Economies of Scale and Product Differentiation:

Our discussion so  far shows that gains from trade primarily occur due  to specialisation  in  production  and  exchange along lines of comparative advantage.  Gains from trade may also arise from another source, viz.  the existence of scale economies (or increasing returns) in certain industries. Economies of scale are said to exist, when large scale production leads to a reduction in unit costs for firms, leading to  lower prices  for consumers. In industries with economies of scale, the smallness of the market is the single most constraint that prevents the realisation of scale economies. This could be a problem especially  in  low income developing countries,  where  industrialisation based on the domestic market alone may only allow production of a narrow range of products.

This is where international trade can play an important  role, by enhancing  the size of the market  facing domestic industry. Clearly with trade,  firms can produce for the domestic as well as foreign markets, allowing  them to enhance the scale of operation and reap the benefits of scale economies. With  falling unit costs, consumers would also benefit from lower product prices.

The  assumption of perfect competition breaks down with the existence of scale economieb. So these trade models (associated with economists like Avinash Dixit, Elhannan Helpman, Paul Krugman  and others) are analysed using models of imperfect competition (such as monopolistic  competition, which  is a market situation  characterised by firms selling differentiated products).

In this situation  there is another source of gains from trade. In the presence of economies of scale  even the variety of goods, a nation produces, is constrained by the smallness of the market size. With trade each nation would specialise in the production of a relatively small variety  of goods  (and reap benefits of scale economies) and import a wide variety goods that it does not produce from the rest of  the world. This widens the range of choice  for consumers and they derive higher utility from a more differentiated consumption  basket. Here trade results in mutual gains, even when countries do not differ in terms of endowments of resources and  technology. An  example is the substantial extent of intra-industry trade taking place among developed  nations. Thus existence of scale economies allows for gains fkom  trade fkom at least two sources. Consumers gain due to lower goods prices (owing to economies of scale) and they also gain from the greater variety in consumption afforded by the  fact  that  owing to  trade, different countries can specialise in  the production of different varieties of goods.