Trade and Communication Costs

by
Richard G. Harris

Simon Fraser University

and
Canadian Institute for Advanced Studies

June 1994 (revised November 1994)

Abstract: Two models in which communications costs are a cost to trade are investigated. One model
looks at the role of communication in determining the firms geographic extent in the use of local factor
services. Communication costs are modelled as a quasi public good network in which communication
services are provided by an average cost pricing monopolist. The network technology is subject to
increasing returns, congestion effects and network externalities. The second model focuses on
communication for the purposes of international trade in goods with similar assumptions on the
technology of communication as in the first model. In this model an important distinction is made
between international equilibrium and global equilibrium. In both models the impact of reductions in
communications costs on the market extent of firms, trade volumes and productivity are examined. The
models have generic multiple equilibria with quite different welfare and comparative static properties.

Paper prepared for the Canadian Journal of Economics Special Memorial Symposium in memory of
Douglas D. Purvis. The author is grateful to the School of Economics at the University of New South
Wales for generous support and hospitality over the period in which this paper was written. Discussions
with Richard Lipsey and Curtis Eaton on the general issues raise in this paper are gratefully
acknowledged. All errors are the sole responsibility of the author.
 1. Introduction
Economic theory generally and international trade theory in particular has long emphasized the
degree of factor mobility as a determinant of international trade patterns and price responses to exogenous
and policy induced changes to the economy. Doug Purvis in one of his first publications turned his
attention to this problem in an extension of the famous Mundell treatment of goods versus factor mobility,
and was one of the first to investigate whether trade and factor movements were complementary or not.
While international trade theory has gone through considerable transformation in the last two decades the
conventional distinction between factors and goods which are 'immobile' and those which are 'mobile'
remains virtually unchanged in most theoretical models. The traditional view of certain factors and goods
as immobile is an analytical fiction which is increasingly hard to rationalize. A distinguishing
characteristic of 'Globalization' is the increased mobility of factors and goods across local, national and
continental boundaries. One major reason for this increased mobility is a reduction in communication
costs. The second is the dramatic increase in the role of services in the economy and more generally the
use of 'knowledge' based inputs to economic activity. Reductions in communications costs result in a
dramatic shrinking of the time and space barriers which inhibit economic exchange over vast distances.1
The purpose of this paper is to consider some simple models of international trade in which
communication costs play an important role. One could argue that communication costs are just another
form of transport cost and therefore one does not need a special class of theory to deal with these issues.
Recent models such as Krugman's(1992) models of trade and economic geography might service the
purpose just as well. This view is incorrect for at least three reasons.
One, a crucial difference between trade with transport costs and trade subject to communication
barriers is in the nature of the presumed transaction costs. Models of trade costs typically use Samuelson's
iceberg model so that costs of transport over space are per unit product; this is usually thought t of as cost
shipping a product of given weight or volume per unit distance. This formulation is used in both
Hotelling type spatial models and models in which distance between markets is given. Communication
costs are different in that the cost of communication is almost entirely if not solely a fixed cost; once a
communications 'network' is installed marginal costs of sending a message are very low. In this paper this
approximated by the assumption that the only message costs are fixed costs. Communication costs of
trade however are dependent on the overall complexity of the message sent. Highly differentiated
products or factor services requires larger volumes of messages--or in slightly different terms require
networks capable of transferring more complex information.
Secondly the nature of the supply of communication is somewhat different, although not entirely
than the provision of transport services. Communication services are often provided by supply networks

1These issues are discussed at some length in Harris(1993) and Melvin(1990).

