The Theory of External Economies
As we have already pointed out, not all scale economies apply at the level of the individual
firm. For a variety of reasons, it is often the case that concentrating production
of an industry in one or a few locations reduces the industry’s costs even if the individual
firms in the industry remain small. When economies of scale apply at the level of
the industry rather than at the level of the individual firm, they are called external
economies. The analysis of external economies goes back more than a century to the
British economist Alfred Marshall, who was struck by the phenomenon of “industrial
districts”—geographical concentrations of industry that could not be easily explained
by natural resources. In Marshall’s time, the most famous examples included such concentrations
of industry as the cluster of cutlery manufacturers in Sheffield and the cluster
of hosiery firms in Northampton.
There are many modern examples of industries where there seem to be powerful external
economies. In the United States these examples include the semiconductor industry,
concentrated in California’s famous Silicon Valley; the investment banking industry,
concentrated in New York; and the entertainment industry, concentrated in Hollywood. In
the rising manufacturing industries of developing countries such as China, external
economies are pervasive—for example, one town in China accounts for a large share of
the world’s underwear production; another produces nearly all of the world’s cigarette
lighters; yet another produces a third of the world’s magnetic tape heads; and so on.
External economies have also played a key role in India’s emergence as a major exporter
of information services, with a large part of this industry still clustered in and around the
city of Bangalore.
Marshall argued that there are three main reasons why a cluster of firms may be more
efficient than an individual firm in isolation: the ability of a cluster to support specialized
suppliers; the way that a geographically concentrated industry allows labor market pooling;
and the way that a geographically concentrated industry helps foster knowledge
spillovers. These same factors continue to be valid today.
Specialized Suppliers
In many industries, the production of goods and services—and to an even greater extent,
the development of new products—requires the use of specialized equipment or support
services; yet an individual company does not provide a large enough market for these services
to keep the suppliers in business. A localized industrial cluster can solve this problem
by bringing together many firms that collectively provide a large enough market to support
a wide range of specialized suppliers. This phenomenon has been extensively documented
in Silicon Valley: A 1994 study recounts how, as the local industry grew, “engineers left
established semiconductor companies to start firms that manufactured capital goods such as
diffusion ovens, step-and-repeat cameras, and testers, and materials and components such
as photomasks, testing jigs, and specialized chemicals. . . . This independent equipment sector
promoted the continuing formation of semiconductor firms by freeing individual producers
from the expense of developing capital equipment internally and by spreading the
CHAPTER 7 External Economies of Scale and the International Location of Production 141
costs of development. It also reinforced the tendency toward industrial localization, as most
of these specialized inputs were not available elsewhere in the country.”1
As the quote suggests, the availability of this dense network of specialized suppliers
has given high-technology firms in Silicon Valley some considerable advantages over
firms elsewhere. Key inputs are cheaper and more easily available because there are many
firms competing to provide them, and firms can concentrate on what they do best, contracting
out other aspects of their business. For example, some Silicon Valley firms that
specialize in providing highly sophisticated computer chips for particular customers have
chosen to become “fabless,” that is, they do not have any factories in which chips can be
fabricated. Instead, they concentrate on designing the chips, and then hire another firm to
actually fabricate them.
A company that tried to enter the industry in another location—for example, in a country
that did not have a comparable industrial cluster—would be at an immediate disadvantage
because it would lack easy access to Silicon Valley’s suppliers and would either have
to provide them for itself or be faced with the task of trying to deal with Silicon
Valley–based suppliers at long distance.
Labor Market Pooling
A second source of external economies is the way that a cluster of firms can create a
pooled market for workers with highly specialized skills. Such a pooled market is to the
advantage of both the producers and the workers, as the producers are less likely to suffer
from labor shortages and the workers are less likely to become unemployed.
The point can best be made with a simplified example. Imagine that there are two companies
that both use the same kind of specialized labor, say, two film studios that make use
of experts in computer animation. Both employers are, however, uncertain about how
many workers they will want to hire: If demand for their product is high, both companies
will want to hire 150 workers, but if it is low, they will want to hire only 50. Suppose also
that there are 200 workers with this special skill. Now compare two situations: one with
both firms and all 200 workers in the same city, the other with the firms, each with 100
workers, in two different cities. It is straightforward to show that both the workers and
their employers are better off if everyone is in the same place.
