External Economies and International Trade
External economies drive a lot of trade both within and between countries. For example,
New York exports financial services to the rest of the United States, largely because external
economies in the investment industry have led to a concentration of financial firms in
Manhattan. Similarly, Britain exports financial services to the rest of Europe, largely
because those same external economies have led to a concentration of financial firms in
London. But what are the implications of this kind of trade? We’ll look first at the effects
of trade on output and prices; then at the determinants of the pattern of trade; and finally at
the effects of trade on welfare.
External Economies, Output, and Prices
Imagine, for a moment, that we live in a world in which it is impossible to trade buttons
across national borders. Assume, also, that there are just two countries in this world,
144 PART ONE International Trade Theory
China and the United States. Finally, assume that production of buttons is subject to
external economies of scale, which lead to a forward-falling supply curve for buttons
in each country. (As the box on page 147 shows, this is actually true of the button
industry.)
In that case, equilibrium in the world button industry would look like the situation
shown in Figure 7-2.5 In both China and the United States, equilibrium prices and output
would be at the point where the domestic supply curve intersects the domestic demand
curve. In the case shown in Figure 7-2, Chinese button prices in the absence of trade
would be lower than U.S. button prices.
Now suppose that we open up the potential for trade in buttons. What will happen?
It seems clear that the Chinese button industry will expand, while the U.S. button
industry will contract. And this process will feed on itself: As the Chinese industry’s output
rises, its costs will fall further; as the U.S. industry’s output falls, its costs will rise. In
the end, we can expect all button production to be concentrated in China.
The effects of this concentration are illustrated in Figure 7-3. Before the opening of
trade, China supplied only its own domestic button market. After trade, it supplies the
world market, producing buttons for both Chinese and U.S. consumers.
Notice the effects of this concentration of production on prices. Because China’s supply
curve is forward-falling, increased production as a result of trade leads to a button
price that is lower than the price before trade. And bear in mind that Chinese button prices
were lower than American button prices before trade. What this tells us is that trade leads
to button prices that are lower than the prices in either country before trade.
5In this exposition, we focus for simplicity on partial equilibrium in the market for buttons, rather than on general
equilibrium in the economy as a whole. It is possible, but much more complicated, to carry out the same
analysis in terms of general equilibrium.
PCHINA
PUS
DCHINA
ACCHINA
DUS
ACUS
Chinese button
production and
consumption
U.S. button
production and
consumption
Price, cost (per button) Price, cost (per button)
Figure 7-2
External Economies Before Trade
In the absence of trade, the price of buttons in China, PCHINA, is lower than the price of
buttons in the United States, PUS.
CHAPTER 7 External Economies of Scale and the International Location of Production 145
This is very different from the implications of models without increasing returns. In the
standard trade model, as developed in Chapter 6, relative prices converge as a result of
trade. If cloth is relatively cheap in Home and relatively expensive in Foreign before trade
opens, the effect of trade will be to raise cloth prices in Home and reduce them in Foreign.
In our button example, by contrast, the effect of trade is to reduce prices everywhere. The
reason for this difference is that when there are external economies of scale, international
trade makes it possible to concentrate world production in a single location, and therefore
to reduce costs by reaping the benefits of even stronger external economies.
External Economies and the Pattern of Trade
In our example of world trade in buttons, we simply assumed that the Chinese industry
started out with lower production costs than the American industry. What might lead to
such an initial advantage?
One possibility is comparative advantage—underlying differences in technology and
resources. For example, there’s a good reason that Silicon Valley is in California, rather than
in Mexico. High-technology industries require a highly skilled work force, and such a work
force is much easier to find in the United States, where 40 percent of the working-age population
is college-educated, than in Mexico, where the number is below 16 percent. Similarly,
there’s a good reason that world button production is concentrated in China, rather than in
Germany. Button production is a labor-intensive industry, which is best conducted in a country
where the average manufacturing worker earns less than a dollar an hour rather than in a
country where hourly compensation is among the highest in the world.
