1.

For each of the examples, explain whether it is a case of external or internal economies of scale:
(Chapter 7, Question 1)

- External economies of scale occur when cost per unit of output depends on the size of industry.
Then, an industry where economies of scale are purely external will typically consisted many
small firms and be perfectly competition.
- Internal economies of scale occur when the cost per unit depends on the size of a firm. Then, it
will result when large firms have a cost advantages over small firms, causing the industry to
become imperfectly competitive.

a. Almost all Hermes products are manufactured in France.

Ans: Hermes is a French high fashion luxury goods, so it is internal economies of scale because
there is a single firm produce the output.

b. Apple has its displays mainly made in Japan and some made in Korea.
Ans: External economies of scale, the Apple industry is concentrated in a few locations.

c. All Toyota Land Cruiser and Prius sold in the United States market are assembled in Japan.
Ans: Internal economies of scale, only a firm in Japan is producing the output for the industry.
d. Gerber used to be an American-owned company, now a subsidiary of the Nestle’ Group,
headquartered in Fremont, Michigan.
Ans: Gerber is an American supplier of baby food and baby products, and Nestle’s Group is a
Swiss multinational food and beverage company, so it is an external economies of scale because
the industry production is concentrated in a few locations.

e. A number of firms doing contract research for the drug industry are concentrated in southeastern
South Carolina.
Ans: External economies of scale as the drug industry are concentrated in southeastern South
Carolina.
f. All Hondas produced in the United States come from plants in Ohio, Indiana or Alabama.
Ans: Internal economies of scale as a single firm is produce the Honda for whole car industry.

g. All airframes for Airbus, Europe's only producer of large aircraft, are assembled in Toulouse,
France.
Ans: Internal economies of scale because a single aircraft firm is producing the output.
h. Cranbury, New Jersey, is the artificial flavor capital of the United States.
Ans: External economies of scale, the industry of artificial flavor is concentrated in the Cranbury,
New Jersey.

2. It is often argued that the existence of increasing returns (economies of scale) is a source of conflict
between countries, since each country is better off if it can increase its production in those industries
characterized by economies of scale. Evaluate this view in terms of the external economy model.
(Chapter 7, Question 2)
Ans: First, trade allows a country to free up resources from a relatively less efficient industry and
expand production in industries with more efficient production.

Second, with increasing returns, this expansion of production will drive down costs and improve
balance of payment (lessen trade deficit), encourages continuous investments in capabilities building
while knowledge gained in the efficient production are typically cannot be traded (can spark
product/process innovation; eg: Qiaotou – a global button town production, small farming village at
Zhejiang province was partially successful due to the firms located at this region continuous to
acquired new knowledge spillovers from both Italy and France, but such industry does not see
dynamic returns are unlikely when you analyze Q9 due to the button/zip industry is still using lower
skilled, lower technology and high proportion of the production activities are labor-intensive) but can
be learned easily and diffused to extend the possibility of spillover to firms located in nearby areas
rather than located at distant place (near proximity is an added advantage e.g. Silicon Valley or Route
128

Third, we also assumed that small producers contribute to aggregate industry output. The spillover is
faster between firms in the vicinity (close proximity/distance) than those father apart (local
knowledge spillover is difficult to transfer if the distance is too great) – clustering effect (e.g.
industrial zone; knowledge spillover or diaspora worked fast in the Silicon Valley region, or software
industry in and around Bangalore and in India).

In absence of trade, the price of buttons in China, P China, is lower than the price of buttons in the
U.S., P U.S.

After trade and established

specialization, with dynamic
increasing returns due to
accumulation of
knowledge or improves its
products, reduce costs or
production techniques (learning-by-doing; learning-by-exporting “firms learn after entering into the
export market” – miracle industrialization through export orientation in East Asian countries)

**The East Asian development experience is a god example of how latecomers can develop, as long
as they put necessary External Economies of Scale pre-conditions ---suppliers/infrastructure/capitals
flows, labor market pool/human capital, knowledge spillovers--- in place.
 When trade is opened, China ends up producing buttons
for the world market, which consists both of its own
domestic market and of the U.S. market. Output rises
from Q1 to Q2, leading to a fall in the price of buttons
from P1 to P2, which is lower than the price of buttons in
either country before trade.