First, consider the situation from the point of view of the companies. If they are in different
locations, whenever one of the companies is doing well, it will be confronted with a
labor shortage: It will want to hire 150 workers, but only 100 will be available. If the firms
are near each other, however, it is at least possible that one will be doing well when the
other is doing badly, so both firms may be able to hire as many workers as they want. By
locating near each other, the companies increase the likelihood that they will be able to
take advantage of business opportunities.
From the workers’ point of view, having the industry concentrated in one location is
also an advantage. If the industry is divided between two cities, then whenever one of the
firms has a low demand for workers, the result will be unemployment: The firm will be
willing to hire only 50 of the 100 workers who live nearby. But if the industry is concentrated
in a single city, low labor demand from one firm will at least sometimes be offset by
high demand from the other. As a result, workers will have a lower risk of unemployment.
Again, these advantages have been documented for Silicon Valley, where it is common
both for companies to expand rapidly and for workers to change employers. The same
study of Silicon Valley that was quoted previously notes that the concentration of firms in
1See p. 40 of the book by Saxenian listed in Further Readings.
142 PART ONE International Trade Theory
a single location makes it easy to switch employers. One engineer is quoted as saying that
“it wasn’t that big a catastrophe to quit your job on Friday and have another job on
Monday. . . . You didn’t even necessarily have to tell your wife. You just drove off in
another direction on Monday morning.”2 This flexibility makes Silicon Valley an attractive
location both for highly skilled workers and for the companies that employ them.
Knowledge Spillovers
It is by now a cliché that in the modern economy, knowledge is at least as important an input
as are factors of production like labor, capital, and raw materials. This is especially true in
highly innovative industries, where being even a few months behind the cutting edge in
production techniques or product design can put a company at a major disadvantage.
But where does the specialized knowledge that is crucial to success in innovative industries
come from? Companies can acquire technology through their own research and
development efforts. They can also try to learn from competitors by studying their products
and, in some cases, by taking them apart to “reverse engineer” their design and manufacture.
An important source of technical know-how, however, is the informal exchange of
information and ideas that takes place at a personal level. And this kind of informal diffusion
of knowledge often seems to take place most effectively when an industry is concentrated
in a fairly small area, so that employees of different companies mix socially and talk
freely about technical issues.
Marshall described this process memorably when he wrote that in a district with many
firms in the same industry, “The mysteries of the trade become no mystery, but are as it
were in the air. . . . Good work is rightly appreciated, inventions and improvements in
machinery, in processes and the general organization of the business have their merits
promptly discussed: If one man starts a new idea, it is taken up by others and combined
with suggestions of their own; and thus it becomes the source of further new ideas.”3
A journalist described how these knowledge spillovers worked during the rise of
Silicon Valley (and also gave an excellent sense of the amount of specialized knowledge
involved in the industry) as follows: “Every year there was some place, the Wagon Wheel,
Chez Yvonne, Rickey’s, the Roundhouse, where members of this esoteric fraternity, the
young men and women of the semiconductor industry, would head after work to have a
drink and gossip and trade war stories about phase jitters, phantom circuits, bubble memories,
pulse trains, bounceless contacts, burst modes, leapfrog tests, p-n junctions, sleeping
sickness modes, slow-death episodes, RAMs, NAKs, MOSes, PCMs, PROMs, PROM
blowers, PROM blasters, and teramagnitudes. . . .”4 This kind of informal information
flow means that it is easier for companies in the Silicon Valley area to stay near the technological
frontier than it is for companies elsewhere; indeed, many multinational firms
have established research centers and even factories in Silicon Valley simply in order to
keep up with the latest technology.
