Interregional Trade and Economic Geography
External economies play an important role in shaping the pattern of international trade, but
they are even more decisive in shaping the pattern of interregional trade—trade that
takes place between regions within countries.
To understand the role of external economies in interregional trade, we first need to
discuss the nature of regional economics—that is, how the economies of regions within a
nation fit into the national economy. Studies of the location of U.S. industries suggest
that more than 60 percent of U.S. workers are employed by industries whose output is
nontradable even within the United States—that is, that must be supplied locally. Table 7-2
shows some examples of tradable and nontradable industries. Thus, motion pictures
made in Hollywood are shown across the country, and indeed around the world, but
newspapers are mainly read in their home cities. Wall Street trades stocks and makes
deals for clients across the United States, but savings banks mainly serve local depositors.
Scientists at the National Institutes of Health develop medical knowledge that is
applied across the whole country, but the veterinarian who figures out why your pet is
sick has to be near your home.
As you might expect, the share of nontradable industries in employment is pretty
much the same across the United States. For example, restaurants employ about 5 percent
of the work force in every major U.S. city. On the other hand, tradable industries vary
greatly in importance across regions. Manhattan accounts for only about 2 percent of
America’s total employment, but it accounts for a quarter of those employed in trading
stocks and bonds and about one-seventh of employment in the advertising industry.
But what determines the location of tradable industries? In some cases, natural
resources play a key role—for example, Houston is a center for the oil industry because
east Texas is where the oil is. However, factors of production such as labor and
capital play a less decisive role in interregional trade than in international trade, for
the simple reason that such factors are highly mobile within countries. As a result,
factors tend to move to where the industries are rather than the other way around. For
example, California’s Silicon Valley, near San Francisco, has a very highly educated
labor force, with a high concentration of engineers and computer experts. That’s not
TABLE 7-2 Some Examples of Tradable and Nontradable Industries
Tradable Industries Nontradable Industries
Motion pictures Newspaper publishers
Securities, commodities, etc. Savings institutions
Scientific research Veterinary services
Source: J. Bradford Jensen and Lori. G. Kletzer, “Tradable Services: Understanding the Scope
and Impact of Services Outsourcing,” in Lael Brainard and Susan M. Collins, eds., Brookings
Trade Forum 2005: Offshoring White Collar Work (Washington, D.C.: Brookings Institution,
2005), pp. 75–116.
CHAPTER 7 External Economies of Scale and the International Location of Production 151
Tinseltown Economics
What is the United States’ most important export
sector? The answer depends to some extent on definitions;
some people will tell you that it is agriculture,
others that it is aircraft. By any measure,
however, one of the biggest exporters in the United
States is the entertainment sector, movies in particular.
In 2008, rental fees generated by exports of
films and tape were $13.6 billion, compared with
only $9.8 billion in domestic box office receipts.
American films dominated ticket sales in much of
the world; for example, they accounted for about
two-thirds of box office receipts in Europe.
Why is the United States the world’s dominant
exporter of entertainment? There are important
advantages arising from the sheer size of the American
market. A film aimed primarily at the French or Italian
markets, which are far smaller than that of the United
States, cannot justify the huge budgets of many
American films. Thus films from these countries are
typically dramas or comedies whose appeal fails to
survive dubbing or subtitles. Meanwhile, American
films can transcend the language barrier with lavish
productions and spectacular special effects.
But an important part of the American
dominance in the industry also comes from the
external economies created by the immense concentration
of entertainment firms in Hollywood.
Hollywood clearly generates two of Marshall’s
types of external economies: specialized suppliers
and labor market pooling. While the final product is
provided by movie studios and television networks,
these in turn draw on a complex web of independent
producers, casting and talent agencies, legal firms,
special effects experts, and so on. And the need for
labor market pooling is obvious to anyone who has
ever watched the credits at the end of a movie: Each
production requires a huge but temporary army
that includes not just cameramen and makeup artists
but musicians, stuntmen and -women, and mysterious
occupations like gaffers and grips (and—oh
yes—actors and actresses). Whether it also generates
the third kind of external economies—knowledge
spillovers—is less certain. After all, as the
author Nathaniel West once remarked, the key to
understanding the movie business is to realize that
“nobody knows anything.” Still, if there is any
knowledge to spill over, surely it does so better in
the intense social environment of Hollywood than it
could anywhere else.
