Scale Economies, Imperfect Competition, and International Trade
Economies of scale
Economies of scale could assume one of two forms:(i) external economies, in which the cost per unit hinges on industry size, as opposed to firm size; or (ii) internal economies, in which the size of individual firms determines the cost of production per unit good, as opposed to industry size. What we mean by external economies is that the costs of a firm are lower on account of the size of the industry that the firm operates in. According to Krugman (2009) labour-market pooling, knowledge spillovers, and specialized capital inputs are some of the factors responsible for the existence of external economies. External economies can be broadly categorised into economies of vertical disintegration, economies of localization, and economies of information.
Internal economies
Internal economies emerge from within the firm due to increasing the firm's scale of production. A firm thus secures internal economies as it experiences independent growth. The key internal economies of a firm include technical economies; marketing economies; managerial economies; and financial economies. Internal economies have been implicated with the causation of imperfectly competitive markets, but do not seem to give rise to perfectly competitive markets (Bernhofen 2011). This calls for a review of various models of imperfect competition, such as monopolistic and monopoly competition. Monopolistic competition is characterised by the existence of several firms within a given industry, each of whom produces its own differentiated product. The demand for the differentiated product in a monopolistic market will thus rely on the number of other related goods available in the market, and their prices as well. According to Krugman, Obstfeld, and Melitz (2012), such a model has proven essential in demonstrating how trade improves the variety of goods available to a country and trade-off between scales. For a firm operating under industry in a monopolistic market, a larger market (for example, the one created by involvement in international trade), tends to reduce the average price of goods (by reducing average costs and increasing production), in addition to making a wide range of goods available to such a market.
Theory of external economies
Marshall identified three key reasons to explain why a number of firms clustered could be far more efficient in comparison with an isolated individual firm: the ability to support specialised suppliers; enabling labour market pooling; and promoting knowledge spillovers (Krugman et al. 2012).
Specialised suppliers
Many industries rely on specialised support services and equipment to produce services and goods and to even develop new products. Nevertheless, an individual firm is not in a position to offer sufficient market for such services in a manner that makes business sense to suppliers (Krugmann et al. 2012). This problem could be overcome by clustering together the various firms and in this way, supporting a market with diverse specialised suppliers. The firms in the industry also benefit from readily available key inputs, and at a cheaper price seeing as there are now many suppliers. Consequently, firms may concentrate on their core business and outsource non-core operations.
Pooling the labour market
When firms are clustered together, this effectively aids in the creation of a pooled market where it is possible to find who possess highly specialised skills. Such labour market polling benefits both the workers and producers since workers are not likely to experience unemployment (Krugmann et al. 2012), while producers are not likely to experience labour shortages.
Knowledge spillovers
In the modern economy, knowledge is regarded as a significant factor of production in the same way that we view capital, labour, and raw materials. Firms engage in various research and development initiatives in a bid to acquire technology. Firms may also acquire knowledge by studying the competition. A key source of technical-knowhow for the firm, nonetheless, is the informal exchange of ideas and knowledge that occurs at the individual level (Krugmann et al. 2012). This form of informal diffusion of knowledge has been shown to occur more efficiently in an industry where the firms tend to be clustered in a small geographical location, thereby facilitating enabling workers from various firms to mix socially and freely address various technical issues.
How external economies influence market equilibrium
Going by the foregoing arguments, clustering firms in one geographical location within an industry offers a pooled labour market, supports specialised suppliers, and promotes knowledge spillover, something that individual firms that are geographically dispersed within an industry cannot achieve (Da Silva 2012). Nevertheless, the strengths of such economies are still supposedly reliant on the size of the industry. Holding all other things constant, a bigger industry translates into stronger economies of scale. Based on this assumption, it seems, therefore, that larger industries are often characterised by reduced costs.
In the presence of external economies, the quantity of goods produced increases, thereby pushing downwards the average cost of producing such goods. This is best exemplified in airplane production, where economies of scale play a crucial role. In this case, only a small number of firms are involved in airplane production, and as such, the industry has assumed the form of imperfect competition (Sgro 2009). These small numbers of firms are in turn scattered at a few locations. Seattle is one such location, home to Boeing, an aircraft manufacturer.
External economies are also significant in the semiconductor industry. For this reason, firms involved in the production of semi conductors are usually concentrated in definite geographical locations. Should a semi conductor firm be established in a given location owing to certain historical reasons, the export of semiconductors attributed to such a country as a result of economies of scale, as opposed to comparative advantage (Steven & Heijdra 2004)?