However, in industries characterized by external economies of scale, comparative
advantage usually provides only a partial explanation of the pattern of trade. It was probably
inevitable that most of the world’s buttons would be made in a relatively low-wage
country, but it’s not clear that this country necessarily had to be China, and it certainly
wasn’t necessary that production be concentrated in any particular location within China.
So what does determine the pattern of specialization and trade in industries with external
economies of scale? The answer, often, is historical contingency: Something gives a
particular location an initial advantage in a particular industry, and this advantage gets
Quantity
of buttons
produced,
demanded
DWORLD DCHINA
ACCHINA
P1
Q1 Q2
P2
Price, cost (per button)
Figure 7-3
Trade and Prices
When trade is opened, China
ends up producing buttons for the
world market, which consists both
of its own domestic market and of
the U.S. market. Output rises from
Q1 to Q2, leading to a fall in the
price of buttons from P1 to P2,
which is lower than the price of
buttons in either country before
trade.
146 PART ONE International Trade Theory
“locked in” by external economies of scale even after the circumstances that created the
initial advantage are no longer relevant. The financial centers in London and New York are
clear examples. London became Europe’s dominant financial center in the 19th century,
when Britain was the world’s leading economy and the center of a world-spanning empire.
It has retained that role even though the empire is long gone and modern Britain is only a
middle-sized economic power. New York became America’s financial center thanks to the
Erie Canal, which made it the nation’s leading port. It has retained that role even though
the canal currently is used mainly by recreational boats.
Often sheer accident plays a key role in creating an industrial concentration.
Geographers like to tell the tale of how a tufted bedspread, crafted as a wedding gift by a
19th-century teenager, gave rise to the cluster of carpet manufacturers around Dalton,
Georgia. Silicon Valley’s existence may owe a lot to the fact that a couple of Stanford
graduates named Hewlett and Packard decided to start a business in a garage in that area.
Bangalore might not be what it is today if vagaries of local politics had not led Texas
Instruments to choose, back in 1984, to locate an investment project there rather than in
another Indian city.
One consequence of the role of history in determining industrial location is that industries
aren’t always located in the “right” place: Once a country has established an advantage
in an industry, it may retain that advantage even if some other country could potentially
produce the goods more cheaply.
Figure 7-4, which shows the cost of producing buttons as a function of the number of
buttons produced annually, illustrates this point. Two countries are shown: China and
Vietnam. The Chinese cost of producing a button is shown as ACCHINA, the Vietnamese
cost as ACVIETNAM. DWORLD represents the world demand for buttons, which we assume
can be satisfied either by China or by Vietnam.
Suppose that the economies of scale in button production are entirely external to firms,
and that since there are no economies of scale at the level of the firm, the button industry
in each country consists of many small, perfectly competitive firms. Competition therefore
drives the price of buttons down to its average cost.
Price, cost (per button)
C0
P1
Q1
1
2
DWORLD
ACCHINA
ACVIETNAM
Quantity of buttons
produced and demanded
Figure 7-4
The Importance of Established
Advantage
The average cost curve for
Vietnam, ACVIETNAM, lies below
the average cost curve for China,
ACCHINA. Thus Vietnam could
potentially supply the world market
more cheaply than China. If
the Chinese industry gets established
first, however, it may be
able to sell buttons at the price ,
which is below the cost that an
individual Vietnamese firm would
face if it began production on its
own. So a pattern of specialization
established by historical accident
may persist even when new
producers could potentially have
lower costs.
C0
P1
CHAPTER 7 External Economies of Scale and the International Location of Production 147
We assume that the Vietnamese cost curve lies below the Chinese curve because, say,
Vietnamese wages are lower than Chinese wages. This means that at any given level of
production, Vietnam could manufacture buttons more cheaply than China. One might
hope that this would always imply that Vietnam will in fact supply the world market.
Unfortunately, this need not be the case. Suppose that China, for historical reasons, establishes
its button industry first. Then, initially, world button equilibrium will be established
at point 1 in Figure 7-4, with Chinese production of units per year and a price of .
