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
◼ 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 good for another type of manufactured
good. 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
34 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
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.
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
Chapter 7 External Economies of Scale and the International Location of Production 35
◼ Answers to Textbook Problems
1. Cases a and d represent external economies of scale as industry production is concentrated in a just a
few locations. The benefits of geographical clustering include a greater variety of specialized services
to support industry operations, access to a larger pool of specialized labor, and thicker input markets.
2. Knowledge cannot be traded, it can be learned easily. Local knowledge spillover is difficult to
transfer if the distance is too great. A face to face interaction and regular discussion would extend the
possibility of spillover to firms located in nearby areas, rather than to firms located at a distant place.
Marshall stated that the mysteries of trade cease to be mysteries when they are in the air. The
spillover is faster between firms in the vicinity than those farther apart. That could be the reason why
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 question,
though the examples in Question 9 provide some ideas. Two industries characterized by dynamic
increasing returns are biotechnology and aircraft design. Biotechnology is an industry in which
4. a. The relatively few locations for production suggest external economies of scale in production.
If these operations are large, there may also be large internal economies of scale in production.
b. Because economies of scale are significant in airplane production, it tends to be done by a small
number of (imperfectly competitive) firms at a limited number of locations. One such location is
Seattle, where Boeing produces airplanes.
c. Because external economies of scale are significant in semiconductor production, semiconductor
industries tend to be concentrated in certain geographic locations. If, for some historical reason, a
semiconductor is established in a specific location, the export of semiconductors by that country is
due to economies of scale and not comparative advantage.
d. “True” scotch whiskey can only come from Scotland. The production of scotch whiskey requires
a technique known to skilled distillers who are concentrated in the region. This labor market
5. a. Commencing international trade would allow India to supply cloth and Japan to supply radios.
This is because, India has an initial advantage of lower price for cloth and similarly, Japan for
radio. The opening of trade would allow India to supply cloth at lower price to Japan and Japan
to supply radios to India at lower price. India’s supply would increase the demand condition of
the Indian cloth industry. Since both are facing a forward falling supply curve, this would reduce
the world market price for both cloth and radio.
36 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
© 2015 Pearson Education Limited
b. If neither country has an initial advantage of lower price, then India is expected to produce cloth
and Japan is expected to produce radio. This is because India is a labor surplus country and cloth
requires more labor than technology. Similarly, Japan would produce radios as radios require
more technology over labor.
6. The three forces driving external economies of scale are access to specialized suppliers, labor market
pooling, and knowledge spillovers. As these forces weaken, so too do the cost advantages of geographic
clustering. The location of production becomes increasingly driven by factor costs when industries
move away from external economies of scale toward traditional constant returns to scale.
7. It is not always true that trade increases the welfare of the people. But usually it improves the situation
of majority of the countries as it brings competition in the world market and reduces the price and
increases choices for the consumer. When a country has low labor cost and low cost of production,
domestic prices of goods are also lowered. In the absence of trade, prices of goods would actually be
lower in a country with a low cost of production. However, the concentration of industries in another
8. Consider again two different scenarios: In scenario 1, there are two firms in the same location and a
local labor supply of 200 for both firms. In scenario 2, the two firms are far apart, and each firm has
a local labor supply of 100. Now suppose that both firms are expanding, increasing their demand
for labor up to 150 each. In the first case, each firm will face a local labor shortage of 50 workers
9. a. External economies of scale are likely due to the need to have a common pool of labor with
technical skills. Dynamic increasing returns may be likely due to the need for continual
innovation and learning.
b. External economies are unlikely because it is difficult to see how the costs of a single firm would
fall if other firms are present in the asphalt industry. Dynamic increasing returns are also unlikely
as the asphalt industry is pretty well established and learning curves are likely to be low.
c. External economies are highly likely because having a great number of support firms and an
available pool of skilled labor in filmmaking are critical to film production. Dynamic returns
are also likely because filmmaking is an industry in which learning is important.