2
which have the characteristics of both natural monopoly and public goods. Natural monopoly is present
because of the strong fixed cost nature in the provision of linkages between any two locations.
Furthermore exclusion is possible however so that so that networks are public goods in only one
dimension-non-rivalry in consumption of network services. It is certainly the case that some transport
services such as air and road transport are subject to similar considerations. Generally however the act of
'transport' corresponds to the act of physically transferring an object from one location to another. It has
been traditional in the trade literature to emphasize the marginal cost of that transfer rather than the fixed
cost. Communication facilitates the transfer of a commodity highly complementary to economic exchange
and specialization--information--rather than the physical commodity itself. Changes in the
communications network therefore rather than simply reducing the cost of a transfer of a commodity over
space (the message unit) at the same time provides for the shrinkage in time of a co-ordination activity
between any two agents emphasized by Jim Melvin(1990) and others. Transactions time is in most
models of international trade largely ignored. Yet one defining characteristic of many transactions in
'services' as opposed to goods is the requirement that they occur if not simultaneously at least very quickly.
Changes in communications technology are therefore responsible for making the exchange of services
over vast differences feasible where it was not previously possible.
The final set of reasons for thinking that communications barriers to trade are different than
transport costs is the communications are subject to an important consumption externality emphasized in
the industrial organization literature on network externalities. My value of being connected to the phone
system is dependent upon the fact that many other people are likewise connected. The central concept of a
network as an ongoing link between large numbers of users is quite different than the notion of a transport
link by sea connecting one supplying region with another- a point-to-point one time connection. The
presence of consumption externalities in the network gives rise to a number of issues different than
encountered in the trade and transport cost literature. One emphasized here is given that communication
is complementary to international exchange any change which impacts on the extent of the consumption
externality will have implications for the volume of international transactions.
The relationship of trade with communications costs is potentially quite complex running across
a number of dimensions of the interactions of technology, market structure and comparative advantage.
In this paper some of these links are explored in two fairly simple models. In one model the emphasis is
on co-ordination of factors services across space--the network costs therefore increase in the 'scope' of the
market over which internal co-ordination of the firm occurs. The role of communication in this model
corresponds to defining the boundaries of firms co-ordination abilities across space. The extent of the
firm is defined by the available communications technology which allows co-ordination internal to the
firm. At the limits of these boundaries trade and the market displaces the firm as the mechanism of
resource co-ordination. Conventional arguments are that economic integration occurs as lower
communications costs increases the extent of the firm within the global economy. This model therefore

3
emphasizes the role of communication within the firm, and between the firm and suppliers of factor
services.
In the second model the emphasis is on trade across space in goods. The transactions costs
associated with exchange are related not to the volume of sales but to the complexity of the product sets
being exchanged. This degree of complexity is approximated within the model by the degree of product
differentiation. Two markets which exchange a more highly differentiated set of products require a
communications network with greater message capacity. Trade requires communication and hence
communication costs are a cost of trade in the conventional sense. The model looks at the transition that
occurs from local market production to international exchange as communication costs fall.

2. Communication and the Organization of Factor Services

Local communication over geographically contiguous regions is of particular importance to

firms. In this section a model is presented which attempts to focus on the 'local' factor market
implications of technical change in communications. Firms can achieve a greater division of labour and
thus increased productivity by getting access to more communications services. This is cast within a
general equilibrium framework by endogenizing the 'number of markets' within a product
differentiated/monopolistic competition theory of trade in differentiated products. A 'local' market size is
captured by focusing on the geographic extent over which firms organize their factor inputs. At one
extreme all markets are essentially points in space; at another they encompass the entire globe. As a by-
product the model illustrates usefully the point that international or interregional 'trade' is defined by
where borders are drawn. In this model the borders are endogenous and determined by the interaction of
firms decisions, as in much of the spatial economics literature, together with factor market clearing
conditions as in traditional trade models. There are 'international' effects of changes in communication
technology directed at local market because the changes affect where market boundaries occur. Now to
the details of the model.
Space and the distribution of resources
The economy is organized geographically along a line of length L. Along this line a composite
factor or production which we shall call 'labour' is distributed uniformly with unit density. The factor can
be thought of heterogeneous although in a symmetric way. Output of any manufactured good in quantity y
depends on a production function of the form
y = f(x,s)
where x denotes the factor input and s denotes the market extent. A larger s refers to use of more
differentiated inputs along the line but within one contiguous geographic zone. As s increases holding x
fixed output increases. This assumption is meant to represent the economies of specialization that are

4
achieved through a finer division of labour within each firm.2 Production on a point of s=0 is the least
productive form of economic organization. In the opposite case s=L and the maximal division of labour is
achieved; in the model neither extreme case will be deemed of any practical relevance.

