1 External Economies and the International Lo-

cation of Production
IT .…rms are concentrated in Silicon Valley despite its congestion and high
land prices. Entertainment industry is concentrated in Los Angeles, Financial
industry, fashion industry, advertisement industry are concentrated in New York
City. Automobile industry used to be concentrated in Detroit and its vicinity.
Why? External economies (sometimes called the Marshallian externality after
Alfred Marshall) occur when increasing the size of a local industry lowers the
average cost of individual …rms in the industry.

1.1 Sources of external economies

Economists consider the following aspects important in explaining external
economies.

1.1.1 specialized suppliers

Firms in Silicon Valley, for example, typically need the service of other …rms who
provide specialized products and capabilities. It is not economical for individual
…rms to possess all these specialized capabilities themselves. Thus, individual
…rms tend to locate where they can easily access these specialized products.
The …rms o¤ering specialized products also need large enough (local) market
for them to be pro…table.

1.1.2 Labor Market Pooling

A …rm in an industry …nds it convenient and pro…table to be able to access a
large pool of specialized labor in its proximity. Workers also …nd it convenient
to have many potential employers in her proximity. Thus, workers with spe-
cialties tend to move to the area where a concentration of …rms demands their
specialties..

1.1.3 Knowledge Spillover

Much technical and market knowledge are transferred through informal inter-
action of workers in an industry. Such interaction typically requires proximity
of workers. If a …rm is located in a center of its industry, it can bene…t more
from this informal spillover of knowledge.

1.2 External Economies and International Trade

With external economy, industry average cost decreases as the size of industry
increases. Consider the case of button industry. Suppose China initially had
a cost advantage in button industry because of its large size domestic market
and lower labor cost. US on the other hand has a higher button price due to its

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smaller domestic market and higher labor cost. If the two countries open trade
in buttons, China will start to take production away from USA due to its lower
button prices. As Chinese production increases, its cost decreases further while
US production decreases and its cost increases. Ultimately, China produces
most buttons for China and USA. This situation is illustrated in Figure 7-2 and
Figure 7-3 (page 158-9).

1.2.1 The importance of established advantage

The nature of external economy makes established advantage very important.
This is illustrated in Figure 7-4. In this hypothetical example, Vietnam has
lower average cost curve for buttons as a function of industry production. If,
however, China has already moved down its cost curve as it supplies its domestic
market, its average cost may be lower than the price Vietnamese need to charge
in a monopolistic competition if it enters the market. This initial advantage is
often obtained as a historical accident. For example, an area in Cambridge, MA
was a potential competitor to Silicon Valley. However, Silicon Valley had already
established its advantage and this is one reason why it never became a serious
competitor to Silicon Valley in IT industry. How does a location establish an
advantage? Often the advantage is obtained by historical accident. There is a
city in China producing a large percentage of buttons for the world. Obviously,
the city must have some advantage in establishing the industry. However, there
may be many other cities in China with similar characteristics.

Exercise 1 De…ne what is meant by: Food industry is capital intensive.

Exercise 2 Suppose in a H-O model, cloth and food are produced with capital
and labor. Home is capital abundant and cloth production is capital intensive.
How would home relative output price of cloth behave as home opens up to
international trade? What can you say about the welfare change of home capital
owners and labor? Explain your answers.

Exercise 3 Suppose that a country has two clusters of an industry. Both are
subject to external economies and monopolistically competitive. Explain why the
cluster with lower current cost tends to grow at the expense of the higher cost
cluster.