External Economies and Market Equilibrium
As we’ve just seen, a geographically concentrated industry is able to support specialized
suppliers, provide a pooled labor market, and facilitate knowledge spillovers in a way that a
geographically dispersed industry cannot. But the strength of these economies presumably
depends on the industry’s size: Other things equal, a bigger industry will generate stronger
external economies. What does this say about the determination of output and prices?
2Saxenian, p. 35.
3Alfred Marshall, Principles of Economics (London: MacMillan, 1920).
4Tom Wolfe, quoted in Saxenian, p. 33.
CHAPTER 7 External Economies of Scale and the International Location of Production 143
P1
Q1
1
D
AC
Quantity of widgets
produced, demanded
Price, cost
(per widget)
Figure 7-1
External Economies and Market
Equilibrium
When there are external
economies of scale, the average
cost of producing a good falls as
the quantity produced rises. Given
competition among many producers,
the downward-sloping average
cost curve AC can be interpreted
as a forward-falling supply curve.
As in ordinary supply-and-demand
analysis, market equilibrium is at
point 1, where the supply curve
intersects the demand curve, D.
The equilibrium level of output is
Q1, the equilibrium price P1.
While the details of external economies in practice are often quite subtle and complex
(as the example of Silicon Valley shows), it can be useful to abstract from the details and
represent external economies simply by assuming that the larger the industry, the lower the
industry’s costs. If we ignore international trade for the moment, then market equilibrium
can be represented with a supply-and-demand diagram like Figure 7-1, which illustrates
the market for widgets. In an ordinary picture of market equilibrium, the demand curve is
downward sloping, while the supply curve is upward sloping. In the presence of external
economies of scale, however, there is a forward-falling supply curve: the larger the
industry’s output, the lower the price at which firms are willing to sell, because their
average cost of production falls as industry output rises.
In the absence of international trade, the unusual slope of the supply curve in Figure 7-1
doesn’t seem to matter much. As in a conventional supply-and-demand analysis, the equilibrium
price, P1, and output, Q1, are determined by the intersection of the demand curve
and the supply curve. As we’ll see next, however, external economies of scale make a huge
difference to our view of the causes and effects of international trade.
As we have already pointed out, not all scale economies apply at the level of the individual
firm. For a variety of reasons, it is often the case that concentrating production
of an industry in one or a few locations reduces the industry’s costs even if the individual
firms in the industry remain small. When economies of scale apply at the level of
the industry rather than at the level of the individual firm, they are called external
economies. The analysis of external economies goes back more than a century to the
British economist Alfred Marshall, who was struck by the phenomenon of “industrial
districts”—geographical concentrations of industry that could not be easily explained
by natural resources. In Marshall’s time, the most famous examples included such concentrations
of industry as the cluster of cutlery manufacturers in Sheffield and the cluster
of hosiery firms in Northampton.
There are many modern examples of industries where there seem to be powerful external
economies. In the United States these examples include the semiconductor industry,
concentrated in California’s famous Silicon Valley; the investment banking industry,
concentrated in New York; and the entertainment industry, concentrated in Hollywood. In
the rising manufacturing industries of developing countries such as China, external
economies are pervasive—for example, one town in China accounts for a large share of
the world’s underwear production; another produces nearly all of the world’s cigarette
lighters; yet another produces a third of the world’s magnetic tape heads; and so on.
External economies have also played a key role in India’s emergence as a major exporter
of information services, with a large part of this industry still clustered in and around the
city of Bangalore.
Marshall argued that there are three main reasons why a cluster of firms may be more
efficient than an individual firm in isolation: the ability of a cluster to support specialized
suppliers; the way that a geographically concentrated industry allows labor market pooling;
and the way that a geographically concentrated industry helps foster knowledge
spillovers. These same factors continue to be valid today.