Market Structure.
In each location there is a non-traded good z produced with a CRS production function
z(t)= Lz
where Lz is labour devoted to the production of the non-traded good at location t. There are no

specialization or externalities in the non-traded industry so aggregation over any region is

straightforward. Total output of non-traded goods within a region of size s is simply equal to s.
The other 'industry' is modelled in the Dixit-Stiglitz Spence (SDS) manner, using the symmetric
CES utility function specification, a monopolistically competitive traded goods industry structure with free
entry, and an endogenous number of products. Let n denote the total number of products produced in this
industry in equilibrium. In a symmetric equilibrium each firm produces an output level of its
differentiated product y. In equilibrium the line will be divided into M markets each of length s with
(1.) M=L/s.
The density of products in any given market is given by d=n/M. (All integer problems are ignored).
Consumers and suppliers of factor services are treated as immobile. They consume both non-traded goods
and differentiated tradables at the point at which they live and work.3
Production and Communications Costs
The central assumption is that production requires communication; in particular organizing
production over space requires communication with all providers of factor services. A common
communications network is available to all firms. To get on the network requires paying a fixed fee W⋅
N(s,d) with the size of the hookup charge dependent upon the size of the region covered denoted also by s,
and the number of other firms using the network, d. N is presumed to be increasing in s, positive for
s>0.(more on the communications market below). W is the wage rate and N is the number of units of
labour required per firm to run the communications network. The joint assumptions on production and
communication are summarized in the firms total cost functions T(y,s) given by
(2.) T(y,s)= a(s)Wy + WN(s,d).

2The model of Becker and Murphy(1992) has some charactersitics similar in theme to those here. They
emphasize the trade off between the gains to a finer internal division of labour within the firms relative to
transactions costs involved in coordinating activities within a firm. The model is this section trades off
between a finer division of labour versus the aggregate cost of communication.
3This very strict assumption can be easily relazed with an alternative intrepretation. Think of workers
and consumers moving about within a market of given size at zero cost. Any movement outside that
market area however is sufficiently costly to preclude it occuring as a realistic alternative.

5
Thus marginal production costs are constant and given by Wa(s) once a communications network
covering an input market s is chosen. Marginal production costs, a(s), are decreasing in s. For a given y
firms choose s such as to minimize total costs of production giving the firms' first order condition
(3.) a'(s)y = -Ns(s,d).

Choice of the extent of communication, or geographic extent of the firm is similar to the modeling of any
cost reducing innovation in a static model.

Firms choose s and y to maximize profits given S-D-S isoelastic perceived demand curves.
Let w=pz=1 be the numeraire. Then each firms sets its price p so marginal revenue equals marginal cost

or
(4.) p(1-1/ε)=a(s)W or p=λa(s)W.
Free entry determines the number of products; s is determined by the firms choice of s in equilibrium.
Implicit in this set-up is an assumption of no overlap of markets; that is firms within a given market area
are served by a common communications network which does not overlap with contiguous markets. This
is not an unreasonable assumption given that the line model is ideal in nature. Think of it as
approximating cities arranged across space and the model can thus be thought of as firms choosing the
size of the area from which factors are drawn. In equilibrium all firms choose the same input area and
this is served by a common communications network.

The Communications Market and Technology.

Each market area is served by a single communications network (phone system for example).
The network can be thought as provided by a public monopoly who employs average cost pricing. Various
assumptions can be made on the network technology.4 The simplest is that costs of a network are
dependent on the size of the market served and the number of firms (users) of the network. Thus if total
costs of a network of size s is given by K(s,d), the cost per firm is simply
(5.) N(s,d)=K(s,d)/d
where d is the number of firms in a given market or on a given network. This assumption emphasizes the
public good, fixed cost nature of a communications network, and also the congestion effect of additional
users on the network. From the point of few of covering fixed costs a public good subject to no
congestion costs would imply that N was decreasing in d--more users can share the common costs of
constructing the network. However if the network is subject to congestion more users raise the cost of
providing a network of given communications quality--thus at some point N may be increasing in d. K
and thus N is always increasing in s and perhaps the marginal cost of network size may also be rising, ie.

4In order to make the model tractable the assumptions on the communications network and market
structure are clearly dramatic simplifications of that used in the industrial organization literature on
telecommunications for example. A good example of this type of modelling is Oren and Smith(1981).