Now introduce the possibility of Vietnamese production. If Vietnam could take over the
world market, the equilibrium would move to point 2. However, if there is no initial
Vietnamese production , any individual Vietnamese firm considering manufacture
of buttons will face a cost of production of . As we have drawn it, this cost is above
the price at which the established Chinese industry can produce buttons. So although the
Vietnamese industry could potentially make buttons more cheaply than China’s industry,
China’s head start enables it to hold on to the industry.
As this example shows, external economies potentially give a strong role to historical
accident in determining who produces what, and may allow established patterns of specialization
to persist even when they run counter to comparative advantage.
Trade and Welfare with External Economies
In general, we can presume that external economies of scale lead to gains from trade over
and above those from comparative advantage. The world is more efficient and thus richer
because international trade allows nations to specialize in different industries and thus
reap the gains from external economies as well as from comparative advantage.
C0
1Q = 02
Q1 P1
Holding the World Together
If you are reading this while fully clothed, the odds
are that crucial parts of your outfit—specifically, the
parts that protect you from a wardrobe malfunction—
came from the Chinese town of Qiaotou, which produces
60 percent of the world’s buttons and a large
proportion of its zippers, too.
The Qiaotou fastener industry fits the classic pattern
of geographical concentration driven by external
economies of scale. The industry’s origins lie in
historical accident: In 1980 three brothers spotted
some discarded buttons in the street, retrieved and
sold them, then realized there was money to be
made in the button business. There clearly aren’t
strong internal economies of scale: The town’s button
and zipper production is carried out by hundreds
of small, family-owned firms. Yet there are clearly
advantages to each of these small producers in operating
in close proximity to the others.
Qiaotou isn’t unique. As a fascinating article on
the town’s industry* put it, in China, “many small
towns, not even worthy of a speck on most maps, have
also become world-beaters by focusing on labourintensive
niches. . . . Start at the toothbrush town of
Hang Ji, pass the tie mecca of Sheng Zhou, head east
to the home of cheap cigarette lighters in Zhang Qi,
slip down the coast to the giant shoe factories of Wen
Ling, then move back inland to Yiwu, which not only
makes more socks than anywhere else on earth, but
also sells almost everything under the sun.”
At a broad level, China’s role as a huge exporter
of labor-intensive products reflects comparative
advantage: China is clearly labor-abundant compared
with advanced economies. Many of those
labor-intensive goods, however, are produced by
highly localized industries, which benefit strongly
from external economies of scale.
*“The Tiger’s Teeth,” The Guardian, May 25, 2005.
148 PART ONE International Trade Theory
However, there are a few possible qualifications to this presumption. As we saw in
Figure 7-4, the importance of established advantage means that there is no guarantee that
the right country will produce a good subject to external economies. In fact, it is possible
that trade based on external economies may actually leave a country worse off than it
would have been in the absence of trade.
An example of how a country can actually be worse off with trade than without is
shown in Figure 7-5. In this example, we imagine that Thailand and Switzerland could
both manufacture watches, that Thailand could make them more cheaply, but that
Switzerland has gotten there first. is the world demand for watches, and, given
that Switzerland produces the watches, the equilibrium is at point 1. However, we now add
to the figure the Thai demand for watches, . If no trade in watches were allowed and
Thailand were forced to be self-sufficient, then the Thai equilibrium would be at point 2.
Because of its lower average cost curve, the price of Thai-made watches at point 2, , is
actually lower than the price of Swiss-made watches at point 1, .
We have presented a situation in which the price of a good that Thailand imports would
actually be lower if there were no trade and the country were forced to produce the good
for itself. Clearly in this situation, trade leaves the country worse off than it would be in
the absence of trade.
There is an incentive in this case for Thailand to protect its potential watch industry
from foreign competition. Before concluding that this justifies protectionism, however, we
should note that in practice, identifying cases like that shown in Figure 7-5 is far from
easy. Indeed, as we will emphasize in Chapters 10 and 11, the difficulty of identifying
external economies in practice is one of the main arguments against activist government
policies toward trade.