Role of economies of scale in theories of imperfect and perfect competition
Perfect competition and monopoly have dominated economic analysis discussions since the nineteenth century. A monopoly implies that a single firm holds exclusive power over all other firms in the industry, in terms of market and output. Consequently, the firm with a monopoly realises superior profits than would be the case in any other market form (Krugmann et al. 2012). On the other hand, perfect competition takes the form of a large number of sellers dealing in a homogeneous good. In perfect competition, none of the sellers enjoys more control over the pricing of goods than the competition. However, individual firms in perfect competition enjoy normal, long-run profits due to the free exit and entry of firms in the industry. According to Steven and Heijdra (2004), competition does not always result in a peaceful state since market forces differentiate utility and profit maximising behaviour with sub-optimal equilibrium situations. The theory of perfect competition identifies an economic good as being distinguishable by time and state of nature of its availability, as well as its material properties.
Consumers have perfect information regarding the various properties of goods, and hence proceed to define their preferences from a collection of other goods. Since consumers own firms, these firms are hence equipped with the ability to produce (Chang & Katayama 2012). This helps to establish a paradigm of a market organisation that converts all agents in the market into price takers. Consumers endeavour to maximise their utility, but this is often hindered by their income, thereby triggering an increase in demand functions. As firms endeavour to maximise their profit levels at the expense of technological possibilities, this in effect paves way for the emergence of the supply functions, thus setting up a competitive equilibrium. One of the main elements of competitive equilibrium is that it allows the sale of each good at a marginal cost. Also, the producer is in a position to increase the production cost of a good in case its price exceeds its marginal cost (Da Silva 2012). This raises the firm's profitability.
The Heckscher-Ohlin and Ricardian models depend on competition to forecast that no monopoly or “excess” profits exist as all the income realised from production is usually paid out to the owners of the factors of production. However, in the presence of economies of scale, large firms tend to be more efficient in comparison with small firms (Chang & Katayama 2012). Consequently, the industry could be made up of either several large firms or a monopoly. This is bound to result in imperfectly competitive production seeing as large firms end up capturing monopoly or excess profits.
How external economies influence international trade
Since the late nineteenth century, economists are cognisant of the fact that increasing returns could be the cause of trade, albeit independently, and that the benefits accruing from large-scale production should not necessarily be restricted to the boundaries of a firm. Marshallian externalities emerge in case of knowledge or other public inputs linked to a firm's production spill over, thereby benefitting other players in the industry. Such spill over could be concentrated in the same sector (for example, the spill over of technology in the Silicon Valley), or it could be between various sectors (for example, steel-mining industries or refining-chemical sectors). External economies of scale afford firms in the industry to produce with a reduced average cost (Bernhofen et al. 2012). Thus, countries that, for various reasons, have merged as leading producers of a good (for example, due to historical accident), are in a position to produce with lower average costs on account of external economies of scale namely, suppliers, agglomeration, and knowledge. Even in a situation whereby another firm could be in a position to produce the same good at lower unit costs, the fact that they do not have external economies of scale means that the firm cannot compete for that particular product. For example, Thailand is in a position to produce watches but because the country lacks external economies of scale, it cannot dislodge Switzerland.
References
Bernhofen D, Falvey R, Greenaway D & Kreickemeier U (2011) Palgrave Handbook of
International Trade. New York: Palgrave MacMillan.
Chang W & Katayama S (2012). Imperfect competition in international trade. New York: Springer.
Da Silva C (2012),’ The Theory Of Imperfect Competition: A Review Of The Post-Keynesian Contribution’, Análise Porto Alegre, vol.18, no. 2, pp. 38-53.
Krugman P (2009). Increasing returns in a comparative advantage world. [Online]. Available at: http://krugman.blogs.nytimes.com/2009/11/04/increasing-returns-in-a-comparative-advantage-world/?_r=0 [Accessed 12 Dec. 2016]
Krugman PR, Obstfeld M & Melitz M (2012), International Economics (9th) Edition, Theory and Policy, New York: Pearson Education, Inc.
Steven B Heijdra B (2004). The Monopolistic Competition Revolution in Retrospect. Cambridge, UK: Cambridge University Press.
Sgro PM (2009) International Economics, Finance and Trade - Volume I. Paris: EOLSS.