6
Kss>0, although the presumption is that over the relevant range there social increasing returns in the cost
of providing a communication network so that Kss<0. It is important to recognize that in the case of

communications technology that market size is measured in two dimensions. There is the conventional
density of users of changes in d for a given geographic area. Market size can also be measured in terms of
geographic size, represented here by the variable s, given the number of users. In each dimension we can
think of there being either increasing or decreasing returns to scale.
The pricing policy of the public communications firm is such that it always charges the true
average cost of an expanded network coverage; we assume therefore that firms in choosing market
coverage, s, know that Ns=Ks/d everywhere. This assumption is clearly unrealistic to a degree. One can

imagine an installed network of size s*; if a firm chooses an s<s* the firm might be quoted an installation
charge quite different than K(s*).5
Note that a key assumption of this model is that the only fixed costs are communications network
costs. The communications network responds to demand by providing a network equal to the size
demanded by the representative firm-hence the same s as an argument in K and C.
Labour Market.
The labour market is competitive and in equilibrium all labour earns the same wage.
Factor market clearing requires that in each local market region of size s
(6.) Lzs + da(s)y + K(s,d) = s.

The RHS of (6) is the total labour supply available in the representative market( factors are available
inelastic supply in unit density). The LHS represents labour demand from non-tradables, tradables and
the communications network. The presumption here is that communication services are produced locally
and not traded internationally.
Income and expenditure, and demand.

In equilibrium income from factor supply in market s is given by Ws=s (given the unit density of supply
assumption). Income in the entire economy is WL=L.
Consumers are assumed to be identical with tastes given by a Cobb-Douglas utility aggregator over traded
and non-traded goods, with share coefficients α and 1-α. Thus demand in a market of size s for non-
tradeds is
(7.) Z=αs/pz=αs.

There is international trade in differentiated products between different markets. With a total of n
differentiated goods selling at price p demand per firm, y, of each differentiated good, assuming free trade
and no transport costs between local markets, is given by

5This model ignores the important fact that a communications network typically requires complementary
investments in equiptment by users. It is not clear that introducing such investments would change the
trade aspects of the model in important ways.

7
(8.) y=(1-α)L/pn.
Equilibrium, Free entry and zero profits
The model is closed with the zero profit condition on the MCE industry which requires that
(9.) py=a(s)y+N(s,d)
With economies of scale output per firm, y, is a variable of interest. From the zero profit condition
together with the markup equation, y is given by
(10.) y= [N/a]/(λ-1).
Any change in y must therefore reflect changes in the ratio of fixed to variable costs. A larger fixed to
variable cost ratio dictates a larger output scale. The fixed to variables cost ratio depends upon both s, the
local market size, the network size, and d the number of local network users.
International Trade
Trade occurs in differentiated products. Each of the d firms in any local market sell to all other
M-1 local markets. Local production of differentiated products (in value terms) is given by
(11.) d {(1-α)s/n}.
Subtracting this from local consumption of all differentiated products gives imports in a single market of
size s as
(12.) Imports(s) = (1-α)s [1-d/n].
= (1-α)s [1-s/L]
The volume of trade therefore depends on the number of local markets and the absolute size of local
markets. As s gets larger imports are at first an increasing function in the size of local markets and then a
decreasing function. Trade in a single market is maximized precisely when s=1/2 L and there are 2 local
markets trading with each other.6 This model highlights the extent to which "trade" is actually a
measurement issue--as markets integrate by having local market size become larger ( bigger s -fewer M)
trade as defined here diminishes even though the volume of economic transactions may actually go up or
down. Total trade volumes are given by multiplying (13) by the number of markets M=L/s or,
(13.) Vol= L(1-α)(1-s/L).
Total trade volumes are strictly decreasing in the size of the local markets, s, or strictly increasing in the
number of markets, M.
Solving the model:
A picture of equilibrium in this spatial model is given in the figure below. Here we have 3 local
markets in the economy each of size s*. In each market there are d firms and one communications
network in each local market. Trade in differentiated products occurs between the three markets.

6Througout this section it will be presumed that the equilibrium value of M is greater than 2.

