Notes on Increasing Returns and New Trade Theory

Increasing returns
Internal economies of scale: doubling your output does not require
doubling of your cost. In other words, the average cost of
production decreases with increased output.
A simple example
US production technology
computer
auto
Vol
AC
Vol
AC
10 mil $100 10 mil $100
20 mil $50
20 mil $50

Japan production technology

Computer
auto
Vol
AC
Vol
AC
10 mil $100 10 mil $100
20 mil $50
20 mil $50

Closed economy
US current production
computer
auto
Vol
AC
Vol
AC
10 mil $100 10 mil $100

Japan current production

Computer
auto
Vol
AC
Vol
AC
10 mil $100 10 mil $100

Possible production allocation with trade

computer
Auto

computer
Auto

production
20 mil
0

production
0
20 mil

AC
$50

AC
0
$50

US
consumption
10 mil
10 mil

export
10 mil
- 10 mil

Japan
consumption
10 mil
10 mil

export
- 10 mil
10 mil

In the new allocation with trade, world production and individual

country consumption remain the same. However, the cost of
production goes down for both goods.
Question:
At what price will the goods be available to consumers?
Increasing returns are usually associated with a monopoly instead
of a firm facing perfect competition.
Can the above allocation be realized as a market equilibrium?
However, note one similarity to the traditional trade model: It
might be possible for both countries to benefit from trade by each
restricting the number of goods produced (specialization) and
expand the production of the remaining goods. In this case, the
reason for specialization comes not from differences in technology
or in factor abundance, but from increasing returns.

Each firm produces a different variety of the same good. So as

market size increases, the number of firms and the number of
varieties increase. And these varieties are available at a lower
price.

Increasing return and trade

Lets say before trade, the equilibrium number of firms in each
country is 5. So 5 varieties of the good are produced in each
country.
When the two countries open up to trade so that the two markets
are integrated, the market size doubles.
The new equilibrium number of firms in the world is between 5
and 10, say 8.
So consumers in each country now have 8 varieties available to
them instead of 5. And these varieties are available at a lower price
than before trade.

After trade, there is a consolidation in this industry: the total

number of firms goes from 10 to 8.
Is this bad? Does this mean that the surviving firms have more
monopoly power?
Apply this model to trade among European countries. What is one
of the benefits of the European Union?

Another type of increasing return

Dynamic increasing return:
The unit cost of production decreases as the cumulative volume of
production goes up.
watch example

The unit cost curve might be decreasing for two different reasons:
Learning-by-doing (learning curve or experience curve)
External economies of scale
Specialized suppliers
Knowledge spillovers
Labor market pooling
Implication of dynamic increasing returns for trade
Gives rise to first-mover advantage.
Trade patterns need not be determined by comparative advantage
or factor endowment, but by chance who the first one was.

Illustration of benefit of labor market pooling:

Tinseltown Economics
Watch the Joe Canada video
http://www.youtube.com/watch?v=pnpVH7kIb_8
What happened to Joe Canada?
http://www.sfgate.com/cgi-bin/article.cgi?
f=/c/a/2001/01/21/MN171726.DTL&hw=NOVA+SCOTIA+CAN
ADA&sn=002&sc=878