It is also worth pointing out that while external economies can sometimes lead to disadvantageous
patterns of specialization and trade, it’s virtually certain that it is still to the
benefit of the world economy to take advantage of the gains from concentrating industries.
Canada might be better off if Silicon Valley were near Toronto instead of San Francisco;
Germany might be better off if the City (London’s financial district, which, along with
Wall Street, dominates world financial markets) could be moved to Frankfurt. But overall,
it’s better for the world that each of these industries be concentrated somewhere.
P1
P2
DTHAI
DWORLD
Price, cost (per watch)
C0
P1
1
2
DWORLD
ACSWISS
ACTHAI
Quantity of watches
produced and demanded
P2
DTHAI
Figure 7-5
External Economies and Losses
from Trade
When there are external
economies, trade can potentially
leave a country worse off than it
would be in the absence of trade.
In this example, Thailand imports
watches from Switzerland, which
is able to supply the world market
at a price low
enough to block entry by Thai
producers, who must initially produce
the watches at cost . Yet if
Thailand were to block all trade in
watches, it would be able to supply
its domestic market at
the lower price, P2.
1DTHAI2
C0
1P11DWORLD 2 2
Dynamic Increasing Returns
Some of the most important external economies probably arise from the accumulation of
knowledge. When an individual firm improves its products or production techniques
through experience, other firms are likely to imitate the firm and benefit from its knowledge.
This spillover of knowledge gives rise to a situation in which the production costs of
individual firms fall as the industry as a whole accumulates experience.
Notice that external economies arising from the accumulation of knowledge differ
somewhat from the external economies considered so far, in which industry costs depend
on current output. In this alternative situation, industry costs depend on experience, usually
measured by the cumulative output of the industry to date. For example, the cost of
producing a ton of steel might depend negatively on the total number of tons of steel produced
by a country since the industry began. This kind of relationship is often summarized
by a learning curve that relates unit cost to cumulative output. Such learning curves are
illustrated in Figure 7-6. They are downward sloping because of the effect on costs of the
experience gained through production. When costs fall with cumulative production over
time rather than with the current rate of production, this is referred to as a case of dynamic
increasing returns.
Like ordinary external economies, dynamic external economies can lock in an initial
advantage or head start in an industry. In Figure 7-6, the learning curve L is that of a country
that pioneered an industry, while is that of a country that has lower input costs—say,
lower wages—but less production experience. Provided that the first country has a sufficiently
large head start, the potentially lower costs of the second country may not allow
that second country to enter the market. For example, suppose the first country has a
cumulative output of units, giving it a unit cost of , while the second country has
never produced the good. Then the second country will have an initial start-up cost, ,
that is higher than the current unit cost, , of the established industry.
Dynamic scale economies, like external economies at a point in time, potentially justify
protectionism. Suppose that a country could have low enough costs to produce a good for
export if it had more production experience, but that given the current lack of experience,
the good cannot be produced competitively. Such a country might increase its long-term
welfare either by encouraging the production of the good by a subsidy or by protecting it
from foreign competition until the industry can stand on its own feet. The argument for
C1
C*0
QL C1
L*
CHAPTER 7 External Economies of Scale and the International Location of Production 149
Unit cost
C1
QL
L
L*
Cumulative
output
C0*
Figure 7-6
The Learning Curve
The learning curve shows that unit
cost is lower the greater the
cumulative output of a country’s
industry to date. A country that
has extensive experience in an
industry (L) may have lower unit
cost than a country with little or
no experience, even if that second
country’s learning curve (L*) is
lower—for example, because of
lower wages.
150 PART ONE International Trade Theory
temporary protection of industries to enable them to gain experience is known as the
infant industry argument; this argument has played an important role in debates over the
role of trade policy in economic development. We will discuss the infant industry argument
at greater length in Chapter 10, but for now we simply note that situations like that
illustrated in Figure 7-6 are just as hard to identify in practice as those involving nondynamic
increasing returns.