8
 economy length L

s*

mkt 1 mkt 2 mkt 3

3 local markets each of size s*

figure 1
Re-write the price-marginal cost condition as p=λa(s) with the mark-up constant λ. Substitute this into
the labour market clearing condition to give
(14.) αs + (1-α)s/λ +K(s,d)= s.
The model will be solved in terms of the variables s, local market size, and d, the number of firms per
market. Tastes as reflected in λ and α and technology as reflected in the network labour requirements
function K(s,d). We are looking for an interior solution of s between 0 and L and positive d. One way to
look at equation (14) is to view it in distribution terms. The RHS represents total local market income.
This accrues to labour producing non tradeds , αs, variable labour costs in the differentiated sector, (1-α)s/
λ and to labour used in supplying communications services, K(s,d). Given that total fixed costs in the
MCE sector are just communications costs the total mark-up on variable labour costs must be just
sufficient to cover the labour bill in the communications sector. Thus we can re-write (14) (labour market
clearing )as
(15.) K(s,d) = (1-α)(1/λ-1)s,
where the RHS is total profits in the MCE sector. It is assumed that for a given d in the relevant range
(15) always has a solution with positive s.
In s-d space we graph (15) as the KK locus depicting labour market equilibrium in each local
market. The slope of the KK locus depends upon the sign of the term
(16.) (Ks - (1-α)(1/λ-1))/Kd.
Assuming a positive solution for s given d from (15) and Ks > (1-α)(1/λ-1) one would expect (16) to be
positive given Kd is positive--thus a larger d imply a larger = s along the KK locus.

Using the zero profit condition and the FOC for firms’ choice of s we can derive a condition
linking the elasticity of variable private production costs with respect to market size and the elasticity of
network costs with respect to network size for given d.
Define the network size elasticity of private production costs as
(17.) A(s) = -a'(s)/a(s)
defined positively since a' is negative. A(s) is the percentage reduction in production costs to any private
firm to a one percent expansion of the network size it uses.
Define the cost elasticity of network size, for a given number of users d, as
(18.) B(s,d)= Ks(s,d)/K(s,d).

9
 Zero profits plus the first order condition (3) on the firm's choice of s implies that in equilibrium
it must be the case that the elasticity of private cost reduction with respect to network size must equal the
cost elasticity of providing the network, or
(19.) A(s) = B(s, d).
Equations (15) and (19) jointly determine s and d.
Solution is somewhat simplified by the fact that A(⋅) is independent of d. The A function
summarizes the effect of market size, or the extent of the communications network on cost reduction or
productivity in the MCE sector. It will be assumed that this function is positive but decreasing in s; thus
as market size gets larger incremental cost reductions get smaller. Thus there are economies to having a
larger input market over space, but these are limited.
The B function reflects the effect of additional market size on the cost of providing the network.
Holding d constant we have no general presumption that B is increasing or decreasing in s; larger market
size may yield a higher or lower cost elasticity to providing a larger network from a given number of
users. Ks might be increasing in s but this does not imply any particular property for the cost elasticity B.

Assume that for a given d (19) has a well defined solution for s, or as it will be referred to henceforth--
the "technological locus" TT in s-d space; i.e. the set of points at which private cost reduction to extended
network size equals public costs of provision. The shape of this locus will depend upon how B shifts with
changes in the number of users, d.

There are two effects at work as the number of users changes--the common cost effect and the
congestion externality. As the number of users increases holding congestion constant, cost per user may
decline. Consider the function K(s, d)= F +ms2d for s positive. Given the linearity of K in d there are no
congestion effects--adding more users does not affect the marginal cost of an additional user. The B
function in this example is given by
(20.) B(s, d) = md/(F +msd) = ms/(F/d + ms2)
In this case adding more users reduces F/d so this would imply a negative relationship between d and s
along the TT locus.
The other case is one in which congestion effects are very important but there are no common
cost effects. Suppose that K(s,d)= m(s2+d2) so B = 2s/(s2+d2). In this case an increase in d lowers B,
generating a positive relationship between s and d along the TT locus. In general it appears there is no
conclusive qualitative property of the TT locus.
These results are summarized in the following diagram giving the KK and TT loci, and provide a
convenient way of carrying out comparative statics..

10
 d T K

T
K

s-d plane--market equilibrium

figure 2
Income Growth and Trade
Income growth in this model has an effect similar to other models of trade in differentiated
products with monopolistic competition and scale economies. An increase in factor supplies represented
by an increase in L, total market size, has no effect on either s or d which are determined independently of
L. From the zero profit and demand conditions the output per firm remains constant and the number of
varieties increases. Total trade volume increases in L from equation (13). An increase in factor density
however holding total market size L constant however has a different effect. In this case equation (15)
changes with the RHS of (15) increasing in density. This shifts the KK locus down provided Kss is

negative giving rise to a higher s* and lower d*--thus intensive income growth leads to a larger local
market size and fewer firms per market. The effect on trade volumes is ambiguous since trade volumes
increase due to a larger total income and hence demand for differentiated products but decrease as the
larger size of local markets naturally reduces the volume of 'international' transactions.
Technological Change in Communications
A special case will help illustrate the working of the model and how one can think about the
potential bias to technological change in communications. Suppose that Network costs which are
separable in network size and number of users. Hence
(21.) K(s,d)= G(s)H(d),
so that B(s)= G'(s)/G(s). The TT locus is independent of d or vertical in s-d plane. Equilibrium s* is
determined solely by the balancing of private cost reductions to larger market size against the network
cost of providing those savings. In the separable case H(•) might be thought of how hook-up costs to
users varies with the number of users. A fall in total network costs K(⋅) will shift the KK locus down.