An indication of the force of Hollywood’s external
economies has been its persistent ability to draw
talent from outside the United States. From Garbo
and von Sternberg to Russell Crowe and Guillermo
del Toro, “American” films have often been made by
ambitious foreigners who moved to Hollywood—
and in the end, reached a larger audience even in
their original nations than they could have if they
had remained at home.
Is Hollywood unique? No, similar forces have
led to the emergence of several other entertainment
complexes. In India, whose film market has been
protected from American domination partly by government
policy and partly by cultural differences, a
moviemaking cluster known as “Bollywood” has
emerged in Bombay. In recent years Bollywood
films have developed a wide following outside
India, and film is rapidly becoming a significant
Indian export industry. A substantial film industry
catering to Chinese speakers has emerged in Hong
Kong; in addition, many U.S.-made action films are
strongly influenced by Hong Kong style. And a specialty
industry producing Spanish-language television
programs for all of Latin America, focusing on
so-called telenovelas, long-running soap operas, has
emerged in Caracas, Venezuela. This last entertainment
complex has discovered some unexpected
export markets: Television viewers in Russia, it
turns out, identify more readily with the characters
in Latin American soaps than with those in U.S.
productions.
because California trains lots of engineers; it’s because engineers move to Silicon
Valley to take jobs in the region’s high-tech industry.
Resources, then, play a secondary role in interregional trade. What largely drives
specialization and trade, instead, is external economies. Why, for example, are so
many advertising agencies located in New York? The answer is, because so many
152 PART ONE International Trade Theory
other advertising agencies are located in New York. As one study put it, “Information
sharing and information diffusion are critical to a team and an agency’s success. . . . In
cities like New York, agencies group in neighborhood clusters. Clusters promote
localized networking, to enhance creativity; agencies share information and ideas and
in doing this face-to-face contact is critical.”6 In fact, the evidence suggests that the
external economies that support the advertising business are very localized: To reap
the benefits of information spillovers, ad agencies need to be located within about
300 yards of each other!
But if external economies are the main reason for regional specialization and interregional
trade, what explains how a particular region develops the external economies
that support an industry? The answer, in general, is that accidents of history play a crucial
role. As noted earlier, a century and a half ago, New York was America’s most
important port city because it had access to the Great Lakes via the Erie Canal. That led
to New York’s becoming America’s financial center; it remains America’s financial
center today thanks to the external economies the financial industry creates for itself.
Los Angeles became the center of the early film industry when films were shot outdoors
and needed good weather; it remains the center of the film industry today, even
though many films are shot indoors or on location, because of the externalities
described in the box on page 151.
A question you might ask is whether the forces driving interregional trade are really all
that different from those driving international trade. The answer is that they are not, especially
when one looks at trade between closely integrated national economies, such as
those of Western Europe. Indeed, London plays a role as Europe’s financial capital similar
to the role played by New York as America’s financial capital. In recent years, there has
been a growing movement among economists to model interregional and international
trade, as well as such phenomena as the rise of cities, as different aspects of the same phenomenon—
economic interaction across space. Such an approach is often referred to as
economic geography.
SUMMARY
1. Trade need not be the result of comparative advantage. Instead, it can result from
increasing returns or economies of scale, that is, from a tendency of unit costs to be
lower with larger output. Economies of scale give countries an incentive to specialize
and trade even in the absence of differences in resources or technology between countries.
Economies of scale can be internal (depending on the size of the firm) or external
(depending on the size of the industry).
2. Economies of scale can lead to a breakdown of perfect competition, unless they take
the form of external economies, which occur at the level of the industry instead of the
firm.
3. External economies give an important role to history and accident in determining the
pattern of international trade. When external economies are important, a country starting
with a large advantage may retain that advantage even if another country could
potentially produce the same goods more cheaply. When external economies are
important, countries can conceivably lose from trade.
6J. Vernon Henderson, “What Makes Big Cities Tick? A Look at New York,” mimeo, Brown University, 2004.