External economies drive a lot of trade both within and between countries. For example,
New York exports financial services to the rest of the United States, largely because external
economies in the investment industry have led to a concentration of financial firms in
Manhattan. Similarly, Britain exports financial services to the rest of Europe, largely
because those same external economies have led to a concentration of financial firms in
London. But what are the implications of this kind of trade? We’ll look first at the effects
of trade on output and prices; then at the determinants of the pattern of trade; and finally at
the effects of trade on welfare.
External Economies, Output, and Prices
Imagine, for a moment, that we live in a world in which it is impossible to trade buttons
across national borders. Assume, also, that there are just two countries in this world,
144 PART ONE International Trade Theory
China and the United States. Finally, assume that production of buttons is subject to
external economies of scale, which lead to a forward-falling supply curve for buttons
in each country. (As the box on page 147 shows, this is actually true of the button
industry.)
In that case, equilibrium in the world button industry would look like the situation
shown in Figure 7-2.5 In both China and the United States, equilibrium prices and output
would be at the point where the domestic supply curve intersects the domestic demand
curve. In the case shown in Figure 7-2, Chinese button prices in the absence of trade
would be lower than U.S. button prices.
Now suppose that we open up the potential for trade in buttons. What will happen?
It seems clear that the Chinese button industry will expand, while the U.S. button
industry will contract. And this process will feed on itself: As the Chinese industry’s output
rises, its costs will fall further; as the U.S. industry’s output falls, its costs will rise. In
the end, we can expect all button production to be concentrated in China.
The effects of this concentration are illustrated in Figure 7-3. Before the opening of
trade, China supplied only its own domestic button market. After trade, it supplies the
world market, producing buttons for both Chinese and U.S. consumers.
Notice the effects of this concentration of production on prices. Because China’s supply
curve is forward-falling, increased production as a result of trade leads to a button
price that is lower than the price before trade. And bear in mind that Chinese button prices
were lower than American button prices before trade. What this tells us is that trade leads
to button prices that are lower than the prices in either country before trade.
5In this exposition, we focus for simplicity on partial equilibrium in the market for buttons, rather than on general
equilibrium in the economy as a whole. It is possible, but much more complicated, to carry out the same
analysis in terms of general equilibrium.
PCHINA
PUS
DCHINA
ACCHINA
DUS
ACUS
Chinese button
production and
consumption
U.S. button
production and
consumption
Price, cost (per button) Price, cost (per button)
Figure 7-2
External Economies Before Trade
In the absence of trade, the price of buttons in China, PCHINA, is lower than the price of
buttons in the United States, PUS.
CHAPTER 7 External Economies of Scale and the International Location of Production 145
This is very different from the implications of models without increasing returns. In the
standard trade model, as developed in Chapter 6, relative prices converge as a result of
trade. If cloth is relatively cheap in Home and relatively expensive in Foreign before trade
opens, the effect of trade will be to raise cloth prices in Home and reduce them in Foreign.
In our button example, by contrast, the effect of trade is to reduce prices everywhere. The
reason for this difference is that when there are external economies of scale, international
trade makes it possible to concentrate world production in a single location, and therefore
to reduce costs by reaping the benefits of even stronger external economies.
External Economies and the Pattern of Trade
In our example of world trade in buttons, we simply assumed that the Chinese industry
started out with lower production costs than the American industry. What might lead to
such an initial advantage?
One possibility is comparative advantage—underlying differences in technology and
resources. For example, there’s a good reason that Silicon Valley is in California, rather than
in Mexico. High-technology industries require a highly skilled work force, and such a work
force is much easier to find in the United States, where 40 percent of the working-age population
is college-educated, than in Mexico, where the number is below 16 percent. Similarly,
there’s a good reason that world button production is concentrated in China, rather than in
Germany. Button production is a labor-intensive industry, which is best conducted in a country
where the average manufacturing worker earns less than a dollar an hour rather than in a
country where hourly compensation is among the highest in the world.