Specialized Suppliers
In many industries, the production of goods and services—and to an even greater extent,
the development of new products—requires the use of specialized equipment or support
services; yet an individual company does not provide a large enough market for these services
to keep the suppliers in business. A localized industrial cluster can solve this problem
by bringing together many firms that collectively provide a large enough market to support
a wide range of specialized suppliers. This phenomenon has been extensively documented
in Silicon Valley: A 1994 study recounts how, as the local industry grew, “engineers left
established semiconductor companies to start firms that manufactured capital goods such as
diffusion ovens, step-and-repeat cameras, and testers, and materials and components such
as photomasks, testing jigs, and specialized chemicals. . . . This independent equipment sector
promoted the continuing formation of semiconductor firms by freeing individual producers
from the expense of developing capital equipment internally and by spreading the
CHAPTER 7 External Economies of Scale and the International Location of Production 141
costs of development. It also reinforced the tendency toward industrial localization, as most
of these specialized inputs were not available elsewhere in the country.”1
As the quote suggests, the availability of this dense network of specialized suppliers
has given high-technology firms in Silicon Valley some considerable advantages over
firms elsewhere. Key inputs are cheaper and more easily available because there are many
firms competing to provide them, and firms can concentrate on what they do best, contracting
out other aspects of their business. For example, some Silicon Valley firms that
specialize in providing highly sophisticated computer chips for particular customers have
chosen to become “fabless,” that is, they do not have any factories in which chips can be
fabricated. Instead, they concentrate on designing the chips, and then hire another firm to
actually fabricate them.
A company that tried to enter the industry in another location—for example, in a country
that did not have a comparable industrial cluster—would be at an immediate disadvantage
because it would lack easy access to Silicon Valley’s suppliers and would either have
to provide them for itself or be faced with the task of trying to deal with Silicon
Valley–based suppliers at long distance.
Labor Market Pooling
A second source of external economies is the way that a cluster of firms can create a
pooled market for workers with highly specialized skills. Such a pooled market is to the
advantage of both the producers and the workers, as the producers are less likely to suffer
from labor shortages and the workers are less likely to become unemployed.
The point can best be made with a simplified example. Imagine that there are two companies
that both use the same kind of specialized labor, say, two film studios that make use
of experts in computer animation. Both employers are, however, uncertain about how
many workers they will want to hire: If demand for their product is high, both companies
will want to hire 150 workers, but if it is low, they will want to hire only 50. Suppose also
that there are 200 workers with this special skill. Now compare two situations: one with
both firms and all 200 workers in the same city, the other with the firms, each with 100
workers, in two different cities. It is straightforward to show that both the workers and
their employers are better off if everyone is in the same place.
First, consider the situation from the point of view of the companies. If they are in different
locations, whenever one of the companies is doing well, it will be confronted with a
labor shortage: It will want to hire 150 workers, but only 100 will be available. If the firms
are near each other, however, it is at least possible that one will be doing well when the
other is doing badly, so both firms may be able to hire as many workers as they want. By
locating near each other, the companies increase the likelihood that they will be able to
take advantage of business opportunities.
From the workers’ point of view, having the industry concentrated in one location is
also an advantage. If the industry is divided between two cities, then whenever one of the
firms has a low demand for workers, the result will be unemployment: The firm will be
willing to hire only 50 of the 100 workers who live nearby. But if the industry is concentrated
in a single city, low labor demand from one firm will at least sometimes be offset by
high demand from the other. As a result, workers will have a lower risk of unemployment.
Again, these advantages have been documented for Silicon Valley, where it is common
both for companies to expand rapidly and for workers to change employers. The same
study of Silicon Valley that was quoted previously notes that the concentration of firms in
1See p. 40 of the book by Saxenian listed in Further Readings.
142 PART ONE International Trade Theory
a single location makes it easy to switch employers. One engineer is quoted as saying that
“it wasn’t that big a catastrophe to quit your job on Friday and have another job on
Monday. . . . You didn’t even necessarily have to tell your wife. You just drove off in
another direction on Monday morning.”2 This flexibility makes Silicon Valley an attractive
location both for highly skilled workers and for the companies that employ them.
Knowledge Spillovers
It is by now a cliché that in the modern economy, knowledge is at least as important an input
as are factors of production like labor, capital, and raw materials. This is especially true in
highly innovative industries, where being even a few months behind the cutting edge in
production techniques or product design can put a company at a major disadvantage.
