How do the factors mentioned below impact international trade : (a) Increasing returns to scale

Understanding Increasing Returns to Scale

Increasing returns to scale (IRTS) arise due to several factors:

• Specialization of Labor: As production expands, workers can specialize in specific tasks, leading to increased efficiency.
• Technological Advancements: Investments in research and development (R&D) and the adoption of new technologies often exhibit IRTS, as the initial fixed costs are spread over a larger output.
• Indivisible Inputs: Some inputs, like specialized machinery or management expertise, are ‘lumpy’ and must be used in fixed amounts regardless of output level. This leads to lower average costs as output increases.
• Network Effects: The value of a product or service increases as more people use it (e.g., social media platforms).

Impact of IRTS on International Trade

1. Shaping Comparative Advantage

Traditional trade theory, based on comparative advantage stemming from differences in labor productivity, is incomplete without considering IRTS. IRTS can create comparative advantage. Countries that are first to achieve scale in a particular industry can establish a cost advantage, even if they initially lacked any inherent productivity advantage. This is often referred to as ‘dynamic comparative advantage’.

For example, South Korea’s success in the semiconductor industry wasn’t initially based on superior resources but on strategic investments and achieving scale, leading to lower costs and a dominant market position.

2. Promoting Specialization and Trade Volume

IRTS incentivize countries to specialize in the production of goods where they can achieve economies of scale. This specialization leads to increased trade volumes as countries export their specialized products and import others. The larger the global market, the greater the potential for exploiting IRTS.

The automotive industry exemplifies this. Production is concentrated in a few countries (Japan, Germany, US, South Korea) due to the massive fixed costs involved in setting up manufacturing facilities and developing new models. These countries then export automobiles globally.

3. The Rise of Global Value Chains (GVCs)

IRTS are a key driver of GVCs. Firms break down production processes into discrete tasks and locate each task in the country where it can be performed most efficiently, often leveraging IRTS. This leads to fragmentation of production and increased trade in intermediate goods.

Consider the iPhone. Components are designed in the US, manufactured in various countries (e.g., screens in Japan, assembly in China), and then assembled into the final product. This fragmentation is driven by the desire to exploit IRTS at each stage of the production process.

4. Impact on Developing Countries

IRTS can present both opportunities and challenges for developing countries:

• Opportunities: Developing countries can participate in GVCs by specializing in specific tasks, attracting foreign investment, and gaining access to technology and know-how.
• Challenges: Developing countries may struggle to achieve the scale necessary to compete in industries with significant IRTS. They may become locked into low-value-added activities within GVCs.

Bangladesh’s garment industry is a prime example. While it has benefited from participating in GVCs, it largely focuses on labor-intensive cutting and sewing, with limited value addition.

5. Implications for Developed Countries

Developed countries often benefit from IRTS through innovation, R&D, and the development of high-value-added products. They can also leverage their strong infrastructure and skilled labor force to attract investment and participate in GVCs.

Germany’s engineering and automotive industries are examples of sectors that benefit from IRTS through continuous innovation and high-quality production.

Trade Policies and IRTS

Trade policies can either facilitate or hinder the exploitation of IRTS. Policies that promote market access, reduce trade barriers, and encourage foreign investment can help firms achieve scale and compete globally. Conversely, protectionist policies can limit market size and prevent firms from realizing economies of scale.