11
This turns out to give some fairly strong and interesting predictions regarding the effect of reductions in
communications costs on numbers of firms and the volume of trade.
Advances in communication technology can be thought of as shifts in the K function. Consider
two cases: (1) reductions in the marginal cost of changing the "geographic extent of the network" treated
as shifts in G'/G such as to reduce the elasticity of network costs at any give s--this results in a shift of the
vertical TT locus to the right--s* will increase--thus market size unambiguously increases; (2) a reduction
in 'hookup' costs for a given market size characterized by downward shifts in the H(d) function.
Type 1 technological change might be thought of as something like the introduction of satellites
or fibre optics which facilitates moving data across greater distances more easily or at lower cost. Type 2
technological change can be thought of as the introduction of better switching technology which allows
handling more users within a given spatial network, or same number of users at lower cost. One way to
think about alternative bias in technological change in the communications sector is to contrast shifts in
the quality and volume of communication over a given geographic area (Type 1) relative to changes in the
marginal costs of providing those connections to additional users within the same geographic area (Type
2).
Type 1. A fall in network size costs increases s, and thus reduces the number of markets. As a(s)
is decreasing in s the larger local market through improved specialization and co-ordination
within the firm results in lower prices and larger output volumes. Both results accord well with what
might be called the local effects of globalization. Improved communications technology gives rise to
firms with greater geographic scope over input markets, improved economies of scale and higher
productivity. The number of firms per market d rises. The effect on total product differentiation is
ambiguous since market size is larger although the number of firms per market has increased.7
Given equation (13) for trade volumes (total imports) it is clear that Type 1 reduction in
communications cost decreases the total volume of trade, as the number of markets is reduced Assuming
that the number of market in equilibrium in greater than two, the reduction in number of markets
increases imports per market.
Type 2: Consider now a fall in 'hookup' costs or shift down in the H(d) function. Since A(⋅) does not
shift this has no effect on local market size s*, and thus no effect on the volume of trade, output per firm
or price. The 'local effects' of this type of globalization or shift in communications technology are thus

7 If H' is negative the number of firms per market falls with type 1 reductions in communications costs. If
H' is negative so additional users actually lower network costs for given s( very strong increasing returns
in the number of users) then an increase in geographic market size actually lowers the number of firms
per market. What is happening is that the cost savings due to improved communications technology
which result in a larger market size must be soaked up somewhere in equilibrium--this is accomplished by
having fewer firms with the cost per firm of communications rising and re balancing equilibrium in the
labour market. Note also that with fewer firms and fewer markets product differentiation in response to
Type 1 technological change case has unambiguously decreased.

12
almost trivial. There are effects however on market density. The KK locus shifts up resulting in a larger
number of firms. A reduction in the hookup costs of a network results in a larger number of firms and an
increase in the level of product differentiation in the economy..8
Network Externalities
It is commonly argued that a major characteristic of communications is that network externalities
are prevalent.9 That is the benefits to one user of the network depend on the fact that other users are also
on the network. To capture this characteristic the model is changed to eliminate cost effects due to either
congestion or common costs in network provision and thus assume that total network costs is linear in the
number of users. Hence
(22.) K(s,d)=F(s)d.
Network externalities are introduced by assuming that the marginal costs of producing differentiated
products is subject to an externality approximated by the number of users per market for given market
size. Let v=d/s be the density of firms producing tradables in any local market. For each firm labour
requirements per unit output of differentiated goods is written as a(s,v) taken as decreasing in v.
Individual firms take v parametrically in choosing s, and in their own entry/exit decisions ignore the
impact they have on other firms' costs through equilibrium changes in v. Network externalities result
naturally in agglomeration effects in that for a given geographic market size, s, the larger the number of
firms, d, the higher productivity. There is a trade-off therefore between economies of scale to local market
size as reflected in s, and market density as reflected in v=d/s.
It is convenient to solve this model in the variables v and s. The two equilibrium conditions
become in this model, using v=d/s
(23.) -as(s,v)/a(s,v)=F'(s)/F(s)

