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- Classical models assume constant return to scale (CRS); i.e., when you double output, for instance, output doubles. New Trade Theories relax this assumption. Instead, increasing return to scale (IRS) is assumed. This assumption implies that doubling the input more than doubles the output. Thus, as an industry increases its production:
- the average factor requirement in that industry declines.
- the average total cost (ATC) in that industry declines.
- IRS could be the result of:
- external economies of scale; i.e., ATC declines as an industry produces more.
- Typically happens in fairly competitive industries with a large number of small firms.
- It could be due to lower cost of specialized equipment/services at geographical locations where production is concentrated (e.g., Silicon Valley).
- It could be due to lower cost of search in hiring where a pool of skilled workers are available at geographical locations where production is concentrated (e.g., Hollywood).
- It could be due to knowledge spillover between firms or skilled labor force who are located at geographical locations where production is concentrated (e.g., Silicon Valley).
- Therefore, the geographic concentration of production may lead to external economies of scale.
- internal economies of scale; i.e., ATC declines as a given firm produces more.
- Typically happens when there are few large firms with cost advantage over small firms.
- Our discussion of New Trade Theory focuses greatly on external economies of scale, for which geography of production matters. Our discussion of New New Trade Theory, however, focuses greatly on internal economics of scale, for which firm size and productivity matters.
- Unlike standard trade model where prices converge as a result of free trade, external economies of scale may lead to a reduction of prices across the board. Trade provides market access for the low cost producers, increasing the scale of their industry, which in turn lowers the cost of their production even further.
- Low cost producers have some initial advantage. This could be the result of comparative advantage. It also could be the result of historical accidents.
- Once advantage in production is well established by one country, then the entry of other countries may be impossible due to the high cost of entry.
- Thus, other countries may find it beneficial to protect their domestic industry. They may argue that temporary protection of an industry may enable them to gain from dynamic increasing returns (where ATC declines as cumulative output, rather than current output, increases), which in turn may allow them to bring their cost of production lower than the existing international prices. This is known as Infant Industries Argument. Traditionally, there are some conditions for the validity of this argument:
- John Stuart Mill’s conditions:
- There should exist a dynamic learning effect, which directly relates to dynamic increasing return to scale.
- Protection must be temporary.
- The protected industry must in future become viable without any further protections.
- Charles Francis Bastable’s condition:
- Cumulative net benefits of protection must exceed its cost.
- In practice, however, choosing the right industry, the appropriate trade policy instrument (e.g., tariff vs. subsidy), and the right timing (i.e., when to begin protection) and timeline (i.e., how to gradually loosen and eventually end protection) are proved to be quite challenging. The realities of political economic environment in a given country may adversely affect the potential gains from infant industry protections.