New Advantages in Economies of Scale Amid Deglobalization

Abstract

Economies of scale refer to the phenomenon in which market agents (i.e., firms) at the microeconomic level increase economic benefits by expanding the scale of production, as evidenced by the decrease in average total cost due to increased output. Applying this to the macro level, a country's population or market scale expansion will drive more sophisticated division of labor and transactions, thereby improving economic efficiency.

According to the theory of economies of scale, large countries could undergo stronger industrial development and faster economic growth and achieve greater wealth than small countries. However, insufficient emphasis has been placed on scale in existing macroeconomic analysis, in our view, and the reality is that many small economies are wealthier than large ones. During the era of globalization over the past few decades, some small countries enjoyed economies of scale brought by the global markets through their participation in division of labor and cooperation in global industry chains.

In the era of deglobalization, however, small countries’ ability to participate in the global division of labor and to enjoy economies of scale at a global level becomes limited. Instead, the importance of statehood in political terms has increased, and large countries can accumulate stronger competitive advantages by leveraging their large scale. In addition, the development of the knowledge economy, especially the digital economy, amplifies the scale advantages enjoyed by large countries, in our opinion.

China is one of the biggest countries in the world in terms of population and economy, which we believe lays a foundation for it to leverage scale advantages under new circumstances. Developing a market economy and promoting internal market competition are key to translating large scale into economic growth, in our view, which requires an expansion of domestic consumption and development of a unified domestic market. We believe attention could be paid to address the market failure caused by distortions such as externalities (a cost or benefit caused by a producer but not borne by that producer) and monopolies and in particular, to improve governance mechanisms for real estate, finance, and the digital economy.

Against the background of deglobalization, scale advantages both provide a new source of economic growth for large countries and lay a foundation for cross-border cooperation. Large countries enjoy advantages in the new landscape of division of labor in global industry chains thanks to their larger industrial systems and tighter integration among different parts of their industry chains. Leveraging its domestic industrial system, China can strengthen industry chain integration with other countries, facilitate in-depth cross-border cooperation, and improve industrial efficiency and security, in our opinion.

Authors of this chapter: PENG Wensheng, ZHOU Zipeng, HONG Canhui. Translator: WANG Qian. Editors: Kenneth HO, Carol KEATY, HONG Canhui, LIU Xinran.

3.1 Economies of Scale Could Become an Important Source of Economic Growth in China

Demographic dividend and globalization, two important historical drivers of China’s rapid economic growth, are gradually diminishing, underscoring the importance of promoting high-quality development. Since 1978, the demographic dividend¹ and integration into the global market have helped China achieve average annual GDP growth of 9.3%² up to 2022, and rapidly catch up with developed economies such as the US and Japan. However, we believe China could shift towards an economic development model that relies more on total factor productivity as the number of working-age people declines, the savings rate trends lower, and capital accumulation slows due to the aging population (Fig. 3.1). At present, China’s economy is undergoing a shift in growth rate, indicating strong demand for development. As stated in the report to the 20th CPC National Congress, development is the top priority, and efforts should be made to accelerate the creation of a new, high-quality development model.³ Therefore, whether scale advantages can facilitate high-quality development is the primary issue we discuss in this chapter.

The role of economies of scale in driving economic development deserves more attention. Economists argue that labor and capital investment may reach bottlenecks, and improvement in total factor productivity is the fundamental driving force for long-term economic development.⁴ In that sense, economies of scale plays a clear role in facilitating total factor productivity growth. Specifically, by promoting people's well-rounded development, building sound industry chains, and encouraging sci-tech innovation, economies can achieve higher output with the same input, among others, which is reflected in economies of scale from a static perspective. When economies of scale continue to play a role, it can be manifested in the realization of long-term development with increasing total output. At present, a prominent feature of China's economy is its fairly large size. China has long been the most populous country in the world, and its GDP was equivalent to 70.3% of that of the US in 2020.⁵ We believe that if China leverages its large population and domestic economy to fully unleash its potential economies of scale, it will better drive its economic development.

Large countries enjoy greater scale advantages against the background of deglobalization. The contribution of large countries’ greater scale to economic growth has been underemphasized in existing macroeconomic analysis, in our view, in part because a large number of small economies have achieved swift economic growth over the past few decades and grew rapidly into wealthy economies. To understand this contradiction, we focus our analysis on the role of globalization. In the era of globalization and free trade after the Second World War, small economies successfully integrated into the global economic system, expanded the size of their potential market, and benefited from global economies of scale. In extreme cases, small economies can still enjoy economies of scale through international trade, even when their domestic demand is limited. Deglobalization has led to frictions among various countries in international markets. In response, countries need to rely more on the scale of their domestic markets, and then participate in international competition. In such a context, large countries show stronger economies of scale than small countries, backed by their large populations and economies, and exhibit more obvious scale advantages.

