External Economies of Scale and the
International Location of Production
In Chapter 3 we pointed out that there are two reasons why countries
specialize and trade. First, countries differ either in their resources or in their
technology and specialize in the things they do relatively well; second,
economies of scale (or increasing returns) make it advantageous for each country
to specialize in the production of only a limited range of goods and services. The
past four chapters considered models in which all trade is based on comparative
advantage; that is, differences between countries are the only reason for trade.
This chapter introduces the role of economies of scale.
The analysis of trade based on economies of scale presents certain problems
that we have avoided so far. Up to now we have assumed that markets are perfectly
competitive, so that all monopoly profits are always competed away.
When there are increasing returns, however, large firms may have an advantage
over small ones, so that markets tend to be dominated by one firm (monopoly)
or, more often, by a few firms (oligopoly). If this happens, our analysis of trade
has to take into account the effects of imperfect competition.
However, economies of scale need not lead to imperfect competition if they
take the form of external economies, which apply at the level of the industry
rather than at the level of the individual firm. In this chapter we will focus on the
role of such external economies of scale in trade, reserving the discussion of
internal economies for the next chapter.
LEARNING GOALS
After reading this chapter, you will be able to:
• Recognize why international trade often occurs from increasing returns to
scale.
• Understand the differences between internal and external economies of
scale.
• Discuss the sources of external economies.
• Discuss the roles of external economies and knowledge spillovers in shaping
comparative advantage and international trade patterns.
138 PART ONE International Trade Theory
TABLE 7-1 Relationship of Input to Output for a Hypothetical Industry
Output Total Labor Input Average Labor Input
5 10 2
10 15 1.5
15 20 1.333333
20 25 1.25
25 30 1.2
30 35 1.166667
Economies of Scale and International Trade: An Overview
The models of comparative advantage already presented were based on the assumption
of constant returns to scale. That is, we assumed that if inputs to an industry were
doubled, industry output would double as well. In practice, however, many industries
are characterized by economies of scale (also referred to as increasing returns), so that
production is more efficient the larger the scale at which it takes place. Where there are
economies of scale, doubling the inputs to an industry will more than double the industry’s
production.
A simple example can help convey the significance of economies of scale for international
trade. Table 7-1 shows the relationship between input and output of a hypothetical
industry. Widgets are produced using only one input, labor; the table shows how the
amount of labor required depends on the number of widgets produced. To produce 10
widgets, for example, requires 15 hours of labor, while to produce 25 widgets requires 30
hours. The presence of economies of scale may be seen from the fact that doubling the
input of labor from 15 to 30 more than doubles the industry’s output—in fact, output
increases by a factor of 2.5. Equivalently, the existence of economies of scale may be seen
by looking at the average amount of labor used to produce each unit of output: If output is
only 5 widgets, the average labor input per widget is 2 hours, while if output is 25 units,
the average labor input falls to 1.2 hours.
We can use this example to see why economies of scale provide an incentive for international
trade. Imagine a world consisting of two countries, the United States and Britain,
both of which have the same technology for producing widgets. Suppose that each country
initially produces 10 widgets. According to the table, this requires 15 hours of labor in
each country, so in the world as a whole, 30 hours of labor produce 20 widgets. But now
suppose that we concentrate world production of widgets in one country, say the United
States, and let the United States employ 30 hours of labor in the widget industry. In a single
country these 30 hours of labor can produce 25 widgets. So by concentrating production
of widgets in the United States, the world economy can use the same amount of labor
to produce 25 percent more widgets.
But where does the United States find the extra labor to produce widgets, and what happens
to the labor that was employed in the British widget industry? To get the labor to
expand its production of some goods, the United States must decrease or abandon the production
of others; these goods will then be produced in Britain instead, using the labor formerly
employed in the industries whose production has expanded in the United States.
Imagine that there are many goods subject to economies of scale in production, and give
them numbers 1, 2, 3, . . . . To take advantage of economies of scale, each of the countries
must concentrate on producing only a limited number of goods. Thus, for example, the
United States might produce goods 1, 3, 5, and so on, while Britain produces 2, 4, 6, and
so on. If each country produces only some of the goods, then each good can be produced
CHAPTER 7 External Economies of Scale and the International Location of Production 139
at a larger scale than would be the case if each country tried to produce everything. As a
result, the world economy can produce more of each good.
How does international trade enter the story? Consumers in each country will still want
to consume a variety of goods. Suppose that industry 1 ends up in the United States and
industry 2 ends up in Britain; then American consumers of good 2 will have to buy goods
imported from Britain, while British consumers of good 1 will have to import it from the
United States. International trade plays a crucial role: It makes it possible for each country
to produce a restricted range of goods and to take advantage of economies of scale without
sacrificing variety in consumption. Indeed, as we will see in Chapter 8, international trade
typically leads to an increase in the variety of goods available.
Our example, then, suggests how mutually beneficial trade can arise as a result of
economies of scale. Each country specializes in producing a limited range of products,
which enables it to produce these goods more efficiently than if it tried to produce everything
for itself; these specialized economies then trade with each other to be able to consume
the full range of goods.
Unfortunately, to go from this suggestive story to an explicit model of trade based on
economies of scale is not that simple. The reason is that economies of scale may lead to a
market structure other than that of perfect competition, and we need to be careful about
analyzing this market structure.