(24.) F(s)v=(1-α)(1/λ-1).
(23) is the firm's first order condition on choice of network size and (24) is the labour market clearing
condition. In s-v space (24) is a negatively sloped locus LL depicting that larger geographic markets
require lower densities of firms in order to keep labour demand constant; F(s) is assumed to be everywhere
increasing in s. Assume that the a(s,v) function is separable in v and s. In this case (23) is a vertical

8If K is independent of d, as would be the case were there virtually no marginal costs to adding users and
unlimited capacity to the network the KK locus and TT locus would both be vertical, and thus no interior
equilibrium with s<L would exist. With no congestion effects and everywhere increasing returns to
network size the logical outcome would be one completely connected market--an example of extreme
globalization. If H' is negative a fall in H will shift KK to the left which, since KK is negatively sloped,
results in a reduction in equilibrium d--again there is the somewhat paradoxical result that even though in
this case more firms reduce per firm communication costs within a given technology, the equilibrium
result is that cost saving technological change results in more firms in equilibrium. This derives from the
fact that free entry can lead to inefficient outcomes if social fixed costs are diminishing in the number of
firms and entrants are charged the average social cost of entry
9See the papers by Katz and Shapiro (1985)(1986) on network externalities generally and the paper by
Oren and Smith(1981) on network externalities in the context of telecommunications.

13
locus in s-v space and s* is independent of v. With these restrictions it is possible to investigate the
impact of changes in either a) the degree of the network externality as reflected in shifts in a(s,v) function
or b) reductions in costs of communications network as reflected in shifts in F(s) leaving the cost elasticity
F'(s)/F(s) unaffected.

v L TT

v*

s
s*
s-v plane--market equilibrium
figure 3

a) Increases in the value of network externalities.

Some changes in communications technology can be thought of as increasing the value of
network externalities. For example fax machines are only useful if other users also have fax machines.
One aspect of modelling the introduction of the fax machine therefore is an increase in the implicit value
of the consumption externality to any user. If a(s,v)=a(s)b(v), then a decrease in the value of b() at any
given value of v can be thought of as increase in the private and social value of the network externality.
Under the separability assumption both s* and v* are unchanged by a shift in the value of network
externalities. Thus neither the density of firms nor the size of local markets is affected by an increase in
the value of network externalities. What happens is that the productivity increase feeds through entirely
into lower prices and higher outputs per firm or greater economies of scale. Total trade measured in value
terms is also unaffected although in quantity terms trade volumes rise as more imports are consumed in all
markets.
A reduction in network costs can be represented simply as a reduction in the F(s) costs.
Assuming this leaves the cost elasticity F'(s)/F(s) unchanged s* remains unchanged. However the LL
locus shifts up allowing for a greater density of firms at any given market size. This increase in the
number of firms per market raises the level of the network externality and thus raises productivity and

14
lower prices. The larger number of firms per market implies that product differentiation rises and thus
expenditure per product falls. Trade in value terms remain constant although the number of products
traded has risen and prices have fallen. The effect on economies of scale is ambiguous. From (10) both
fixed costs, F(s*), and variable costs, a(s*,v), fall. From (24) a one percent fall in fixed costs results in a
one percent increase in density. A very strong externality in b(v) would result in raising F/a and thus
increasing the scale of the firm.
It is clear that to get a result which suggests that shifts in communications technology is
responsible for greater globalization, measured as an increase in local market size, s*, the strict
separability assumptions used above must be relaxed. Looking at the TT locus if it is assumed that
dv/ds>0 along the TT locus this is equivalent to assuming that an increase in market scale must be
associated with an increase in market density in order that firms be appropriately balancing marginal
production cost reductions against the increased fixed costs of a larger input market size. Intuitively this
seems quite plausible--an increase in v, and hence the value of network consumption externalities, raises
the productivity of the variable factors (lower a)--this in turn raises the value to the firm at the margin of
further increases in the local scope of the market inducing the firm to choose a larger s. If this is the case
then a reduction in network costs will result in both a larger local market and a more dense local market.
The shift up in the LL locus raises s* and v*. In this case then advances in communications technology
leads to outcomes which might be identifiable with 'globalization'.

15