Distinguish between external and internal economies of scale and use these concepts to explain the phenomenon of intra- industry trade. Can the Heckscher-Ohlin model of trade explain intra-industry trade?
Economies of scale refer to the phenomenon which expanding the scale of output will increase the profits. In a certain time period, the products of firm increase while the cost decreases. To expand the scale of operation can reduce the average costs, thereby increasing the level of profits. The two ways: internal and external economies of scale can achieve this. The size of the enterprise should be considered firstly, and the following are effect on AC curve and relative factors.
Internal economies of scale derived from the increase of the amount of outputs of the enterprise itself rather than depending on the industry as a whole (Kevin and Hamid, 2001). Due to the production scale and increased production, the fixed cost, such as management costs, information costs, design costs, research and development costs, allocated on each product will become less and less which will decline the cost of product in average, either through specializing on some certain products or other factors. When the costs decrease on average, the given price of good is fixed, profit margins of these firms will be increased so that the individual firm will gain benefit from internal economies of scale.
External economies of scale means when the output of the entire industry has been enlarged due to the increased amount of enterprises, hence, the average cost of production of enterprises in this industry declines (Kevin and Hamid, 2001). External economies of scale theory also pointed out that industry with large-scale regional areas is more efficient than the smaller one when other conditions are equal. The expansion of the scale of the industry can result in increasing returns to the firms in that region which will lead to some kind of industry and its auxiliary departments of large-scale are highly concentrated in one or several locations, thus form the external economies of scale. Unlike internal economies of scale, external economies of scales depend on the size of the individual enterprise in the industry because both small-scale and large firms can gain benefits from it.
Secondly, there are several factors contributing to internal and external economies of scale. A technical economy is an important factor that causes internal economies of scale (Kevin and Hamid, 2001). With the increase in the scale of production, there will be more specific for the workers to do. Repeated practices and specialization can be used to improve their productivity in one single job for most of the workers. When productivity rises per worker, the firm can actually produce more goods than before and hence, the average cost of the goo decreases. Marketing economies and financial economies also play an important role in the existence of internal economies of scale. Marketing economies refer to bulk purchase on raw materials which means cheaper prices. Financial economies means when a firm increases its scale of production and need capital to purchase more raw materials of production, it can get a lower interest rates from a bank as its larger assets and greater selling potential.
And external economies mainly depend on three kinds of economies. Concentration economies will be discussed first. When firms in the same industry are located close to each other, they can share the skilled workers and infrastructure provided by local government. With these conveniences, firms are able to lower the average costs of production because of the high productivity. Disintegration and information economies also can use the sale of the by-products to lower average costs of production.
Finally, the two kinds of economies of scale affect the firm’s average cost curve in different way. As you can see from the graph, the original position for output is OQ1 which needs OC1 to produce. However, if the company was to increase the output to OQ2, according to curve LRAC1, the cost will be OC2. The increase of output leads to the decrease of cost, which means the internal economies of scale existing. However, external economies of scale don’t cause the movement on LRAC1, it is the shift downwards, moving from LRAC1 to LRAC2. When the firm also produce the same amount of product at OQ1, the cost will be OC2 now, which dues to the advancement of the industry as a whole.
Intra-industry trade refers to a trade of products which belong to the same industry. Intra-industry trade is a trade of similar products which has been a key factor in trade growth for several years. Intra-industry trade gives opportunities for business to gain profit from the economies of scale. That means, if they focus on producing some certain types of products with some certain range rather than covering all ranges of specific products, the companies will gain more economic benefits. Also, intra-industry trade can expand the categories of product in the same industry and provide the opportunity of having a number of different products with the markets. Innovation is another important factor in economies of scale and to some extent, intra-industry trade can stimulate innovation in industry which can prevent the economy from short-term economic fluctuations (Paul, Maurice and Marc, 2007/2008).
Heckscher-Ohlin model refers to a model which tries to explain the occurrence of international trade (Steven and Michael, 2007). Hechkscher-Ohlin model, which based on using the idea of comparative advantage and an explanation of why countries trade, actually cannot explain the intra-industry trade (Michael, 1990). Intra-industry trade involves products from the same industry which are traded between countries, however, Heckscher-Ohlin theory states that countries will concentrate on exporting those products for the production of which their abundant resources are going to be used. Hechscher-Ohlin still fails to explain intra-industry trade between countries as the theory contradicts to the notion of intra-industry trade in fundamental level.