However, in industries characterized by external economies of scale, comparative
advantage usually provides only a partial explanation of the pattern of trade. It was probably
inevitable that most of the world’s buttons would be made in a relatively low-wage
country, but it’s not clear that this country necessarily had to be China, and it certainly
wasn’t necessary that production be concentrated in any particular location within China.
So what does determine the pattern of specialization and trade in industries with external
economies of scale? The answer, often, is historical contingency: Something gives a
particular location an initial advantage in a particular industry, and this advantage gets
Quantity
of buttons
produced,
demanded
DWORLD DCHINA
ACCHINA
P1
Q1 Q2
P2
Price, cost (per button)
Figure 7-3
Trade and Prices
When trade is opened, China
ends up producing buttons for the
world market, which consists both
of its own domestic market and of
the U.S. market. Output rises from
Q1 to Q2, leading to a fall in the
price of buttons from P1 to P2,
which is lower than the price of
buttons in either country before
trade.
146 PART ONE International Trade Theory
“locked in” by external economies of scale even after the circumstances that created the
initial advantage are no longer relevant. The financial centers in London and New York are
clear examples. London became Europe’s dominant financial center in the 19th century,
when Britain was the world’s leading economy and the center of a world-spanning empire.
It has retained that role even though the empire is long gone and modern Britain is only a
middle-sized economic power. New York became America’s financial center thanks to the
Erie Canal, which made it the nation’s leading port. It has retained that role even though
the canal currently is used mainly by recreational boats.
Often sheer accident plays a key role in creating an industrial concentration.
Geographers like to tell the tale of how a tufted bedspread, crafted as a wedding gift by a
19th-century teenager, gave rise to the cluster of carpet manufacturers around Dalton,
Georgia. Silicon Valley’s existence may owe a lot to the fact that a couple of Stanford
graduates named Hewlett and Packard decided to start a business in a garage in that area.
Bangalore might not be what it is today if vagaries of local politics had not led Texas
Instruments to choose, back in 1984, to locate an investment project there rather than in
another Indian city.
One consequence of the role of history in determining industrial location is that industries
aren’t always located in the “right” place: Once a country has established an advantage
in an industry, it may retain that advantage even if some other country could potentially
produce the goods more cheaply.
Figure 7-4, which shows the cost of producing buttons as a function of the number of
buttons produced annually, illustrates this point. Two countries are shown: China and
Vietnam. The Chinese cost of producing a button is shown as ACCHINA, the Vietnamese
cost as ACVIETNAM. DWORLD represents the world demand for buttons, which we assume
can be satisfied either by China or by Vietnam.
Suppose that the economies of scale in button production are entirely external to firms,
and that since there are no economies of scale at the level of the firm, the button industry
in each country consists of many small, perfectly competitive firms. Competition therefore
drives the price of buttons down to its average cost.
Price, cost (per button)
C0
P1
Q1
1
2
DWORLD
ACCHINA
ACVIETNAM
Quantity of buttons
produced and demanded
Figure 7-4
The Importance of Established
Advantage
The average cost curve for
Vietnam, ACVIETNAM, lies below
the average cost curve for China,
ACCHINA. Thus Vietnam could
potentially supply the world market
more cheaply than China. If
the Chinese industry gets established
first, however, it may be
able to sell buttons at the price ,
which is below the cost that an
individual Vietnamese firm would
face if it began production on its
own. So a pattern of specialization
established by historical accident
may persist even when new
producers could potentially have
lower costs.
C0
P1
CHAPTER 7 External Economies of Scale and the International Location of Production 147
We assume that the Vietnamese cost curve lies below the Chinese curve because, say,
Vietnamese wages are lower than Chinese wages. This means that at any given level of
production, Vietnam could manufacture buttons more cheaply than China. One might
hope that this would always imply that Vietnam will in fact supply the world market.
Unfortunately, this need not be the case. Suppose that China, for historical reasons, establishes
its button industry first. Then, initially, world button equilibrium will be established
at point 1 in Figure 7-4, with Chinese production of units per year and a price of .