Deglobalization drives China to shift to a growth model that relies more on scale advantages. Against the background of geopolitical conflicts and intensifying technological competition, the trend of deglobalization has become increasingly visible and the division of labor in global industry chains has slowed or even shown signs of a reversal.⁶ As the previous model of international division of labor faces challenges, China's historical paths to improving economic efficiency could face obstacles, including the export model that relies heavily on external demand and comparative advantages as well as learning-by-exporting. On the contrary, the domestic market has become more decisive to technological progress, economic growth, and trade patterns. Therefore, the scale advantages as a large country may play a more important role in driving China's economic growth.

Against the backdrop of competition among major countries, China could rely more on scale advantages to develop a knowledge economy. Besides deglobalization, another new trend worthy of attention is the boom of the knowledge economy, especially the digital economy. Compared with the traditional economy, the knowledge economy is characterized by its stronger non-rivalrous nature and economies of scale. Therefore, the original scale of a company or industry often determines the level of its competitiveness in the future. In addition, large countries can successfully support the sizable initial investment needed in the development of the knowledge economy and the large scale of subsequent innovation on multiple fronts, thus exhibiting competitive edges in this regard. In other words, the domestic markets of large countries play the role of “initial incubators”, which can more rapidly cultivate mature knowledge-based products and quickly seize share of the international markets. For example, China and the US have become home to a large number of internet giants, while European companies may lag behind in global competition. However, this also means that governments are more inclined to support domestic companies internally and adopt market segmentation and trade protectionism externally. Against the background of competition among large countries, China could rely more on its scale advantages to secure a favorable environment for the development of the knowledge economy in the face of the abovementioned competitive pressures from other countries, in our opinion.

Fig. 3.1

Note Producer here is defined as the population aged 20–64; consumer is defined as the population aged below 20 and above 64. Source Population Division of United Nations Department of Economic and Social Affairs, CICC Global Institute

China's demographic dividend is diminishing.

In summary, we believe China is characterized by strong demand for development, a large population, and a large economy. Scale advantages will likely replace demographic dividend and globalization to become an important source of China's economic growth against the background of deglobalization and development of the knowledge economy.

3.2 Theoretical Origins and Functions of Large Countries’ Scale Advantages

3.2.1 Economies of Scale and Scope Together Constitute Large Countries’ Scale Advantages

Population and market scale facilitate division of labor and bring economies of scale on the industrial side. Early economic theories tend to explore the sources of economies of scale from the production side—e.g., how scale promotes division of labor and forms thereof. Known as the founder of modern economics, Adam Smith believed that population growth leads to specialized division of labor, which improves productive powers of labor and drives an increase in returns to scale in the overall economy.⁷ Alfred Marshall made a distinction between “internal” division of labor within individual enterprises and “external” development of the industry.⁸ The latter stems from industrial development driven by the growth of the working population. Thus, firms can improve the efficiency of production by sharing skilled labor and other infrastructure, resulting in external economies of scale. On this basis, Allyn Young noted that the expansion of the market demand will also lead to new forms of division of labor among industries, including roundabout methods of production⁹ and the rise of the intermediate goods sector to further improve economic efficiency.¹⁰ Backed by Young's theory, the demand side also started to attract attention as one of the sources of economies of scale.

Mutually reinforcing demand and supply and concentration of production factors and industrial agglomeration strengthen economies of scale. The new economic geography theory takes multiple sources of economies of scale into consideration, and believes that concentration of production factors and industrial agglomeration within a certain geographical area could enhance economies of scale. First, industrial development tends to take place near large markets, and producers of final goods and intermediate goods are generally attracted to larger consumer markets and clusters of final goods producers due to transportation cost considerations (i.e., backward linkages). Second, producers of final goods are attracted to clusters of intermediate goods producers and to regions with better industrial development (i.e., forward linkages). These two effects work together and reinforce each other, driving factors and industries to concentrate in specific regions and increasing returns to scale. Third, the positive externalities of industrial development enhance economies of scale as industries concentrate in specific regions, allowing firms to share infrastructure and improve division of labor among industries. Fourth, transportation costs support concentration of production factors and push up the income level of clusters. That helps advantageous regions build larger local markets with strong demand, which in turn further reinforces economies of scale.

Economies of scope are another important source of scale advantages enjoyed by large economies. Economies of scope refer to the improvement in efficiency brought by increase in variety of products rather than quantity—i.e., the cost of producing multiple products together is lower than producing each product separately. Specifically, vertical integration strategies, product diversification strategies, and sharing of sales and R&D channels at the corporate and industry levels could all create economies of scope.¹¹ As small economies face restrictions from their small populations and market scale, their industrial development tends to focus on specific areas and is highly dependent on overseas markets. Therefore, small economies are in a disadvantageous position in achieving economies of scope, making it difficult for them to gain scale advantages. In contrast, large countries, by leveraging their sizable domestic markets, are better positioned to facilitate production diversification and make full use of domestic resources and technologies to create new products and services. Thus, large countries generally outperform in industry diversification and specialization of labor. In addition, economies of scale and economies of scope could be mutually reinforcing, but only under the prerequisite of a sufficiently large market and a vertically integrated industry chain, in our opinion. Therefore, large countries are better positioned to achieve economies of scope than small countries, in our view, which constitutes an additional source of scale advantages for large countries.