CHAPTER 7 External Economies of Scale and the International Location of Production 153
KEY TERMS
average cost of production, p. 143
dynamic increasing
returns, p. 149
economic geography, p. 152
economies of scale, p. 138
external economies
of scale, p. 139
forward-falling supply
curve, p. 143
infant industry argument, p. 150
internal economies of
scale, p. 139
interregional trade, p. 150
knowledge spillovers, p. 140
labor market pooling, p. 140
learning curve, p. 149
specialized suppliers, p. 140
PROBLEMS
1. For each of the following examples, explain whether it is a case of external or internal
economies of scale:
a. Most musical wind instruments in the United States are produced by more than a
dozen factories in Elkhart, Indiana.
b. All Hondas sold in the United States are either imported or produced in
Marysville, Ohio.
c. All airframes for Airbus, Europe’s only producer of large aircraft, are assembled in
Toulouse, France.
d. Hartford, Connecticut, is the insurance capital of the northeastern United States.
2. It is often argued that the existence of increasing returns is a source of conflict between
countries, since each country is better off if it can increase its production in
those industries characterized by economies of scale. Evaluate this view in terms of
the external economy model.
3. Give two examples of products that are traded on international markets for which
there are dynamic increasing returns. In each of your examples, show how innovation
and learning-by-doing are important to the dynamic increasing returns in the industry.
4. Evaluate the relative importance of economies of scale and comparative advantage in
causing the following:
a. Most of the world’s aluminum is smelted in Norway or Canada.
b. Half of the world’s large jet aircraft are assembled in Seattle.
c. Most semiconductors are manufactured in either the United States or Japan.
d. Most Scotch whiskey comes from Scotland.
e. Much of the world’s best wine comes from France.
5. Consider a situation similar to that in Figure 7-3, in which two countries that can produce
a good are subject to forward-falling supply curves. In this case, however, suppose
that the two countries have the same costs, so that their supply curves are identical.
a. What would you expect to be the pattern of international specialization and trade?
What would determine who produces the good?
b. What are the benefits of international trade in this case? Do they accrue only to the
country that gets the industry?
6. It is fairly common for an industrial cluster to break up and for production to move to
locations with lower wages when the technology of the industry is no longer rapidly
improving—when it is no longer essential to have the absolutely most modern
machinery, when the need for highly skilled workers has declined, and when being at
the cutting edge of innovation conveys only a small advantage. Explain this tendency
of industrial clusters to break up in terms of the theory of external economies.
7. Recently, a growing labor shortage has been causing Chinese wages to rise. If this
trend continues, what would you expect to see happen to external economy industries
154 PART ONE International Trade Theory
currently dominated by China? Consider, in particular, the situation illustrated in
Figure 7-4. How would change take place?
8. In our discussion of labor market pooling, we stressed the advantages of having two
firms in the same location: If one firm is expanding while the other is contracting, it’s
to the advantage of both workers and firms that they be able to draw on a single labor
pool. But it might happen that both firms want to expand or contract at the same time.
Does this constitute an argument against geographical concentration? (Think through
the numerical example carefully.)
9. Which of the following goods or services would be most likely to be subject to (1) external
economies of scale and (2) dynamic increasing returns? Explain your answers.
a. Software tech-support services
b. Production of asphalt or concrete
c. Motion pictures
d. Cancer research
e. Timber harvesting
FURTHER READINGS
Frank Graham. “Some Aspects of Protection Further Considered.” Quarterly Journal of Economics
37 (1923), pp. 199–227. An early warning that international trade may be harmful in the presence
of external economies of scale.
Li & Fung Research Centre. Industrial Cluster Series, 2006–2010. Li and Fung, a Hong Kong–based
trading group, has published a series of reports on rising industrial concentrations in Chinese
manufacturing.
Staffan Burenstam Linder. An Essay on Trade and Transformation. New York: John Wiley and Sons,
1961. An early and influential statement of the view that trade in manufactures among advanced
countries mainly reflects forces other than comparative advantage.
Michael Porter. The Competitive Advantage of Nations. New York: Free Press, 1990. A best-selling
book that explains national export success as the result of self-reinforcing industrial clusters, that
is, external economies.
Annalee Saxenian. Regional Advantage. Cambridge: Harvard University Press, 1994. A fascinating
comparison of two high-technology industrial districts, California’s Silicon Valley and Boston’s
Route 128.
World Bank. World Development Report 2009. A huge survey of the evidence on economic geography,
with extensive discussion of industrial clusters in China and other emerging economies.
