Economies of scale:

Another important determinant of trade  is economies of scale or  increasing returns  to  scale in production. As you have learnt in micro economics, economies of scale mean that production at a larger scale can be achieved at a lower cost. When production within an industry has this characteristic, specialisation and trade can result in improvements in productive efficiency, competitiveness  and welfare.

Trade between countries need not depend upon inter-country differences  in the presence of economies of scale.  It is possible that countries could be identical in all respects and  yet  find  it advantageous to  trade. Thus, presence of economies of  scale is often used  to explain trade between  industrialised countries like the US, Japan and  the European Union. When  traditional models of  trade  failed  to explain  trade  among these countries with similar technologies, endowments and similar consumer preferences, economies of scale could provide reasoning.

To reiterate, economies of scale in production mean  that production at a larger scale (more output) can be achieved at a lower cost (i.e. with economies or savings). A simple way  to  formalise this is  to  assume that  the  unit-labow requirement  in  production  of  a good  is a function of the  level of output produced. In Figure 2.1 we present a graph of the unit-labour requirement in steel production as a function of the scale (level of output) of production. At production  level Q¹_s the unit-labour requirement  is given by a¹_LS.  If production were to rise to Q²_s then the unit-labour requirement would fall to a²_LS.  This means that at the higher level of output, it requires less labour (i.e. fewer re- sources or cost) per unit of output than it required at the smaller scale. With  a simple adjustment it  is possible to show that  economies of scale in production are equivalent to increasing returns to scale. Increasing returns to scale  in production means that an  increase  in resource usage, by  say x%, results in an increase  in output by more than x%. In the adjoining diagram we plot  labour  productivity in steel production  when  production exhibits increasing returns to scale. [This graph is derived by plotting the reciprocal of the unit-labour requirement (i.e. 1/a¹_LS)  for each output level in Figure. Note  that as output  (scale) increases  from Q¹_s  to Q²_s  labour productivity (given by  the reciprocal of the unit-labour requirement) also rises.  In other words, output per unit of  labour input increases  as  the scale  of production rises, hence increasing returns to scale

Another way to characterise economies of scale is with a decreasing average cost  curve. Average costs, AC, are calculated as the total costs to produce output Q, TC (Q), divided by total output. Thus AC  (Q) = TC (Q)/Q. When average costs decline as output increases it means that it becomes cheaper to produce the average unit as the scale of production rises, hence economies of scale.

Economies of scale are most likely to be found in industries with large fixed costs in production. Fixed costs are those costs that must be incurred even if production were  to drop to zero. For example fixed costs arise when large amounts of capital equipment must be put into place even if only one unit is to be produced and if the costs of this equipment must still be paid even with zero output. In this case the larger the output, the more the costs of this equipment can be spread out among more units of the good. Large fixed costs and hence economies of scale are prevalent in highiy capital-intensive  industries such as chemicals, petroleum, steel, automobiles etc.