Economies of Scale and Market Structure
In the example in Table 7-1, we represented economies of scale by assuming that the
labor input per unit of production is smaller the more units produced; this implies that at
a given wage rate per hour, the average cost of production falls as output rises. We did
not say how this production increase was achieved—whether existing firms simply
produced more, or whether there was instead an increase in the number of firms. To
analyze the effects of economies of scale on market structure, however, one must be
clear about what kind of production increase is necessary to reduce average cost.
External economies of scale occur when the cost per unit depends on the size of the
industry but not necessarily on the size of any one firm. Internal economies of scale
occur when the cost per unit depends on the size of an individual firm but not necessarily
on that of the industry.
The distinction between external and internal economies can be illustrated with a hypothetical
example. Imagine an industry that initially consists of 10 firms, each producing
100 widgets, for a total industry production of 1,000 widgets. Now consider two cases.
First, suppose the industry were to double in size, so that it now consists of 20 firms, each
one still producing 100 widgets. It is possible that the costs of each firm will fall as a result
of the increased size of the industry; for example, a bigger industry may allow more efficient
provision of specialized services or machinery. If this is the case, the industry
exhibits external economies of scale. That is, the efficiency of firms is increased by having
a larger industry, even though each firm is the same size as before.
Second, suppose the industry’s output is held constant at 1,000 widgets, but that the
number of firms is cut in half so that each of the remaining five firms produces 200 widgets.
If the costs of production fall in this case, then there are internal economies of scale: A firm
is more efficient if its output is larger.
External and internal economies of scale have different implications for the structure of
industries. An industry where economies of scale are purely external (that is, where there
are no advantages to large firms) will typically consist of many small firms and be perfectly
competitive. Internal economies of scale, by contrast, give large firms a cost advantage
over small firms and lead to an imperfectly competitive market structure.
140 PART ONE International Trade Theory
Both external and internal economies of scale are important causes of international
trade. Because they have different implications for market structure, however, it is difficult
to discuss both types of scale economy–based trade in the same model. We will therefore
deal with them one at a time. In this chapter we focus on external economies, in the next
on internal economies.
In the example in Table 7-1, we represented economies of scale by assuming that the
labor input per unit of production is smaller the more units produced; this implies that at
a given wage rate per hour, the average cost of production falls as output rises. We did
not say how this production increase was achieved—whether existing firms simply
produced more, or whether there was instead an increase in the number of firms. To
analyze the effects of economies of scale on market structure, however, one must be
clear about what kind of production increase is necessary to reduce average cost.
External economies of scale occur when the cost per unit depends on the size of the
industry but not necessarily on the size of any one firm. Internal economies of scale
occur when the cost per unit depends on the size of an individual firm but not necessarily
on that of the industry.
The distinction between external and internal economies can be illustrated with a hypothetical
example. Imagine an industry that initially consists of 10 firms, each producing
100 widgets, for a total industry production of 1,000 widgets. Now consider two cases.
First, suppose the industry were to double in size, so that it now consists of 20 firms, each
one still producing 100 widgets. It is possible that the costs of each firm will fall as a result
of the increased size of the industry; for example, a bigger industry may allow more efficient
provision of specialized services or machinery. If this is the case, the industry
exhibits external economies of scale. That is, the efficiency of firms is increased by having
a larger industry, even though each firm is the same size as before.
Second, suppose the industry’s output is held constant at 1,000 widgets, but that the
number of firms is cut in half so that each of the remaining five firms produces 200 widgets.
If the costs of production fall in this case, then there are internal economies of scale: A firm
is more efficient if its output is larger.
External and internal economies of scale have different implications for the structure of
industries. An industry where economies of scale are purely external (that is, where there
are no advantages to large firms) will typically consist of many small firms and be perfectly
competitive. Internal economies of scale, by contrast, give large firms a cost advantage
over small firms and lead to an imperfectly competitive market structure.
140 PART ONE International Trade Theory
Both external and internal economies of scale are important causes of international
trade. Because they have different implications for market structure, however, it is difficult
to discuss both types of scale economy–based trade in the same model. We will therefore
deal with them one at a time. In this chapter we focus on external economies, in the next
on internal economies.
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