Explain the concept of scale economies. Explain the difference between internal and external scale economies. What pattern of trade do we expect to see in industries with substantial external scale economies?
What will be an ideal response?
POSSIBLE RESPONSE: Scale economies are realized when the increase in output outpaces the increase in the expenditures on all inputs in the production process. As an example, if we double all input factors, with scale economies, the output produced will be more than double. As a consequence, the average cost of production will decline with a rise in the level of output. Internal scale economies are observed when the expansion of the size of the firm is the basis for the decline in its average cost. In contrast, external scale economies arise if the average cost of production declines with an increase in the size of the entire industry within a specific geographic area.
The presence of substantial external scale economies in an industry typically results in the clustering of the production in a few specific geographical areas. Examples are the concentration of the banking and finance industries in London and New York City, the production of stylish clothing, shoes and accessories in Italy, and the production of watches in Switzerland. With low average costs (and high product quality) in these locations, these countries are net exporters of the product, and other countries import the product. The actual locations that will prosper is difficult to predict. It depends on factors such as domestic market size, history, and government intervention.
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