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Q. This question will ask you to analyse the effect of trade liberalisation when there are economies of scale in production. a) Explain the difference between external and internal economies of scale.

b) Give three examples of phenomena that can generate external economies of scale, and one example of a phenomenon that can generate internal economies of scale. Explain your answers.

c) Can economies of scale cause countries to gain from trading with each other even if the countries are identical in all aspects? If so, explain why.

d) What can we say about how trade affects the location of firms in a sector depending on whether there are external or internal economies of scale? Explain your answer.

e) Explain how external economies of scale can cause a country to be negatively affected by trade liberalisation.

Answer 1

a) The differences between external and internal economies of scale are:

Internal economies of scale relate to the firm itself (and only that firm), there can be an increase in its overall capacity or an increase in all of its factors of productions - this is a long term concept and requires time and planning by the firm. The sources of such an economy of scale are its physical assets, managerial style, finacial security and its power over suppliers.

Whereas an external economy of scale is the cost implications of an increase of the industry (this only applies to the pre-existing firms). This means a decrease in AC (average cost) due to specialists entering, technology, more suppliers, more finance available and FI teams.

Comparative analysis:

BASIS FOR COMPARISON	INTERNAL ECONOMIES OF SCALE	EXTERNAL ECONOMIES OF SCALE
Meaning	Internal economies of scale are those that arise on account of an increase in the scale of production and plant-size.	External economies of scale are those that arise outside the entity and accrue to the growing entities.
Long run average cost curve	Falls due to the expansion in output by the firm up to a certain extent.	Shifts downward due to the expansion in size of the industry or economy as a whole up to a certain extent.
Reflected as	Movement along the LAC curve.	Shift of the LAC curve.

b) phenomena that can generate internal economies of scale are:

Internal economies of scale occur when something inside the firm makes the average cost of production lower:

• Specialisation: covering all areas of management and work can be very difficult, however when operating on a large scale, workers can specialize in the activities in which they are best and more productive.
• phenomena that can generate external economies of scale are:
• Cluster effect. If firms locate in a similar area, then this makes it more efficient for suppliers to meet a larger base of purchasers. For example, if you set up a pharmaceutical firm in the Ruhr Valley, Germany, there will be already suppliers and transport links to deal with the related aspects of the industry.
• Skilled labour. If similar firms locate in a particular region it will encourage skilled labour to seek work in this area. For example, Silicon Valley outside San Francisco has become a hotspot for IT related industries. This attracts skilled workers. Firms have to spend less on recruiting the skilled labour.
• Transport links. If mining becomes concentrated in a certain area, then there will develop better transport links for shipping the goods to the market. Therefore, as new firms enter or existing firms expand – then they can take advantage of the existing infrastructure to get lower average costs.
• c) yes, economies of scale cause countries to gain from trading with each other even if the countries are identical in all aspects Major reason that international trade may take place is the existence of economies of scale (also called increasing returns to scale) in production. Economies of scale means that production at a larger scale (more output) can be achieved at a lower cost (i.e., with economies or savings). When production within an industry has this characteristic, specialization and trade can result in improvements in world productive efficiency and welfare benefits that accrue to all trading countries.

• Trade between countries need not depend on country differences under the assumption of economies of scale. Indeed, it is conceivable that countries could be identical in all respects and yet find it advantageous to trade. For this reason, economies-of-scale models are often used to explain trade among countries like the United States, Japan, and the European Union. For the most part, these countries, and other developed countries, have similar technologies, similar endowments, and to some extent similar preferences. Using classical models of trade (e.g., Ricardian, Heckscher-Ohlin), these countries would have little reason to engage in trade. Yet trade between the developed countries makes up a significant share of world trade. Economies of scale can provide an answer for this type of trade.

• d) trade affects the location of firms in a sector depending on whether there are external or internal economies of scale the explanation from external economy is:

• Businesses/trade in the same industry tend to cluster in together. For example, a film studio might determine that California is a particularly good location for year-round film-making, so it moves to Hollywood(affecting the location of firm) . New movie producers also move to Hollywood because there are more camera operators, actors, costume designers, and screenwriters in the area. Then, more studios might decide to move to Hollywood to take advantage of the specialized labor and infrastructure already in place, thanks to the success of the first firm.As more and more firms succeed in the same area, new industry entrants can take advantage of even more localized benefits. It makes sense for industries to concentrate in areas where they are already strong . thus business get affected due to location in external economies of scale.

• e)

• trade liberalization can negatively affect certain businesses within a nation because of greater competition from foreign producers and may result in less local support for those industries. There may also be a financial and social risk if products or raw materials come from countries with lower environmental standards.

  Trade liberalization can pose a threat to developing nations or economies because they are forced to compete in the same market as stronger economies or nations. This challenge can stifle established local industries or result in the failure of newly developed industries there.

  Countries with advanced education systems tend to adapt rapidly to a free-trade economy because they have a labor market that can adjust to changing demands and production facilities that can shift their focus to more in-demand goods. Countries with lower educational standards may struggle to adapt to a changing economic environment . This is howexternal economies of scale can cause a country to be negatively affected by trade liberalisation.