Now introduce the possibility of Vietnamese production. If Vietnam could take over the
world market, the equilibrium would move to point 2. However, if there is no initial
Vietnamese production , any individual Vietnamese firm considering manufacture
of buttons will face a cost of production of . As we have drawn it, this cost is above
the price at which the established Chinese industry can produce buttons. So although the
Vietnamese industry could potentially make buttons more cheaply than China’s industry,
China’s head start enables it to hold on to the industry.
As this example shows, external economies potentially give a strong role to historical
accident in determining who produces what, and may allow established patterns of specialization
to persist even when they run counter to comparative advantage.
Trade and Welfare with External Economies
In general, we can presume that external economies of scale lead to gains from trade over
and above those from comparative advantage. The world is more efficient and thus richer
because international trade allows nations to specialize in different industries and thus
reap the gains from external economies as well as from comparative advantage.
C0
1Q = 02
Q1 P1
Holding the World Together
If you are reading this while fully clothed, the odds
are that crucial parts of your outfit—specifically, the
parts that protect you from a wardrobe malfunction—
came from the Chinese town of Qiaotou, which produces
60 percent of the world’s buttons and a large
proportion of its zippers, too.
The Qiaotou fastener industry fits the classic pattern
of geographical concentration driven by external
economies of scale. The industry’s origins lie in
historical accident: In 1980 three brothers spotted
some discarded buttons in the street, retrieved and
sold them, then realized there was money to be
made in the button business. There clearly aren’t
strong internal economies of scale: The town’s button
and zipper production is carried out by hundreds
of small, family-owned firms. Yet there are clearly
advantages to each of these small producers in operating
in close proximity to the others.
Qiaotou isn’t unique. As a fascinating article on
the town’s industry* put it, in China, “many small
towns, not even worthy of a speck on most maps, have
also become world-beaters by focusing on labourintensive
niches. . . . Start at the toothbrush town of
Hang Ji, pass the tie mecca of Sheng Zhou, head east
to the home of cheap cigarette lighters in Zhang Qi,
slip down the coast to the giant shoe factories of Wen
Ling, then move back inland to Yiwu, which not only
makes more socks than anywhere else on earth, but
also sells almost everything under the sun.”
At a broad level, China’s role as a huge exporter
of labor-intensive products reflects comparative
advantage: China is clearly labor-abundant compared
with advanced economies. Many of those
labor-intensive goods, however, are produced by
highly localized industries, which benefit strongly
from external economies of scale.
*“The Tiger’s Teeth,” The Guardian, May 25, 2005.
148 PART ONE International Trade Theory
However, there are a few possible qualifications to this presumption. As we saw in
Figure 7-4, the importance of established advantage means that there is no guarantee that
the right country will produce a good subject to external economies. In fact, it is possible
that trade based on external economies may actually leave a country worse off than it
would have been in the absence of trade.
An example of how a country can actually be worse off with trade than without is
shown in Figure 7-5. In this example, we imagine that Thailand and Switzerland could
both manufacture watches, that Thailand could make them more cheaply, but that
Switzerland has gotten there first. is the world demand for watches, and, given
that Switzerland produces the watches, the equilibrium is at point 1. However, we now add
to the figure the Thai demand for watches, . If no trade in watches were allowed and
Thailand were forced to be self-sufficient, then the Thai equilibrium would be at point 2.
Because of its lower average cost curve, the price of Thai-made watches at point 2, , is
actually lower than the price of Swiss-made watches at point 1, .
We have presented a situation in which the price of a good that Thailand imports would
actually be lower if there were no trade and the country were forced to produce the good
for itself. Clearly in this situation, trade leaves the country worse off than it would be in
the absence of trade.
There is an incentive in this case for Thailand to protect its potential watch industry
from foreign competition. Before concluding that this justifies protectionism, however, we
should note that in practice, identifying cases like that shown in Figure 7-5 is far from
easy. Indeed, as we will emphasize in Chapters 10 and 11, the difficulty of identifying
external economies in practice is one of the main arguments against activist government
policies toward trade.
