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Economies of scale and International Trade

Economies of scale and International Trade. Dianna DaSilva- Glasgow. outline. Introduction Relaxing the assumptions of the H-O model Trade based on economies of scale. INTRODUCTION.

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Economies of scale and International Trade

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  1. Economies of scale and International Trade Dianna DaSilva- Glasgow

  2. outline • Introduction • Relaxing the assumptions of the H-O model • Trade based on economies of scale International Trade Theory- ECN 422, 2012/2013

  3. INTRODUCTION • How does relaxing the assumptions of the H-O model affect its explanation of the basis and gains from trade ? • Some assumptions when relaxed do not invalidate the conclusions of the model. Others require new explanations of patterns of international trade that the H-O model is unable to explain. • These complement the theory which remains valid. International Trade Theory- ECN 422, 2012/2013

  4. RELAXING ASSUMPTIONS OF THE H-O MODEL • Assumption 1- trade could be explained in a two dimensional model: 2 nations (nation 1 and 2), 2 commodities (X and Y) and 2 factors of production (labour and capital). • When relaxed this assumption does not invalidate the H-O model as long as the number of products is equal to or greater than the number of factors. International Trade Theory- ECN 422, 2012/2013

  5. RELAXING ASSUMPTIONS OF THE H-O MODEL • The use of two factors simplifies the analysis by allowing for intensity to be measured two ways, labour/ capital, otherwise a factor intensity index is necessary. International Trade Theory- ECN 422, 2012/2013

  6. RELAXING ASSUMPTIONS OF THE H-O MODEL • Assumption No. 2- Both nations use the same technology in production • This assumption is not valid as nations often do use different technologies. • Where nation’s have access to different production techniques factor use may not be based on factor abundance. International Trade Theory- ECN 422, 2012/2013

  7. RELAXING ASSUMPTIONS OF THE H-O MODEL • Reconciled? • Where technology is treated as a factor of production (differences in technology among nations) then it can fall under the H-O model. • However, technological change over time requires new explanations of trade. • Trade based on changes in technology over time are explained by the technological gap and product cycle models. International Trade Theory- ECN 422, 2012/2013

  8. RELAXING ASSUMPTIONS OF THE H-O MODEL • Assumption No. 3- Commodity X is labour intensive and commodity Y is capital intensive in both nations. • When relaxed this assumption leads to factor intensity reversal which could invalidate the H-O model. • However, factor intensity reversal has not been proven empirically, to exist significantly. International Trade Theory- ECN 422, 2012/2013

  9. RELAXING ASSUMPTIONS OF THE H-O MODEL • Assumption No. 4- both commodities are produced under constant returns to scale in both nations • Increasing returns to scale occurs in a number of industries that are currently engaged in trade. • Increasing returns to scale occurs where output grows more than the increase in inputs or factors of production. International Trade Theory- ECN 422, 2012/2013

  10. RELAXING ASSUMPTIONS OF THE H-O MODEL • Reconciled? • New explanation of trade based on increasing returns to scale. International Trade Theory- ECN 422, 2012/2013

  11. RELAXING ASSUMPTIONS OF THE H-O MODEL • Assumption No. 5- There is incomplete specialization in production in both nations. • If trade brings about complete specialization in production in one of the nations relative commodity prices will be equalized but factor prices will not. International Trade Theory- ECN 422, 2012/2013

  12. RELAXING ASSUMPTIONS OF THE H-O MODEL • Assumption No. 6 - Tastes are equal in both nations • Though in the real world preferences are not equal this does not invalidate the model as it requires that preferences be broadly similar. International Trade Theory- ECN 422, 2012/2013

  13. RELAXING ASSUMPTIONS OF THE H-O MODEL • Assumption No. 7 there is perfect competition in both commodities and factor markets in both nations. • Perfect competition does not exist in the real world, evidenced by the nature of manufactures trade. • A considerable volume of trade between nations is intra- industry trade which occurs when a nation both imports and exports goods in the same industry (monopolies and oligopolies) International Trade Theory- ECN 422, 2012/2013

  14. RELAXING ASSUMPTIONS OF THE H-O MODEL • Intra- industry trade can be explained by economies of scale combined with product differentiation. Each nation specializes in a segment of the industry, producing a product that is differentiated in some way. E.g. Cars. • H-O model explains trade between different industries. For example, a nation exports goods from industry x and imports goods from industry Y. This is inter- industry trade. International Trade Theory- ECN 422, 2012/2013

  15. RELAXING ASSUMPTIONS OF THE H-O MODEL • Assumption No. 8- There is perfect factor mobility within each nation but no international factor mobility • International factor mobility does not invalidate the model International Trade Theory- ECN 422, 2012/2013

