International Trade Theory and Policy
by Steven M. Suranovic

Trade 80-0

Economies of Scale and International Trade: Overview

Another 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 upon 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 between countries like the US, Japan and the European Union. For the most part these countries, and other developed countries, have similar technologies, endowments and to some extent similar preferences. Using classical models of trade (Ricardian, Heckscher-Ohlin), these countries would have little reason to engage in trade. And 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.

Another feature of international trade that remains unexplained with classical models is the phenomenon of intra-industry trade. A quick look at the aggregate trade data reveals that many countries export and import similar products. For example, the US imports and exports automobiles, it imports and exports machine tools, it imports and exports steel, etc. To some extent intra-industry trade arises because many different types of products are aggregated into one category. For example, many different types of steel are produced, from flat-rolled to specialty steels. It may be that production of some types of steel require certain resources or technologies in which one country has a comparative advantage. Another country may have the comparative advantage in another type of steel. However, since all of these types are generally aggregated into one export/import category, it could appear as if the countries are exporting and importing "identical" products when in actuality they are exporting one type of steel and importing another type.

Nevertheless it is possible to explain intra-industry trade in a model that includes economies of scale and differentiated products even when there are no differences in resources or technologies across countries. This model is called the monopolistic competition model. Its focus is on consumer demand for a variety of characteristics embodied in the goods sold in a product category. In this model, advantageous trade in differentiated products can occur even when countries are very similar in their productive capacities.

International Trade Theory and Policy - Chapter 80-0: Last Updated on 2/15/07