International trade theory recognizes three fundamental reasons for countries to trade: comparative advantage (to exploit differences in countries' tastes, technologies, or factor endowments), economies of scale (to concentrate on fewer tasks in order to produce more efficiently), and imperfect competition (to expose firms to more competition). Comparative advantage has always been dominant in trade theory, although economies of scale also long played a secondary role. This changed in the late 1970s, when economists realized that the lion's share of world trade consisted of the exchange of similar (manufactured) goods between similar (rich) countries.
A common reaction to this realization was that such trade could not be due to comparative advantage. But if similar countries trade similar goods, price elasticities (the sensitivities of demands and supplies of goods to price variations) are likely to be high since the traded products will likely be good substitutes. Similar countries would have similar relative prices in autarky (the absence of international trade), so comparative-advantage trade, establishing a world price between the two autarky prices, would imply a modest price change in each country. But, with high elasticities, this could still involve heavy trade. Likewise, dissimilar countries trading very distinct goods - manufactures for primary products, for example - could be expected to experience large price changes, but the resulting trade volumes could be small as price elasticities are likely to be low.
So, comparative advantage was not necessarily inconsistent with actual trade. Nevertheless, it was important to consider alternative possibilities because, although trade to exploit differences does not imply that the greater the differences, the greater the trade, it does imply, other things being equal, that the greater the differences, the greater the gains from trade. Thus one might conclude that the smaller part of world trade - that between dissimilar countries in quite different products - is more important for policy. But if trade patterns are significantly due to something other than comparative advantage, this conclusion need not follow.
Increasing returns to scale (IRS) and imperfect competition supply alternatives. This article considers the former, often also referred to as economies of scale.
Types of Scale Economies In practice, scale economies occur in great variety, so a classification of the more important attributes is useful.
Internal versus external (to the firm). Scale economies are internal if the individual firm can reduce average costs by operating at a higher scale (e.g., assembly-line operations and equipment made possible by large-scale production). They are external if the individual firm operates subject to constant returns to scale (CRS), but costs are lower the larger the industry in which the firm is located (e.g., well-developed infrastructure and a large supply of skilled workers consequent on a large industrial sector). Internal economies are inconsistent with a perfectly competitive equilibrium, and external economies are, well, externalities. Since the theory of comparative advantage assumes perfect competition and no externalities, trade due to economies of scale alone cannot be comparative-advantage trade.
National versus international. Economies of scale may depend on the scale of operations within a nation (e.g., large plant size) or on the scale of operations globally (e.g., division of labor and free trade in intermediate goods). Either might be internal or external to the firm. An example of internal, international economies of scale is research and development (R&D) by a multinational firm that utilizes the results of the R&D in several countries.
Aggregative versus disaggregative. Increasing returns may be a property of manufacturing generally (e.g., the size of the industrial sector) or of individual manufactured goods (e.g., the number of red sedans).
These three considerations generate eight types of scale economies, each relevant in reality. Comparative-advantage trade can also be due to many causes, but they all matter solely in terms of how they influence differences in relative autarky prices. This imparts an attractive formal unity to that theory's predictions. Trade due to economies of scale is dramatically different: Basic implications are indeed very sensitive to the type of scale economy. Consider first national, aggregative, increasing returns external to the firm.