External economies play an important role in shaping the pattern of international trade, but
they are even more decisive in shaping the pattern of interregional trade—trade that
takes place between regions within countries.
To understand the role of external economies in interregional trade, we first need to
discuss the nature of regional economics—that is, how the economies of regions within a
nation fit into the national economy. Studies of the location of U.S. industries suggest
that more than 60 percent of U.S. workers are employed by industries whose output is
nontradable even within the United States—that is, that must be supplied locally. Table 7-2
shows some examples of tradable and nontradable industries. Thus, motion pictures
made in Hollywood are shown across the country, and indeed around the world, but
newspapers are mainly read in their home cities. Wall Street trades stocks and makes
deals for clients across the United States, but savings banks mainly serve local depositors.
Scientists at the National Institutes of Health develop medical knowledge that is
applied across the whole country, but the veterinarian who figures out why your pet is
sick has to be near your home.
As you might expect, the share of nontradable industries in employment is pretty
much the same across the United States. For example, restaurants employ about 5 percent
of the work force in every major U.S. city. On the other hand, tradable industries vary
greatly in importance across regions. Manhattan accounts for only about 2 percent of
America’s total employment, but it accounts for a quarter of those employed in trading
stocks and bonds and about one-seventh of employment in the advertising industry.
But what determines the location of tradable industries? In some cases, natural
resources play a key role—for example, Houston is a center for the oil industry because
east Texas is where the oil is. However, factors of production such as labor and
capital play a less decisive role in interregional trade than in international trade, for
the simple reason that such factors are highly mobile within countries. As a result,
factors tend to move to where the industries are rather than the other way around. For
example, California’s Silicon Valley, near San Francisco, has a very highly educated
labor force, with a high concentration of engineers and computer experts. That’s not
TABLE 7-2 Some Examples of Tradable and Nontradable Industries
Tradable Industries Nontradable Industries
Motion pictures Newspaper publishers
Securities, commodities, etc. Savings institutions
Scientific research Veterinary services
Source: J. Bradford Jensen and Lori. G. Kletzer, “Tradable Services: Understanding the Scope
and Impact of Services Outsourcing,” in Lael Brainard and Susan M. Collins, eds., Brookings
Trade Forum 2005: Offshoring White Collar Work (Washington, D.C.: Brookings Institution,
2005), pp. 75–116.
CHAPTER 7 External Economies of Scale and the International Location of Production 151
Tinseltown Economics
What is the United States’ most important export
sector? The answer depends to some extent on definitions;
some people will tell you that it is agriculture,
others that it is aircraft. By any measure,
however, one of the biggest exporters in the United
States is the entertainment sector, movies in particular.
In 2008, rental fees generated by exports of
films and tape were $13.6 billion, compared with
only $9.8 billion in domestic box office receipts.
American films dominated ticket sales in much of
the world; for example, they accounted for about
two-thirds of box office receipts in Europe.
Why is the United States the world’s dominant
exporter of entertainment? There are important
advantages arising from the sheer size of the American
market. A film aimed primarily at the French or Italian
markets, which are far smaller than that of the United
States, cannot justify the huge budgets of many
American films. Thus films from these countries are
typically dramas or comedies whose appeal fails to
survive dubbing or subtitles. Meanwhile, American
films can transcend the language barrier with lavish
productions and spectacular special effects.
But an important part of the American
dominance in the industry also comes from the
external economies created by the immense concentration
of entertainment firms in Hollywood.
Hollywood clearly generates two of Marshall’s
types of external economies: specialized suppliers
and labor market pooling. While the final product is
provided by movie studios and television networks,
these in turn draw on a complex web of independent
producers, casting and talent agencies, legal firms,
special effects experts, and so on. And the need for
labor market pooling is obvious to anyone who has
ever watched the credits at the end of a movie: Each
production requires a huge but temporary army
that includes not just cameramen and makeup artists
but musicians, stuntmen and -women, and mysterious
occupations like gaffers and grips (and—oh
yes—actors and actresses). Whether it also generates
the third kind of external economies—knowledge
spillovers—is less certain. After all, as the
author Nathaniel West once remarked, the key to
understanding the movie business is to realize that
“nobody knows anything.” Still, if there is any
knowledge to spill over, surely it does so better in
the intense social environment of Hollywood than it
could anywhere else.