3. Evaluate the relative importance of economies of scale and comparative advantage in causing the
following: (Chapter 7, Question 4)

a. Most of the world’s gold is produced in South Africa or Tanzania.

Ans: Economic of scale on geography let world’s gold is produced in South Africa or Tanzania.

b. Half of the world’s production of uranium comes from just ten mines in six countries.
Ans: Economic of scale o world’s production of uranium because the number of the firms comes
from different countries.

c. Most beef meat comes from either Australia or Argentina.

Ans: Economic of scale on location let Australia and Argentina can product beef meet. Soil,
climactic conditions and historical breeding reflects the comparative advantages too.

d. Most Champagne comes from France.

Ans: Most of Champagne comes from France. The production require special techniques
(specialized suppliers) and it’s ready a French trademark. This labor market pooling suggests
external economy of scale. But soil and climactic conditions too are favourable for producing it
and this reflects comparative advantage.

e. Most of the world’s aluminum is smelted in Norway or Canada.

Ans: It has an economic of scale on location. World’s aluminum is smelted in Norway or Canada
due to the better resources and facilities, it has comparative advantage.

f. Half of the world’s large jet aircraft are assembled in Seattle.

 Ans: Economies of scale are significant in airplane production. It tends to be done by a small
number of firms at a limited number of locations. One such location in Seattle, where Boeing
produces airplanes.

g. Most semiconductors are manufactured in either the United States or Japan.

Ans: External economies of scale are significant in semiconductor production. Semiconductor
industries tend to be concentrated in certain geographically location. If, for some historical reason,
a semiconductor is established in a specific location, the export of semiconductors by that country
is due to economies of scale and not comparative advantage.

h. Most Scotch whiskey comes from Scotland.

Ans: Scotch whiskey can only come from Scotland and it is the 3rd biggest industry in Scotland
economy. The production of scotch whiskey require a technique known to skilled distillers who
are concentrated in the region. This labor market pooling suggests external economies of scale.
Also, soil, climactic conditions are favorable for grains used in local scotch production. This
reflects comparative advantage.

i. Much of the world’s best wine comes from France.

Ans: France has a particular blend of climactic conditions and land that is difficult to reproduce
elsewhere. This generates a comparative advantage in wine production.

4. Consider two countries – India and Japan – facing a forward falling supply curve. Both produce
two commodities – cloth and radios. India, a labor surplus country, produces cloth using cheap labor.
This reduces its domestic price in comparison to Japan. Similarly, Japan being technologically
advanced produces radios at a lower cost than India. If both are open to trade, ceteris paribus.
(Chapter 7, Question 5)

a. What will happen to the world market price for cloth and radio?

Ans: Trade allows India to supply cloth and Japan to supply radios. This is because India has an
initial advantage of lower prices for cloth and also Japan lower prices for radio. Trade would allow
India to supply cloth at a lower price to Japan and Japan able to supply radio to India at a lower
price. Since both are facing a forward falling supply curve, this would reduce the world market price
for both cloth and radio.

Clothing:
 For clothing industry prior to free trade,
you can observed that India has
comparative in clothing since is a labor
abundant country and cloth is a labor-
intensive good. Hence, India is able to
produce a lower cost and can sell at lower
price (P India). In contrast, Japan showed
lesser comparative advantage in the
clothing industry with only producing it a
higher cost and led to higher price (P Jpn).

When free trade is allowed between the two

countries, India ends up producing cloth for the
world market (including for their own domestic
market and for Japan) at a lower prices as output
(demand) rises to D world. India benefited from
cloth specialization and an increases in market
share/demand, while Japan benefited from free
trade through lower product (P2) rather than
manufacturing on their own in autarkic mode.

