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15.4: Returns to scale and dynamic gains from trade

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    The theory of comparative advantage explains why economies should wish to trade. The theory is based upon the view that economies are 'inherently' different in their production capabilities. But trade is influenced by more than these differences. We will explore how returns to scale may be exploited to generate benefits from trade, and also how economies might gain from one-another by learning as a result of trading. This learning can increase domestic productivity.

    Returns to scale

    One of the reasons Canada signed the North America Free trade Agreement (NAFTA) was that economists convinced the Canadian government that a larger market would enable Canadian producers to be even more efficient than in the presence of trade barriers. Rather than opening up trade in order to take advantage of existing comparative advantage, it was proposed that efficiencies would actually increase with market size. This argument is easily understood in terms of increasing returns to scale concepts that we developed in Chapter 8. Essentially, economists suggested that there were several sectors of the Canadian economy that were operating on the downward sloping section of their long-run average cost curve.

    Increasing returns are evident in the world market place as well as the domestic marketplace. Witness the small number of aircraft manufacturers—Airbus and Boeing are the world's two major manufacturers of large aircraft. Enormous fixed costs—in the form of research, design, and development—or capital outlays frequently result in decreasing unit costs, and the world marketplace can be supplied at a lower cost if some specialization can take place. Facebook is the giant in social media. Entertainment streaming companies like Netflix, Amazon, Disney and Hulu are few in number because of scale economies. Consider the specific example of automotive trade. In North America, Canadian auto plants produce different vehicle models than their counterparts in the US. Canada exports some models of a given manufacturer to the United States and imports other models. This is the phenomenon of intra-industry trade and intra-firm trade. How can we explain these patterns?

    Intra-industry trade is two-way international trade in products produced within the same industry.

    Intra-firm trade is two-way trade in international products produced within the same firm.

    In the first instance, intra-industry trade reflects the preference of consumers for a choice of brands; consumers do not all want the same vehicle, or the same software, or the same furnishings. The second element to intra-industry trade is that increasing returns to scale characterize many production processes. Let us see if we can transform the returns to scale ideas developed in earlier chapters into a production possibility framework.

    Figure 15.3 Intra industry trade
    img479.png
    Hunda can produce either 100,000 of each vehicle or 40,000 of both in each plant. Hence production possibilities are given by the points A, Z, and B. Pre-trade it produces at Z in each economy due to trade barriers. Post-trade it produces at A in one economy and B in the other, and ships the vehicles internationally. Total production increases from 160,000 to 200,000 using the same resources.

    Consider the example presented in Figure 15.3, where the hypothetical company Hunda Motor Corporation currently has a large assembly plant in each of Canada and the US where it produces two types of vehicles; sedans and sports utility vehicles (SUVs). Intially, restrictions on trade in automobiles, in the form of tariffs, between the two countries make it too costly to ship models across the border. Hence Hunda produces both sedans and SUVs in each plant. But for several reasons, switching between model production is costly and results in reduced output. Hunda can produce 40,000 vehicles of each type per annum in its plants, but could produce 100,000 of a single model in each plant, using the same amount of capital and labour. This is a situation of increasing returns to scale, and in this instance the scale economies are what make gains from trade possible - as opposed to any innate comparative advantage between the economies. If trade barriers against the shipment of autos across national boundaries can be eliminated, then Hunda can take advantage of scale economies in each plant and increase its total production without using more capital and labour.

    As this example implies, an opening up of trade increases the potential market size, and producers who experience increasing returns to scale stand to benefit from an enlarged market because their potential unit costs fall. Returns to scale are not limited to finished goods. Returns to scale characterize the production of many intermediate goods, which are goods used to produce other final goods or services. Manufacturers rarely produce all of the components entering their final products; they have supply chains for components that comprise numerous suppliers. In the automotive industry transmissions, gearboxes and seats are such intermediate goods. If either returns to scale, or comparative advantage, characterize their supply then there are gains to trade in these goods. In the context of the North American Free Trade Agreement (NAFTA). and its most recent form (the US Mexico and Canada Agreement - USMCA), automotive parts as well as automobiles can be shipped free of tariffs across borders provided that they satisfy regional value content (RVC) rules. We observe, for example, transmissions being produced in Ontario and seats in Mexico, and these goods are also shipped freely within North America provided they satisfy the RVC rules. Scale economies characterize transmission manufacture, and comparative advantage characterizes seat production – labour costs are lower in Mexico, and seats are labor intensive.

    Content requirements apply to some goods under the NAFTA/USMCA. In the case of vehicles and their components, NAFTA required a 62.5% regional value content - that is, to be imported into one of the NAFTA signatories free of tariffs, 62.5% of the vehicle value had to be attributable to production in one of the three economies. This requirement was designed to prevent the members from using an excessive amount of components from low-wage economies and thereby undermine production of parts and vehicles in North America. The USMCA raises (by the year 2023) the regional value component (RVC) to 75% for most vehicles (70% for heavy trucks), and the RVC to between 65% and 75% on vehicle parts.

    Supply chain: denotes the numerous sources for intermediate goods used in producing a final product

    Intermediate good: one that is used in the production of final output

    Regional value content: requires that a specified percentage of the final value of a product originate in the economies covered in the Agreement.

    Dynamic gains from trade

    The term dynamic gains denotes the potential for domestic producers to increase productivity as a result of competing with, and learning from, foreign producers.

    Dynamic gains: the potential for domestic producers to increase productivity by competing with, and learning from, foreign producers.

    Production processes in reality are seldom static. Innovation is constant in the modern world, and innovation is manifested in the form of productivity improvements. An economy's production possibility frontier is determined by its endowments of capital and labour and also the efficiency with which it uses those productive factors. Total factor productivity defines how efficiently the factors of production are combined. Research suggests that in developed economies this productivity increases by about 1% per annum. This means that more output can be produced using the same amounts of capital and labour because production is being carried out more efficiently. In graphical terms, such productivity improvements effectively push out an economy's production possibility frontier by 1% per annum. For economies in the process of development, this productivity growth may be as high as 3% or 4% per annum – for the reason that these economies can observe and learn from economies that are ahead of it technologically.

    Freer trade forces domestic firms to compete with foreign firms that may be more productive. Domestic firms that can learn and adapt to competition by becoming more efficient will survive, firms that cannot adapt will not. Inevitably, there will be winners and losers in the production sector of the economy, whereas in the consumption sector most consumers should be winners.

    Total factor productivity: a measure of how efficiently the factors of production are combined.


    This page titled 15.4: Returns to scale and dynamic gains from trade is shared under a CC BY-NC-SA 4.0 license and was authored, remixed, and/or curated by Douglas Curtis and Ian Irvine (Lyryx) via source content that was edited to the style and standards of the LibreTexts platform; a detailed edit history is available upon request.