An indication of the force of Hollywood’s external
economies has been its persistent ability to draw
talent from outside the United States. From Garbo
and von Sternberg to Russell Crowe and Guillermo
del Toro, “American” films have often been made by
ambitious foreigners who moved to Hollywood—
and in the end, reached a larger audience even in
their original nations than they could have if they
had remained at home.
Is Hollywood unique? No, similar forces have
led to the emergence of several other entertainment
complexes. In India, whose film market has been
protected from American domination partly by government
policy and partly by cultural differences, a
moviemaking cluster known as “Bollywood” has
emerged in Bombay. In recent years Bollywood
films have developed a wide following outside
India, and film is rapidly becoming a significant
Indian export industry. A substantial film industry
catering to Chinese speakers has emerged in Hong
Kong; in addition, many U.S.-made action films are
strongly influenced by Hong Kong style. And a specialty
industry producing Spanish-language television
programs for all of Latin America, focusing on
so-called telenovelas, long-running soap operas, has
emerged in Caracas, Venezuela. This last entertainment
complex has discovered some unexpected
export markets: Television viewers in Russia, it
turns out, identify more readily with the characters
in Latin American soaps than with those in U.S.
productions.
because California trains lots of engineers; it’s because engineers move to Silicon
Valley to take jobs in the region’s high-tech industry.
Resources, then, play a secondary role in interregional trade. What largely drives
specialization and trade, instead, is external economies. Why, for example, are so
many advertising agencies located in New York? The answer is, because so many
152 PART ONE International Trade Theory
other advertising agencies are located in New York. As one study put it, “Information
sharing and information diffusion are critical to a team and an agency’s success. . . . In
cities like New York, agencies group in neighborhood clusters. Clusters promote
localized networking, to enhance creativity; agencies share information and ideas and
in doing this face-to-face contact is critical.”6 In fact, the evidence suggests that the
external economies that support the advertising business are very localized: To reap
the benefits of information spillovers, ad agencies need to be located within about
300 yards of each other!
But if external economies are the main reason for regional specialization and interregional
trade, what explains how a particular region develops the external economies
that support an industry? The answer, in general, is that accidents of history play a crucial
role. As noted earlier, a century and a half ago, New York was America’s most
important port city because it had access to the Great Lakes via the Erie Canal. That led
to New York’s becoming America’s financial center; it remains America’s financial
center today thanks to the external economies the financial industry creates for itself.
Los Angeles became the center of the early film industry when films were shot outdoors
and needed good weather; it remains the center of the film industry today, even
though many films are shot indoors or on location, because of the externalities
described in the box on page 151.
A question you might ask is whether the forces driving interregional trade are really all
that different from those driving international trade. The answer is that they are not, especially
when one looks at trade between closely integrated national economies, such as
those of Western Europe. Indeed, London plays a role as Europe’s financial capital similar
to the role played by New York as America’s financial capital. In recent years, there has
been a growing movement among economists to model interregional and international
trade, as well as such phenomena as the rise of cities, as different aspects of the same phenomenon—
economic interaction across space. Such an approach is often referred to as
economic geography.
SUMMARY
1. Trade need not be the result of comparative advantage. Instead, it can result from
increasing returns or economies of scale, that is, from a tendency of unit costs to be
lower with larger output. Economies of scale give countries an incentive to specialize
and trade even in the absence of differences in resources or technology between countries.
Economies of scale can be internal (depending on the size of the firm) or external
(depending on the size of the industry).
2. Economies of scale can lead to a breakdown of perfect competition, unless they take
the form of external economies, which occur at the level of the industry instead of the
firm.
3. External economies give an important role to history and accident in determining the
pattern of international trade. When external economies are important, a country starting
with a large advantage may retain that advantage even if another country could
potentially produce the same goods more cheaply. When external economies are
important, countries can conceivably lose from trade.
6J. Vernon Henderson, “What Makes Big Cities Tick? A Look at New York,” mimeo, Brown University, 2004.