But where does the specialized knowledge that is crucial to success in innovative industries
come from? Companies can acquire technology through their own research and
development efforts. They can also try to learn from competitors by studying their products
and, in some cases, by taking them apart to “reverse engineer” their design and manufacture.
An important source of technical know-how, however, is the informal exchange of
information and ideas that takes place at a personal level. And this kind of informal diffusion
of knowledge often seems to take place most effectively when an industry is concentrated
in a fairly small area, so that employees of different companies mix socially and talk
freely about technical issues.
Marshall described this process memorably when he wrote that in a district with many
firms in the same industry, “The mysteries of the trade become no mystery, but are as it
were in the air. . . . Good work is rightly appreciated, inventions and improvements in
machinery, in processes and the general organization of the business have their merits
promptly discussed: If one man starts a new idea, it is taken up by others and combined
with suggestions of their own; and thus it becomes the source of further new ideas.”3
A journalist described how these knowledge spillovers worked during the rise of
Silicon Valley (and also gave an excellent sense of the amount of specialized knowledge
involved in the industry) as follows: “Every year there was some place, the Wagon Wheel,
Chez Yvonne, Rickey’s, the Roundhouse, where members of this esoteric fraternity, the
young men and women of the semiconductor industry, would head after work to have a
drink and gossip and trade war stories about phase jitters, phantom circuits, bubble memories,
pulse trains, bounceless contacts, burst modes, leapfrog tests, p-n junctions, sleeping
sickness modes, slow-death episodes, RAMs, NAKs, MOSes, PCMs, PROMs, PROM
blowers, PROM blasters, and teramagnitudes. . . .”4 This kind of informal information
flow means that it is easier for companies in the Silicon Valley area to stay near the technological
frontier than it is for companies elsewhere; indeed, many multinational firms
have established research centers and even factories in Silicon Valley simply in order to
keep up with the latest technology.
External Economies and Market Equilibrium
As we’ve just seen, a geographically concentrated industry is able to support specialized
suppliers, provide a pooled labor market, and facilitate knowledge spillovers in a way that a
geographically dispersed industry cannot. But the strength of these economies presumably
depends on the industry’s size: Other things equal, a bigger industry will generate stronger
external economies. What does this say about the determination of output and prices?
2Saxenian, p. 35.
3Alfred Marshall, Principles of Economics (London: MacMillan, 1920).
4Tom Wolfe, quoted in Saxenian, p. 33.
CHAPTER 7 External Economies of Scale and the International Location of Production 143
P1
Q1
1
D
AC
Quantity of widgets
produced, demanded
Price, cost
(per widget)
Figure 7-1
External Economies and Market
Equilibrium
When there are external
economies of scale, the average
cost of producing a good falls as
the quantity produced rises. Given
competition among many producers,
the downward-sloping average
cost curve AC can be interpreted
as a forward-falling supply curve.
As in ordinary supply-and-demand
analysis, market equilibrium is at
point 1, where the supply curve
intersects the demand curve, D.
The equilibrium level of output is
Q1, the equilibrium price P1.
While the details of external economies in practice are often quite subtle and complex
(as the example of Silicon Valley shows), it can be useful to abstract from the details and
represent external economies simply by assuming that the larger the industry, the lower the
industry’s costs. If we ignore international trade for the moment, then market equilibrium
can be represented with a supply-and-demand diagram like Figure 7-1, which illustrates
the market for widgets. In an ordinary picture of market equilibrium, the demand curve is
downward sloping, while the supply curve is upward sloping. In the presence of external
economies of scale, however, there is a forward-falling supply curve: the larger the
industry’s output, the lower the price at which firms are willing to sell, because their
average cost of production falls as industry output rises.
In the absence of international trade, the unusual slope of the supply curve in Figure 7-1
doesn’t seem to matter much. As in a conventional supply-and-demand analysis, the equilibrium
price, P1, and output, Q1, are determined by the intersection of the demand curve
and the supply curve. As we’ll see next, however, external economies of scale make a huge
difference to our view of the causes and effects of international trade.
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