Economies of Scale and International Trade - Essay Example

Article 2 Economies of Scale and International Trade Introduction The importance of 'economies of scale' especially in production on a large-scale has often been recognized in the context of international trade. Economies of scale have also had a great impact in the rapid growth of industrialization in several countries after the war. This is particularly emphasized in the works of Balassa, Kravis, and Ohlin. However the role played by 'increasing returns' in promoting trade is an area that has not received as much attention in theoretical studies. (Anon). This paper presents a structural model to explain the impact of economies of scale in trade promotion, much more than variations in technology or other 'factor endowments' can ever hope to achieve. Economies of Scale The general theoretical approach assumes that scale economies remain as an external factor for firms in such a manner that an ideally competitive market scenario is available. (Anon). However, the model under study assumes economies of scale as "internal to firms" where the market structure is based on "Chamberlinian monopolistic competition." (Anon). The author chooses the Chamberlinian model to benefit from the following advantages: It is simple. It does not suffer from the "multiple equilibria" rule that applies in cases where scale economies are assumed to be external. It is compatible with much of current literature relating to "intraindustry" trade that accommodates a broad repertoire of product lines. The author undertakes this study in three parts dealing with the: Application of a monopolistic competition model (basically rooted in the Dixit-Stiglitz model) that is suitable for a 'closed economy'. Analysis of the impact of commencing trade, as also of 'factor mobility' and increase in population. Digest of outcomes and final conclusions. (Anon) Monopolistic Competition Model Although basically a modified version of the model designed by Dixit and Stiglitz, the author here uses separate forms for the study of two factors- 'cost' and 'utility'. The primary assumption deals with the mass production of some goods in a community that shares a common 'utility' function. As such the acceptance of these goods is considered to be uniform. It is also assumed that production 'cost' is a constant for all these goods, while the labor employed for manufacture is seen as a 'linear function of output'. One factor that remains variable is the 'elasticity of demand' that each producer might have to tackle. While marginal costs are assumed to be stable, average costs are considered to be reducing. Manufacture of unit goods would match the numbers derived from individual consumer needs, which equals the number of individual workers. Yet another assumption is that there is 'full employment'. The Problem The problem is simply stated in a symmetrical manner with three variable factors that need to be arrived at: Pricing of each product in relation to corresponding wages Output of each product Total number of products manufactured The Solution An approach to a solution again is suggested in three steps. The first is to assess the 'demand curve' for a given company. The next step involves a study of the relative pricing policies that companies apply, and linking of output with the profitability factor. Thirdly, profitability as well as entry is studied to arrive at the number of companies. The demand curve for a given company is worked out by considering consumer behavior of individuals, based on budget availability and the 'marginal utility of income'. The level of individual consumption in relation to output is read as the total demand for the product of a company. The company's pricing policy can hardly influence the consumer's 'marginal utility of income' where there is mass production of goods. The pricing behavior of a company is generally assumed to be based on the motive to maximize profit. Pricing decisions may not be expected to influence that of other companies in a large economy. The two major factors considered in setting a price that maximizes profit are the 'elasticity of demand' and the 'marginal cost'. A key factor that determines the elasticity of demand as a variable is the output. It therefore becomes necessary to fix a 'profit-maximizing output' as well as a 'profit-maximizing price'. However profits will naturally settle to a zero position as when new competing companies enter the fray. In a competitive environment, marginal revenue for a firm equals marginal cost, but the output (or economies of scale) will ensure that a margin of profit exists by virtue of average revenue remaining above average cost. This triggers profit-maximizing, and with more firms entering the fray, the prices will fall back to neutralize marginal cost and marginal revenue. This process is widely known as Chamberlin's 'tangency solution'. Market Growth This model based on scale economies could be further broadened and applied to provide for market growth by focusing on three factors- increases in the work force; trade; and mobility or migration. Another factor that might considerably influence growth relates to the 'welfare' aspects of representative consumers as reflected in either an increase in 'real wage' or the availability of extended choice of products. Trade Impacts The effects of scale economies on trade are then analyzed. According to the present model, trade is possible between two countries that have identical factor endowments, such as tastes, technology, wage, price, transportation cost, etc. Given the large-scale production as well as wide variety of goods, both countries will benefit from higher levels of welfare. In this model, the direction as well as the volume of trade flows cannot be ascertained. With each good being manufactured only in one of the two countries, there would be no need for market competition. Each country manufactures goods according to the proportionate needs of its work force. With singular pricing, each country would expend in proportion to its labor force. Balance of trade exists with no individual budget constraint remaining. Conclusion This model is similar to the one proposed by Linder in 1961, with the exception that he fails to discuss scale economies. The final outcome of this study shows that other things (technology, tastes, and factor endowments) being equal, economies of scale can have impact on the growth and gains of trade on the international arena. "____Increasing Returns, Monopolistic Competition, and International Trade" Read More