppliers.
Labor Market Pooling.
Knowledge Spillovers.
External Economies and Market Equilibrium.
External Economies and International Trade.
External Economies, Output, and Prices.
External Economies and the Pattern of Trade.
Box: Holding the World Together.
Trade and Welfare with External Economies.
Dynamic Increasing Returns.
Interregional Trade and Economic Geography.
Box: Tinseltown Economics.
Summary
38 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition
■ Chapter Overview
In previous chapters, trade between nations was motivated by their differences in factor productivity or
relative factor endowments. The type of trade that occurred, for example of food for manufactures, is
based on comparative advantage and is called interindustry trade. This chapter introduces trade based on
economies of scale in production. Such trade in similar productions is called intraindustry trade and
describes, for example, the trading of one type of manufactured goods for another type of manufactured
goods. It is shown that trade can occur when there are no technological or endowment differences but
when there are economies of scale or increasing returns in production, as opposed to the constant returns
to scale assumed in previous chapters.
Economies of scale can either take the form of (1) external economies, whereby the cost per unit depends
on the size of the industry but not necessarily on the size of the firm; or as (2) internal economies, whereby
the production cost per unit of output depends on the size of the individual firm but not necessarily on the
size of the industry. Internal economies of scale give rise to imperfectly competitive markets, unlike the
perfectly competitive market structures that were assumed to exist in earlier chapters. Industries
characterized by purely external economies of scale will typically consist of many small firms and be
perfectly competitive. The focus of this chapter is on external economies, while the next chapter looks at
internal economies.
External economies of scale (EES) lead to a clustering of firms in one location for three main reasons:
1. Specialized suppliers: By locating next to firms in the same industry, you are able to specialize in one
aspect of the production process and outsource other stages of production to neighboring firms.
2. Labor market pooling: Firms with specific skill needs will prefer to locate near a large pool of
workers with those skills to limit labor market shortages. At the same time, skilled workers prefer to
locate close to the firms that hire them to limit unemployment.
3. Knowledge spillovers: Having similar firms located next to one another can lead to increased sharing
of ideas and partnerships.
Market equilibrium in an EES industry is determined by the intersection of market demand and supply as
in the constant returns case. The key difference here is that the market supply curve is forward falling,
reflecting the fact that average costs in the industry actually fall as industry production (i.e., size) rises.
This distinction drives trade in this model. When two countries trade, it makes sense to concentrate
production in one country because this will lead to lower average costs than splitting production across
two countries. With trade, the country with the lower average cost will export the good. This will lead to
Chapter 7 External Economies of Scale and the International Location of Production 39
more production in the exporting country and less production in the importing country. As the industry is
characterized by EES, this will cause costs in the exporting country to fall and costs to rise in the
importing country. Eventually, all production will locate in the exporting country at a lower market price
than would have prevailed without trade.
The pattern of trade is only partially explained by comparative advantage. Rather, it may be a historical
accident that led to the formation of an industry in a particular location. The chapter gives the example of
why global button manufacturing is concentrated in one town in China, mostly because one firm in the
1980s began producing buttons there. That the location of production is not entirely dependent on
comparative advantage presents situations in which trade can actually make a country worse off. For
example, if button production is already established in China, then Chinese button producers have an
advantage over firms in countries without an established button industry (due to external economies of
scale in the button industry). Without trade, the button industry in a low-wage country could develop to the
point where it is actually producing at a scale such that the price of buttons is lower than the world price
established by the Chinese button industry. This suggests that a country could actually make itself better
off by closing off from trade to let external economies of scale industries develop, assuming that the
country has a large enough market to support an efficient scale of production. However, these cases may
be difficult to identify, and protectionism can lead to unintended consequences such as retaliatory tariffs.
External economies may also be the result of learning curves (dynamic increasing returns). In this
scenario, the unit cost of production falls as the cumulative output of an industry rises. Industries that have
been around for a long time are further out on their learning curves and will have an advantage over new
industries that still have to undergo the process of “learning by doing.” The presence of these learning
curves may justify infant industry tariff protection, as a new industry in a country could potentially be
competitive but needs to be protected until it develops the acquired knowledge of established global
competitors. On the other hand, it may be difficult to identify such situations, and tariff protection presents
several problems, which will be discussed in later chapters (notably rent–seeking behavior by protected
firms).
■ Answers to Textbook Problems
1. Cases a and d represent external economies of scale as industry production is concentrated in a just a
40 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition
© 2018 Pearson Education, Inc.
output for the whole industry. As the output of a single firm increases, average costs will fall. This
can lead to imperfect competition as it supports a limited number of firms in an industry.
2. This view is flawed in the sense that countries produce more than one good. Trade allows a country
to free up resources from a relatively less efficient industry and expand production in industries with
3. Dynamic increasing returns occur whenever average costs fall with cumulative output. In other
words, a learning curve exists that favors established producers over startups. This is an open-ended
42 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition
© 2018 Pearson Education, Inc.
gives it a cost advantage over any Vietnamese firms who would enter into the industry and face an
initial cost higher than the established Chinese firms. Production would only shift to Vietnam if
China’s average cost curve were to shift up enough so that the new equilibrium price and cost in
China lies above the startup cost in Vietnam.
8. Consider again two different scenarios: In scenario 1, there are two firms in the same location and a
9. The fact that Bangladeshi apparel producers are clustered in or near Dhaka despite the terrible traffic
conditions suggests that there are large external economies in clothing production. Having access to a