It is also worth pointing out that while external economies can sometimes lead to disadvantageous
patterns of specialization and trade, it’s virtually certain that it is still to the
benefit of the world economy to take advantage of the gains from concentrating industries.
Canada might be better off if Silicon Valley were near Toronto instead of San Francisco;
Germany might be better off if the City (London’s financial district, which, along with
Wall Street, dominates world financial markets) could be moved to Frankfurt. But overall,
it’s better for the world that each of these industries be concentrated somewhere.
P1
P2
DTHAI
DWORLD
Price, cost (per watch)
C0
P1
1
2
DWORLD
ACSWISS
ACTHAI
Quantity of watches
produced and demanded
P2
DTHAI
Figure 7-5
External Economies and Losses
from Trade
When there are external
economies, trade can potentially
leave a country worse off than it
would be in the absence of trade.
In this example, Thailand imports
watches from Switzerland, which
is able to supply the world market
at a price low
enough to block entry by Thai
producers, who must initially produce
the watches at cost . Yet if
Thailand were to block all trade in
watches, it would be able to supply
its domestic market at
the lower price, P2.
1DTHAI2
C0
1P11DWORLD 2 2
Dynamic Increasing Returns
Some of the most important external economies probably arise from the accumulation of
knowledge. When an individual firm improves its products or production techniques
through experience, other firms are likely to imitate the firm and benefit from its knowledge.
This spillover of knowledge gives rise to a situation in which the production costs of
individual firms fall as the industry as a whole accumulates experience.
Notice that external economies arising from the accumulation of knowledge differ
somewhat from the external economies considered so far, in which industry costs depend
on current output. In this alternative situation, industry costs depend on experience, usually
measured by the cumulative output of the industry to date. For example, the cost of
producing a ton of steel might depend negatively on the total number of tons of steel produced
by a country since the industry began. This kind of relationship is often summarized
by a learning curve that relates unit cost to cumulative output. Such learning curves are
illustrated in Figure 7-6. They are downward sloping because of the effect on costs of the
experience gained through production. When costs fall with cumulative production over
time rather than with the current rate of production, this is referred to as a case of dynamic
increasing returns.
Like ordinary external economies, dynamic external economies can lock in an initial
advantage or head start in an industry. In Figure 7-6, the learning curve L is that of a country
that pioneered an industry, while is that of a country that has lower input costs—say,
lower wages—but less production experience. Provided that the first country has a sufficiently
large head start, the potentially lower costs of the second country may not allow
that second country to enter the market. For example, suppose the first country has a
cumulative output of units, giving it a unit cost of , while the second country has
never produced the good. Then the second country will have an initial start-up cost, ,
that is higher than the current unit cost, , of the established industry.
Dynamic scale economies, like external economies at a point in time, potentially justify
protectionism. Suppose that a country could have low enough costs to produce a good for
export if it had more production experience, but that given the current lack of experience,
the good cannot be produced competitively. Such a country might increase its long-term
welfare either by encouraging the production of the good by a subsidy or by protecting it
from foreign competition until the industry can stand on its own feet. The argument for
C1
C*0
QL C1
L*
CHAPTER 7 External Economies of Scale and the International Location of Production 149
Unit cost
C1
QL
L
L*
Cumulative
output
C0*
Figure 7-6
The Learning Curve
The learning curve shows that unit
cost is lower the greater the
cumulative output of a country’s
industry to date. A country that
has extensive experience in an
industry (L) may have lower unit
cost than a country with little or
no experience, even if that second
country’s learning curve (L*) is
lower—for example, because of
lower wages.
150 PART ONE International Trade Theory
temporary protection of industries to enable them to gain experience is known as the
infant industry argument; this argument has played an important role in debates over the
role of trade policy in economic development. We will discuss the infant industry argument
at greater length in Chapter 10, but for now we simply note that situations like that
illustrated in Figure 7-6 are just as hard to identify in practice as those involving nondynamic
increasing returns.
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