  16. RELAXING ASSUMPTIONS OF THE H-O MODEL • Assumption No. 9- there are no transportation costs, tariffs, or other obstructions to the free flow of international trade. • In the real world there are barriers to trade in various forms, including transportation cost which affects industry location. International Trade Theory- ECN 422, 2012/2013

  17. RELAXING ASSUMPTIONS OF THE H-O MODEL • Assumption 10- All resources are fully employed in both nations. • All resources are not fully utilized in the real world. Unemployment is likely to occur where there is a recession or frictional unemployment . • However, this does not invalidate the model. International Trade Theory- ECN 422, 2012/2013

  18. RELAXING ASSUMPTIONS OF THE H-O MODEL • Assumption 11- international trade is balanced between two nations. • If trade is not balanced a situation could arise where countries import commodities that they do have a comparative advantage in producing with balanced trade. • However, this does not invalidate the model. International Trade Theory- ECN 422, 2012/2013

  19. RELAXING ASSUMPTIONS OF THE H-O MODEL • New theories of trade: • Economies of scale and product differentiation model (assmp 4 & 7) • Technological gap and product cycle model (assmp 2) • Transportation costs (assmp 9) International Trade Theory- ECN 422, 2012/2013

  20. TRADE BASED ON ECONOMIES OF SCALE • When defining comparative advantage, the Ricardian model and the Heckscher-Ohlin model both assume constant returns to scale: • If all factors of production are doubled then output will also double. • This produces a ppf that is concave from the origin. International Trade Theory- ECN 422, 2012/2013

  21. TRADE BASED ON ECONOMIES OF SCALE • But a firm or industry may have increasing returns to scale or economies of scale: • If all factors of production are doubled, then output will more than double. • In the presence of increasing returns to scale, the pff is convex from the origin rather than concave. International Trade Theory- ECN 422, 2012/2013

  22. TRADE BASED ON ECONOMIES OF SCALE • Increasing returns may occur because of the greater division of labour and specialization that occurs at a larger scale of operation. • The majority of world manufacture trade is based on increasing returns to scale. International Trade Theory- ECN 422, 2012/2013

  23. TRADE BASED ON ECONOMIES OF SCALE • In recent years, outsourcing has been an important source of increasing returns to scale. • Outsourcing is international trade in parts and components– new international economies of scale and is a strategy by firms to reduce production costs in order to remain competitive. International Trade Theory- ECN 422, 2012/2013

  24. Major outsourcing companies globally • IBM • Infoys Technologies • Tota Consultancy Services • Wipro Technologies • Hewlett- Packard • GenpactTech • Source: International Association of Outsourcing Professionals International Trade Theory- ECN 422, 2012/2013

  25. TYPES OF ECONOMIES OF SCALE • External vs. Internal economies of scale • Economies of scale could arise from either efficiency gains derived by firm or industry size. International Trade Theory- ECN 422, 2012/2013

  26. TYPES OF ECONOMIES OF SCALE • Internal economies of scale occur when the cost per unit of output depends on the size of a firm. • Large firms may have a cost advantage over small firms which leads to an imperfectly competitive market. International Trade Theory- ECN 422, 2012/2013

  27. TYPES OF ECONOMIES OF SCALE • External economies of scale occur when cost per unit of output depends on the size of the industry. • Larger industries may allow for more efficient provision of services or equipment to firms in the industry. • If external economies exist, a country that has a large industry will have low costs of producing that industry’s good or service. International Trade Theory- ECN 422, 2012/2013

  28. TYPES OF ECONOMIES OF SCALE • If external economies exist, the pattern of trade may be due to historical accidents: • Countries that start out as large producers in certain industries tend to remain large producers even if some other country could potentially produce the goods more cheaply. International Trade Theory- ECN 422, 2012/2013

  29. TYPES OF ECONOMIES OF SCALE External economies may arise due to: • Labor pooling: a large and concentrated industry may attract a pool of workers, reducing employee search and hiring costs for each firm. • Knowledge spillovers: workers from different firms may more easily share ideas that benefit each firm when a large and concentrated industry exists. International Trade Theory- ECN 422, 2012/2013

  30. TYPES OF ECONOMIES OF SCALE • 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 for Silicon Valley firms than for firms elsewhere. International Trade Theory- ECN 422, 2012/2013

  31. Clusters and external economies • Clusters are an emerging tool of industrial organization that allows for increased economies of scale and export competitiveness. • The foundations of the cluster concept originate with Economist Alfred Marshall, who in Principles of Economics (1890) described the phenomenon as “the concentration of specialized industries in particular localities”. • even small firms could enjoy economies of scale comparable to those of large firms. International Trade Theory- ECN 422, 2012/2013

  32. Clusters and external economies • Michael Porter in his book ‘The Competitive Advantage of Nations (1990)’ argued that the growth prospects of a country are tied up in the ability of that country to be able to identify existing drivers of growth, and on a cluster-based policy effectively promote the development of those sectors. International Trade Theory- ECN 422, 2012/2013

