The Economics of Public Policy 9. External Economies of Scale and the Location of Economic Activity

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1 Fletcher School of Law and Diplomacy, Tufts University The Economics of Public Policy 9. External Economies of Scale and the Location of Economic Activity Prof George Alogoskoufis

2 Why do External Economies of Scale Arise Why are average costs in an industry or a sector lower if the industry or the sector is geographically concentrated in one area. The question was put first and answered by Alfred Marshall, one of the most important neoclassical economists. Marshall emphasized three factors: 1. The emergence of specialized suppliers in the area, serving all the firms in the industry with low cost supplies of intermediate services and products required by the industry. 2. The emergence of a skilled workforce with accumulated experience in the particular skills required by the industry. 3. The continuous transfer and dissemination of know-how between managers and workers, because of the proximity between firms and interpersonal exchanges of information. All these factors are related to positive externalities which reduce costs and increase productivity. 2

3 Eminent Economists Alfred Marshall Alfred Marshall (26 July July 1924) was one of the most influential economists of his time. In 1885 he became Professor of Political Economy at the University of Cambridge, where he remained until his retirement in His book, Principles of Economics (1890), was the dominant economic textbook in England for many years. It brings the ideas of supply and demand, marginal utility, and costs of production into a coherent whole. Marshall is considered as one of the founders of neoclassical economics. Although he took economics to a more mathematically rigorous level, he did not want mathematics to overshadow economics and thus make economics irrelevant to the layman. 3

4 Geographically Concentrated Industries due to External Economies The US automotive industry in Detroit. The concentration of the global car industry in Japan and Europe. Silicon Valley in California. The concentration of the production of consumer electronics in Japan, Korea and China. The concentration of banking, financial and investment firms in New York, London, Frankfurt, Hong Kong and Tokyo. The concentration of the global film industry in Hollywood. The concentration of the global music industry in London, New York and Los Angeles. The concentration of the watch industry in Switzerland. The concentration of the production of garments, and the assembly of television sets and smartphones in China. The concentration of the shipbuilding industry in Japan, South Korea, China. 4

5 Other Geographically Concentrated due to External Economies Cutlery industry in Sheffield, England and the production of woolen socks in Northampton, England (in the times of Alfred Marshall). Scotch Whisky (Highlands, Speyside, Islay, in Scotland, Japan). Red Wine (Bordeaux and Burgundy, France, Napa Valley, California) Sparkling wine (Champagne, France) Cheese and Ham (Parma, Italy) Cigars (Habana, Cuba) Buttons and Zippers (Qiaotou, China) 5

6 External Economies and Equilibrium in a Competitive Industry 6

7 Market Equilibrium in the USA and China with Trade Restrictions 7

8 Market Equilibrium in the USA and China with Free Trade 8

9 The Importance of Initial Conditions and the Potential Suboptimality of Equilibrium with External Economies 9

10 Eminent Economists Paul Krugman Paul Robin Krugman (February 28, 1953-) is an American economist, who is Professor of Economics at the Graduate Center of the City University of New York, a former Professor of Economics at MIT and Princeton, and a columnist for The New York Times. In 2008, Krugman was awarded the Nobel Memorial Prize in Economic Sciences for his contributions to New Trade Theory and New Economic Geography. The Prize Committee cited Krugman's work explaining the patterns of international trade and the geographic distribution of economic activity, by examining the effects of economies of scale and of consumer preferences for diverse goods and services. 10

11 Qiaotou and the Global Production of Buttons and Zips Because of external economies, the international location of production in various sectors is to a large extent the result of historical accidents which give a head start to one or other country or location the moment trade is liberalized. A dramatic example is the case of Qiaotou in China. In 1980, three brothers in Qiaotou started up a business by picking buttons off the street. Thirty five years on, this remote town makes almost every zip and button we wear. Just down the road, another has become a global centre for toothbrushmaking, while a third is now the world capital of socks. [See the exciting article in The Guardian, May 24, 2005] 11

12 Interregional Trade and Economic Geography External economies play an important role in determining the structure of interregional and international trade. This is because within countries, with the exception of natural resources, inputs are quite agile. Thus, if a sector starts expanding in a particular region, and productivity starts rising in this sector, it will quickly attract both capital and labor that will reinforce its expansion. The same happens with international trade. If a country has a price advantage in a sector characterized by external economies, consumers will switch demand to the product of this country, causing the sector to expand in this particular country, at the expense of related sectors in other countries. Thus, sectors characterized by external economies will tend to concentrated in particular regions or countries. Apart from comparative advantage and scale economies internal to firms, what largely determines specialization, the location of economic activity and trade are externalities. The location of the various sectors we have mentioned is largely the result of historical "accidents", which created positive externalities such as those emphasized by Marshall. 12

13 Conclusions about the Effects of Interregional and International Trade The pattern of interregional and international trade can be a result of both comparative advantage and economies of scale. External economies of scale give various regions and countries an opportunity for specialization, even in sectors in which there is not necessarily a comparative advantage. Internal scale economies are incompatible with perfect competition. External economies of scale are consistent with perfect competition, but also imply a special role for the historical development of various sectors and for random events in determining the structure of international trade. 13

14 The Location of Economic Activity in the USA Evidence from a Satellite Picture of the USA at Night 14

15 The Location of Economic Activity in Europe Evidence from a Satellite Picture of Europe at Night 15

16 The Location of Economic Activity in South East Asia Evidence from a Satellite Picture Night 16

17 Some Facts about the Location of Economic Activity Economic activity is highly concentrated geographically at the national level as well as within nations. People located in the core enjoy higher incomes and lower unemployment rates. While income inequality across nations has narrowed steadily with economic integration, the geographical distribution of economic activity within states has become more concentrated, as measured for example by per capita income. As far as specialization is concerned, globalization had very important effects on the relocation of economic activity among nations. Most nations have become more specialized on a sector by sector basis. At the sub-national level, industry has become spatially more concentrated as well. 17

18 Externalities and Industrial, Regional and Trade Policy External economies such as the ones we have mentioned can potentially justify the industrial policies of many nations to nurture and protect so called infant industries, in the expectation that as these industries grow they will generate external economies that will propel them to expand even further. They also justify the regional policies of many countries, which provide special incentives for investment in backward regions. There are many examples of industrial and international trade policies that were justified on infant industry protection arguments. The industrial policy of Japan in the first four decades after World War II could be justified on such grounds, although it did not concentrate on specific industries. The rescue of Harley Davidson during the Reagan years. The attempts by Brazil and China to protect their computer and car industries respectively. Some would also argue that the industrial revolution in the United States in the 19th century happened because of the protection afforded by tariffs to the infant US industry by Alexander Hamilton, the first US Secretary of the Treasury. 18