CHAPTER 7 External Economies of Scale and the International Location of Production 153
KEY TERMS
average cost of production, p. 143
dynamic increasing
returns, p. 149
economic geography, p. 152
economies of scale, p. 138
external economies
of scale, p. 139
forward-falling supply
curve, p. 143
infant industry argument, p. 150
internal economies of
scale, p. 139
interregional trade, p. 150
knowledge spillovers, p. 140
labor market pooling, p. 140
learning curve, p. 149
specialized suppliers, p. 140
PROBLEMS
1. For each of the following examples, explain whether it is a case of external or internal
economies of scale:
a. Most musical wind instruments in the United States are produced by more than a
dozen factories in Elkhart, Indiana.
b. All Hondas sold in the United States are either imported or produced in
Marysville, Ohio.
c. All airframes for Airbus, Europe’s only producer of large aircraft, are assembled in
Toulouse, France.
d. Hartford, Connecticut, is the insurance capital of the northeastern United States.
2. It is often argued that the existence of increasing returns is a source of conflict between
countries, since each country is better off if it can increase its production in
those industries characterized by economies of scale. Evaluate this view in terms of
the external economy model.
3. Give two examples of products that are traded on international markets for which
there are dynamic increasing returns. In each of your examples, show how innovation
and learning-by-doing are important to the dynamic increasing returns in the industry.
4. Evaluate the relative importance of economies of scale and comparative advantage in
causing the following:
a. Most of the world’s aluminum is smelted in Norway or Canada.
b. Half of the world’s large jet aircraft are assembled in Seattle.
c. Most semiconductors are manufactured in either the United States or Japan.
d. Most Scotch whiskey comes from Scotland.
e. Much of the world’s best wine comes from France.
5. Consider a situation similar to that in Figure 7-3, in which two countries that can produce
a good are subject to forward-falling supply curves. In this case, however, suppose
that the two countries have the same costs, so that their supply curves are identical.
a. What would you expect to be the pattern of international specialization and trade?
What would determine who produces the good?
b. What are the benefits of international trade in this case? Do they accrue only to the
country that gets the industry?
6. It is fairly common for an industrial cluster to break up and for production to move to
locations with lower wages when the technology of the industry is no longer rapidly
improving—when it is no longer essential to have the absolutely most modern
machinery, when the need for highly skilled workers has declined, and when being at
the cutting edge of innovation conveys only a small advantage. Explain this tendency
of industrial clusters to break up in terms of the theory of external economies.
7. Recently, a growing labor shortage has been causing Chinese wages to rise. If this
trend continues, what would you expect to see happen to external economy industries
154 PART ONE International Trade Theory
currently dominated by China? Consider, in particular, the situation illustrated in
Figure 7-4. How would change take place?
8. In our discussion of labor market pooling, we stressed the advantages of having two
firms in the same location: If one firm is expanding while the other is contracting, it’s
to the advantage of both workers and firms that they be able to draw on a single labor
pool. But it might happen that both firms want to expand or contract at the same time.
Does this constitute an argument against geographical concentration? (Think through
the numerical example carefully.)
9. Which of the following goods or services would be most likely to be subject to (1) external
economies of scale and (2) dynamic increasing returns? Explain your answers.
a. Software tech-support services
b. Production of asphalt or concrete
c. Motion pictures
d. Cancer research
e. Timber harvesting
FURTHER READINGS
Frank Graham. “Some Aspects of Protection Further Considered.” Quarterly Journal of Economics
37 (1923), pp. 199–227. An early warning that international trade may be harmful in the presence
of external economies of scale.
Li & Fung Research Centre. Industrial Cluster Series, 2006–2010. Li and Fung, a Hong Kong–based
trading group, has published a series of reports on rising industrial concentrations in Chinese
manufacturing.
Staffan Burenstam Linder. An Essay on Trade and Transformation. New York: John Wiley and Sons,
1961. An early and influential statement of the view that trade in manufactures among advanced
countries mainly reflects forces other than comparative advantage.
Michael Porter. The Competitive Advantage of Nations. New York: Free Press, 1990. A best-selling
book that explains national export success as the result of self-reinforcing industrial clusters, that
is, external economies.
Annalee Saxenian. Regional Advantage. Cambridge: Harvard University Press, 1994. A fascinating
comparison of two high-technology industrial districts, California’s Silicon Valley and Boston’s
Route 128.
World Bank. World Development Report 2009. A huge survey of the evidence on economic geography,
with extensive discussion of industrial clusters in China and other emerging economies.
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