  33. Clusters and external economies “Clusters are geographically close groups of interconnected companies and associated institutions in a particular field, linked by common technologies and skills. They normally exist within a geographic area where ease of communication, logistics and personal interaction is possible. Clusters are normally concentrated in regions and sometimes in a single town”. (Michael Porter) International Trade Theory- ECN 422, 2012/2013

  34. Clusters and external economies • Businesses attain international competitiveness where they have the capacity to improve efficiency, boost productivity and continually innovate. • the nature of competition has changed globally with competition increasingly driven by knowledge and skills and businesses moving away from vertically integrated operations towards the outsourcing of various aspects of the production process (Porter 2007) . International Trade Theory- ECN 422, 2012/2013

  35. Clusters and external economies • Clusters support competitiveness by stimulating productivity (Porter 2007; Ketels 2003) because they encourage collaboration at the industry level and encourage strategic partnerships among all entities having an impact on an industry, including to address common challenges.. International Trade Theory- ECN 422, 2012/2013

  36. Clusters and external economies • Clusters also support innovation by allowing for potential economies of scale to be realized by each firm by further specializing production within each firm, by joint purchasing of common raw materials to attract bulk discounts or by joint marketing. • Clusters also help to build external economies of scale which are increasing returns associated with the provision of enabling services such as education and R&D (Porter 2007; Rowe-Setz 2004) International Trade Theory- ECN 422, 2012/2013

  37. Clusters and external economies • Clusters are increasingly being used to improve export competitiveness. • Porter in support of cluster policies argues that: • Cluster-based policies should increasingly replace industry-level and firm-level policies, because cluster policy is more efficient, minimizes distortions to competition, and is better aligned with the nature of competition in the modern economy. (Porter 2007: 2) International Trade Theory- ECN 422, 2012/2013

  38. Clusters and external economies • Two-thirds of European Union countries have introduced the cluster approach in their innovation policy (UNIDO 2010). • The high-tech industry of Bangalore, India; the Chilean Wine Clusters and the Sialkot, Pakistan, Surgical instruments cluster are examples of successful clusters in developing countries (UNIDO 2010). International Trade Theory- ECN 422, 2012/2013

  39. INTERNAL ECONOMIES OF SCALE AND COMPARATIVE ADVANTAGE International Trade Theory- ECN 422, 2012/2013

  40. INTERNAL ECONOMIES OF SCALE AND COMPARATIVE ADVANTAGE • It is indifferent which of the two nations specialize in the production of commodity X or commodity Y. Because economies of scale exists for both goods, the actual good in which a nation specializes depends upon the historical circumstances unique to each country. International Trade Theory- ECN 422, 2012/2013

  41. INTERNAL ECONOMIES OF SCALE AND COMPARATIVE ADVANTAGE • In the absence of trade each nation would produce both goods to satisfy domestic consumption of both goods. Prior to trade in the presence of economies of scale, there may be no difference in costs across nations. • If there are economies of scale, each industry will be at sub-optimal levels. If one nation produced only one good and the other nation produced only the other good, the cost of production would fall. Trade will allow each nation to specialize in the production of one of the goods, decreasing the cost and price of each good. International Trade Theory- ECN 422, 2012/2013

  42. INTERNAL ECONOMIES OF SCALE AND COMPARATIVE ADVANTAGE • Only as specialization proceeds will a comparative advantage develop. • Comparative advantage that is developed is an acquired comparative advantage, by contrast, comparative advantage in the H-O model exist prior to trade and specialization, and so might be called natural comparative advantage. International Trade Theory- ECN 422, 2012/2013

  43. INTERNAL ECONOMIES OF SCALE AND COMPARATIVE ADVANTAGE • H-O type trade (which is based on existing or natural comparative advantage) is likely to occur between nations that have very dissimilar resource bases e.g. trade between the developed countries of the North and developing countries of the South. • However, trade between countries need not depend upon country differences under the assumption of economies of scale. In fact, countries could be identical in all respects and yet find it advantageous to trade. International Trade Theory- ECN 422, 2012/2013

  44. INTERNAL ECONOMIES OF SCALE AND COMPARATIVE ADVANTAGE • Trade based on acquired comparative advantage is more likely to be intra-industry trade and can occur between countries that are similar. • For this reason, economies of scale models are often used to explain trade between countries like the US, Japan and the European Union as these countries tend to have similar technologies, endowments and to some extent similar preferences. • Under the H-O model and the Ricardian model these countries would have little reason to engage in trade. International Trade Theory- ECN 422, 2012/2013

  45. Homework • Read up on dynamic increasing returns to scale and the learning curve. International Trade Theory- ECN 422, 2012/2013

  46. Further reading • Salvatore (2007) , Chapter 6 International Trade Theory- ECN 422, 2012/2013

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