International Location of Production
In Chapter 3 we pointed out that there are two reasons why countries
specialize and trade. First, countries differ either in their resources or in their
technology and specialize in the things they do relatively well; second,
economies of scale (or increasing returns) make it advantageous for each country
to specialize in the production of only a limited range of goods and services. The
past four chapters considered models in which all trade is based on comparative
advantage; that is, differences between countries are the only reason for trade.
This chapter introduces the role of economies of scale.
The analysis of trade based on economies of scale presents certain problems
that we have avoided so far. Up to now we have assumed that markets are perfectly
competitive, so that all monopoly profits are always competed away.
When there are increasing returns, however, large firms may have an advantage
over small ones, so that markets tend to be dominated by one firm (monopoly)
or, more often, by a few firms (oligopoly). If this happens, our analysis of trade
has to take into account the effects of imperfect competition.
However, economies of scale need not lead to imperfect competition if they
take the form of external economies, which apply at the level of the industry
rather than at the level of the individual firm. In this chapter we will focus on the
role of such external economies of scale in trade, reserving the discussion of
internal economies for the next chapter.
LEARNING GOALS
After reading this chapter, you will be able to:
• Recognize why international trade often occurs from increasing returns to
scale.
• Understand the differences between internal and external economies of
scale.
• Discuss the sources of external economies.
• Discuss the roles of external economies and knowledge spillovers in shaping
comparative advantage and international trade patterns.
138 PART ONE International Trade Theory
TABLE 7-1 Relationship of Input to Output for a Hypothetical Industry
Output Total Labor Input Average Labor Input
5 10 2
10 15 1.5
15 20 1.333333
20 25 1.25
25 30 1.2
30 35 1.166667
Economies of Scale and International Trade: An Overview
The models of comparative advantage already presented were based on the assumption
of constant returns to scale. That is, we assumed that if inputs to an industry were
doubled, industry output would double as well. In practice, however, many industries
are characterized by economies of scale (also referred to as increasing returns), so that
production is more efficient the larger the scale at which it takes place. Where there are
economies of scale, doubling the inputs to an industry will more than double the industry’s
production.
A simple example can help convey the significance of economies of scale for international
trade. Table 7-1 shows the relationship between input and output of a hypothetical
industry. Widgets are produced using only one input, labor; the table shows how the
amount of labor required depends on the number of widgets produced. To produce 10
widgets, for example, requires 15 hours of labor, while to produce 25 widgets requires 30
hours. The presence of economies of scale may be seen from the fact that doubling the
input of labor from 15 to 30 more than doubles the industry’s output—in fact, output
increases by a factor of 2.5. Equivalently, the existence of economies of scale may be seen
by looking at the average amount of labor used to produce each unit of output: If output is
only 5 widgets, the average labor input per widget is 2 hours, while if output is 25 units,
the average labor input falls to 1.2 hours.
We can use this example to see why economies of scale provide an incentive for international
trade. Imagine a world consisting of two countries, the United States and Britain,
both of which have the same technology for producing widgets. Suppose that each country
initially produces 10 widgets. According to the table, this requires 15 hours of labor in
each country, so in the world as a whole, 30 hours of labor produce 20 widgets. But now
suppose that we concentrate world production of widgets in one country, say the United
States, and let the United States employ 30 hours of labor in the widget industry. In a single
country these 30 hours of labor can produce 25 widgets. So by concentrating production
of widgets in the United States, the world economy can use the same amount of labor
to produce 25 percent more widgets.
But where does the United States find the extra labor to produce widgets, and what happens
to the labor that was employed in the British widget industry? To get the labor to
expand its production of some goods, the United States must decrease or abandon the production
of others; these goods will then be produced in Britain instead, using the labor formerly
employed in the industries whose production has expanded in the United States.
Imagine that there are many goods subject to economies of scale in production, and give
them numbers 1, 2, 3, . . . . To take advantage of economies of scale, each of the countries
must concentrate on producing only a limited number of goods. Thus, for example, the
United States might produce goods 1, 3, 5, and so on, while Britain produces 2, 4, 6, and
so on. If each country produces only some of the goods, then each good can be produced
CHAPTER 7 External Economies of Scale and the International Location of Production 139
at a larger scale than would be the case if each country tried to produce everything. As a
result, the world economy can produce more of each good.
How does international trade enter the story? Consumers in each country will still want
to consume a variety of goods. Suppose that industry 1 ends up in the United States and
industry 2 ends up in Britain; then American consumers of good 2 will have to buy goods
imported from Britain, while British consumers of good 1 will have to import it from the
United States. International trade plays a crucial role: It makes it possible for each country
to produce a restricted range of goods and to take advantage of economies of scale without
sacrificing variety in consumption. Indeed, as we will see in Chapter 8, international trade
typically leads to an increase in the variety of goods available.
Our example, then, suggests how mutually beneficial trade can arise as a result of
economies of scale. Each country specializes in producing a limited range of products,
which enables it to produce these goods more efficiently than if it tried to produce everything
for itself; these specialized economies then trade with each other to be able to consume
the full range of goods.
Unfortunately, to go from this suggestive story to an explicit model of trade based on
economies of scale is not that simple. The reason is that economies of scale may lead to a
market structure other than that of perfect competition, and we need to be careful about
analyzing this market structure.
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