Chapter 6 Economies of Scale, Imperfect Competition, and International Trade
Economies of Scale and Market Structure
• external economies of scale occur when cost per unit depends on size of industry but not necessarily on size of any one firm
• internal economies of scale occur when cost per unit depends on size of individual firm but not necessarily on that of industry
• an industry where economies of scale are purely external (that is, where there are no advantages to large firms) will typically consist
of many small firms and be perfectly competitive; by contrast, internal economies of scale give large firms a cost advantage over
small and lead to an imperfectly competitive market structure
• both external and internal economies of scale are important causes of international trade
The Theory of Imperfect Competition
• in imperfect competition, firms are aware that they can influence the prices and that they can sell more only by reducing their price
• imperfect competition is characteristic both of industries in which there are only a few major producers and of industries in which
each producer’s product is seen by consumers as strongly differentiated from those of rival firms
• under these circumstances each firm views itself as a price setter, choosing the price of its product, rather than a price taker
• the usual market structure in industries is characterized by internal economies of scale is one of oligopoly: several firms, each of
them large enough to affect prices, but none with an uncontested monopoly
• in monopolistic competition models two key assumptions are made to get around the problem of interdependence:
1) Each firm is assumed to be able to differentiate its product from that of its rival. That is, because they want to buy this firm’s
particular product, the firm’s customers will not rush to buy others’ products because of a price difference. Differentiation
assures that each firm has a monopoly in its product within an industry and is therefore somewhat insulated from competition.
2) Each firm is assumed to take the prices charged by its rivals as given—that is, it ignores the impact of its own price on the
prices of other firms. As a result, the monopolistic competition model assumes that even though each firm is in reality facing
competition from other firms, it behaves as if it were a monopolist—hence the model’s name.
• Q = S × [1 / n – b × (P – P-bar)] where Q is the firm’s sales, S is the total sales of the industry, n is the number of firms
in the industry, b is a constant term representing the responsiveness of a firm’s sales to its price, P is the price charged by the firm
itself, and P-bar is the average price charged by its competitors
Monopolistic Competition and Trade
The Effects of Increased Market Size
• the number of firms in a monopolistically competitive industry and the prices they charge are affected by the size of the market
• in larger markets there usually will be both more firms and more sales per firm; consumers in a large market will be offered both
lower prices and a greater variety of products than consumers in small markets
Economies of Scale and Comparative Advantage
• the exchange of one good (X) for the same good is called intraindustry trade
• the exchange of X for another good (Y) is called interindustry trade
• four points about this pattern of trade:
1) Interindustry (X for Y) trade reflects comparative advantage. The pattern of interindustry trade is that Home, the capital-
abundant country, is a net exporter of capital-intensive X and a net importer of labour-intensive Y.
2) Intraindustry trade (X for X) does not reflect comparative advantage. Even if the countries had the same overall capital-labour
ratio, their firms would continue to produce differentiated products and the demand of consumers for products made abroad
would continue to generate intraindustry trade. It is economies of scale that keep each country from producing the full range of
products for itself; thus economies of scale can be an independent source of international trade.
3) The pattern of intraindustry trade itself is unpredictable. All that is known is that the countries will produce different products.
Since history and accident determine the details of the trade pattern, an unpredictable component of the trade pattern is an
inevitable feature of a world where economies of scale are important. While the precise pattern of intraindustry trade within X
sector is arbitrary, pattern of interindustry trade between X and Y is determined by underlying differences between countries.
4) The relative importance of intraindustry and interindustry trade depends on how similar countries are. If Home and Foreign are