Radio:
 After trade, Japan gained from increase demand to D world à raise to Q2, while India gained from
importing radio from Japan at lower prices à fell to P2.

b. What would you expect of the international trade and who would produce what, if neither India
nor Japan has an initial advantage of lower price?

Ans: If neither country has an initial advantage of lower prices, then India is expected to produce
cloth( clothing labor-intensive goods) and Japan is expected to produce radio (Japan is capital
abundant so produce capital-intensive goods). This is because India is a labor abundant country
and cloth requires more labor than
technology. Similarly, Japan would produce
radios as radios require more technology over
labor.

5. It is fairly common for an industrial cluster to

break up and for production to move to locations
with lower wages when the technology of the
industry is no longer rapidly improving. When it
is no longer essential to have the absolutely most
modern machinery, when the need for highly
skilled workers has declined and when being at
the cutting edge of innovation conveys only a
small advantage. Explain this tendency of
industrial clusters to break up in terms of the theory of external economies. (Chapter 7, Problem 6)
 Ans: To support the aspiration of individual cluster structure to work successfully, all these three
forces driving the external economies of scale are interrelate among themselves, namely (1) access to
specialized suppliers, (2) labor market pooling and (3) knowledge spillovers, which in turn is set as a
start to support export-biased industries, attract more FDI, and to compete with those outside the
clusters. As these three forces weaken and the clusters are gradually becoming mature trying to
survive without any transformation or upgrading, such used-to-be dominant clusters can start losing
their competitive advantage when industrial linkages become fragmented so do the cost advantages of
geographic clustering. As a result, the location of production becomes increasingly driven by factors
costs when industries move away from external economies of scale toward traditional constant
returns to scale, worst still some firms will be forced out of such competition/ industry due to
decreasing return to scale.

6. Is it always true that trade increases the welfare of a nation? Under what circumstances would the
concentration of industries in one country leave another country worse off when trade resumes
between them? Explain with an example. (Chapter 7, Problem 7)

Ans: We assume that the Thailand could make watches more cheaply, but Switzerland got there first.
The price of watch could lower in Thailand when absence of trade.

After trade, Thailand worse off than before trade. Switzerland is able to supply the world market (D
world) at a lower price (P1) that enough to block the Thailand’s producer entry the market because
Thailand must produce the watch at cost (C0) initially. If Thailand were to block all trade in watches,
it would be able to supply its domestic market at P2.

7. Which of the following goods or services would be most likely to be subject to (1) external
economies of scale and (2) dynamic increasing returns? Explain your answers.

- External economies of scale in production is said to be present when cost per unit of output falls
due to some external factors. Now, a production process is said to exhibit dynamic increasing
returns if the average costs fall as cumulative output over time rises.

a. Software tech-support services

 Ans: External economies of scale likely due to the need to have a common pool of labor with
technical skills. Dynamic increasing returns maybe likely due to the need for continual innovation
and learning.

b. Production of asphalt or concrete

Ans: External economies of scale are unlikely because it is difficult to see how the costs of a single
firm would fall if other firms are present in the asphalt industry. Dynamic increasing returns are
also unlikely as the asphalt industry is pretty well established and learning curves are likely to be
low.

c. Motion pictures

Ans: External economies of scale are highly likely because having a great number of support firms
and available pool of skilled labor in filmmaking are critical to film production. Dynamic
increasing returns also likely because filmmaking is an industry in which learning is important.

d. Cancer research

Ans: External economies of scale are somewhat likely in that it may be advantageous to have other
researchers nearby. Dynamic returns are highly likely because such research builds on itself
through a learning-by-doing process.

e. Timber harvesting

Ans: External economies of scale are somewhat likely if there are a set of skills unique to the
timber industry that would lead to a clustering of timber forms and timber workers. Dynamic
increasing returns are unlikely as the technology used in timber harvesting is relatively stable.

8. As we saw in the text, the Chinese town of Qiaotou produces 60 percent of the world’s buttons. One
problem is that Qiaotou is a relatively small village and its production is carried out by small, family-
owned businesses. What does this tell you about the comparative advantage versus the external
economies in the production of buttons? (Chapter 7, Problem 9)

Ans: This is a external economies of scale. The Chinese industry buttons gives a cost advantage
because of the available pool of skilled labor with the support of Yongjia country government to
improved basic infrastructure, and collaboration networks between firms and nearby universities from
Huannan and Lanzhou to raise button quality and handle material waste effectively as well as
stimulating new product development. However, as the technology used in producing buttons is
relative stable. The only comparative advantage that China might have in this industry is related to
the experience and cost efficiency of the labor.

MCQ
1. If a firm's output more than doubles when all inputs are doubled, production is said to occur
under conditions of
A) constant returns to scale
B) intra-industry equilibrium
C) increasing returns to scale
D) decreasing returns to scale

2. External economies of scale often arise because similar firms

A) locate in the same geographic region
B) collude to fix prices and increase profits
C) have excellent internal logistics
D) agree to cooperate to expand global trade
E) have economies of scale in production

3. External economies of scale arise when the cost per unit

A) rises as the industry and the average firm grows larger
B) rises as the industry grows larger and falls as the average firm grows larger
C) falls as the industry grows larger and rises as the average firm grows larger
D) falls as the industry and the average firm grows larger

4. If output is increased in the long-run, average production costs in the presence of internal
economies of scale will ________, and in the presence of external economies of scale, will
________.
A) decrease; remain constant
B) increase; remain constant
C) increase; decrease
D) decrease; decrease

5. The Internet has made transactions between businesses (B2B trading) fast and easy. Any
business in any location can access specialized knowledge, labor, and materials. It is likely that
these virtual economic communities will result in
A) government intervention and regulation
B) consolidation of industries into a small number of powerful firms
C) suppression of innovations and collusive behavior, driving up prices
D) internal economies of scale
E) external economies of scale
6. If two countries begin trade and both produce a product subject to external economies of scale,
then the country with the ________ rate of production will ________ production until it controls
________ of the market.
A) higher; decrease; 0%
B) lower; increase; 100%
C) higher; increase; 100%
D) higher; increase; 50%

7. Restaurant meals are an example of a ________ good and clothing is an example of a

________ good. The pattern of interregional trade is determined primarily by ________.
A) traded; nontraded; internal economies
B) nontraded; traded; external economies
C) nondurable; durable; natural resource
D) durable; nondurable; natural resources

8. Patterns of interregional trade are primarily determined by ________ rather than ________
because factors of production are generally ________.
A) internal economies; external economies; mobile
B) external economies; population; immobile
C) external economies; natural resources; mobile
D) internal economies; population; immobile

9. The learning curve describes the ________ relationship between ________ and ________.
A) inverse; unit cost; cumulative output
B) direct; unit cost; cumulative output
C) inverse; education; annual income
D) direct; education; annual income

10. The long-run market supply curve in the presence of internal economies of scale is
________, and in the presence of external economies of scale, it is ________.
A) downward sloping; downward sloping
B) upward sloping; horizontal
C) downward sloping; horizontal
D) upward sloping; downward sloping

11. When there are external economies of scale, an increase in the size of the market will
A) decrease the number of firms and lower the price per unit.
B) decrease the number of firms and raise the price per unit.
C) increase the number of firms and raise the price per unit
D) increase the number of firms and lower the price per unit.

12. In the cases listed below, ________ is NOT the result of external economies of scale.
A) A number of firms doing contract research for the drug industry are concentrated in
southeastern South Carolina.
B) Most semiconductors are manufactured in either the United States or Japan.
C) All airframes for Airbus, Europe’s only producer of large aircraft, are assembled in
Toulouse, France.
D) Cranbury, New Jersey, is the artificial flavor capital of the United States.

True or False
13. A country is likely to be better off in the long run if it pursues self-sufficiency. False

14. Cancer research is highly likely subject to dynamic increasing returns because such research
builds on itself through a learning-by-doing process, while timber harvesting is unlikely as the
technology used in timber harvesting is relatively stable. True