3.2.2 Large Countries’ Scale Advantages are Conducive to Industrial Development and Economic Growth

Large countries provide room for more intense competition and innovation, which is conducive to cultivating larger and more competitive firms.¹² First, the scale advantage of large countries provides ample room for a larger number of companies and products, which can facilitate market competition and drive firms to lower the markup ratio. With lower markups, firms must sell more goods to break even, leading to an increase in firm size.¹³ Assuming economic equilibrium, large countries can cultivate larger and more competitive companies backed by their sizable domestic markets. Second, as such companies leverage large countries’ scale advantages to amortize their fixed R&D costs over a greater number of goods, they find it profitable to adopt more advanced technologies, thus supporting innovation on multiple fronts.¹⁴

Large market scale expands room for innovation, driving development and upgrading of domestic industries. Innovation activities fall into two categories—i.e., those requiring large initial investment with strong economies of scale, and those requiring relatively small initial investment and creating less strong economies of scale.¹⁵ Firms in large countries are characterized by their greater size and ability to make significant initial investments, thus showing competitive advantages in innovation activities with strong economies of scale. In contrast, firms in small countries generally participate in innovation activities with limited economies of scale. However, they might face fiercer cost competition as firms in large countries can also participate in such innovation activities. This means that large countries’ scale advantages may help them both expand corporate innovation and stimulate industrial development. In other words, we believe large countries are in a better position to gain dominance in high-end technological industries with stronger returns to scale as they excel in both types of innovation activities.

The new growth theory holds that large countries’ scale advantage could boost economic growth. The traditional theory holds that economic growth is independent of scale as it assumes that countries have the same level of exogenous technological capability and small countries can actually grow faster. This conclusion can explain, in part, the convergence of growth across countries in the era of globalization after the Second World War, but not the fact that some countries have posted stagnant growth while the US has long maintained leadership in economic growth. Unlike neoclassical economics, the new growth theory that emerged in the 1980s holds that technological progress comes from learning by doing,¹⁶ or human capital accumulation and R&D inputs.¹⁷ Therefore, as large countries support mass production, human capital accumulation, and R&D inputs, they may witness faster technological progress and economic growth. Of note, as technologies have strong spillover effects within a country, allowing different industries to adopt new technologies as soon as they are developed, large countries also enjoy additional economies of scale, underpinning their economic growth. Driven by these factors, large countries can achieve faster economic growth by leveraging their scale advantages, in our opinion.

3.2.3 Large Scale Helps Large Countries Gain Dominance in Cross-Border Industry Chains

Traditional trade theory neglects the importance of scale. Regarding international trade models, the traditional theory of comparative advantage holds that a country will import a product if it has higher demand for that product compare to other products. This theory holds that the fundamental driving force of trade stems from differences in production among countries (i.e., comparative advantage). Moreover, if there is a diminishing return to scale on the production side, production activities seeking to address a country's higher domestic demand should be allocated to multiple countries. As a result, a country would increase imports of the product and the gap among countries in terms of demand is narrowed via the production side.

The new economic geography theory emphasizes that sizable domestic demand market will result in a home market effect,¹⁸ which has a decisive impact on international trade patterns. For industries with increasing returns to scale, large countries enjoy stronger economies of scale thanks to their larger population and economies, which manifests itself as the home market effect on the export side. Specifically, leveraging the large market with stronger demand, domestic companies have accumulated initial scale advantages, with their products featuring lower production costs and higher quality. As a result, domestic companies gain competitive advantages in the international markets and quickly seize market share, as evidenced by increased exports of such products from the domestic market and strengthened scale advantages by marketing the products in the global markets. In other words, strong home market demand drives the production side via increasing returns to scale, and the country increases production and exports of the product. In extreme cases, some economists¹⁹ even believe international trade is nothing but an extension across national frontiers of a country’s own web of economic activity. In this process, the scale of domestic demand is a key factor triggering home market effects, which means large countries should attach greater importance to their scale advantages on the demand side.

Large countries are more likely to have home market effects in industries with high levels of product differentiation and complexity. According to the experiences of OECD countries—e.g., the radar communication and automobile manufacturing industries in these countries—home market effects do exist.²⁰ Specifically, at the country level, home market effects are more important for very large and very small countries.²¹ This reflects very large economies’ sizable domestic markets and very small economies’ success in leveraging economies of scale during the globalization process over the past few decades (by focusing on specific industries and integrating themselves into global industry chains). At the industry level, industries with greater transport costs and higher levels of product differentiation and complexity also have stronger home market effects.²² Such industries tend to require a larger initial investment, and a bigger domestic market can support the large initial investment needed and trigger subsequent stronger economies of scale. For example, due to aging populations and households’ stronger purchasing power, domestic pharmaceutical markets in developed countries usually exhibit strong demand, which provides the impetus for innovation and R&D spending in the pharmaceutical industry.²³ The home market effects help these countries gain a greater competitive advantage in the export of pharmaceuticals.²⁴

Scale advantages help large countries focus their industries and export sectors on high-quality, high-value-added, and high-end technological products. Home market effects can boost domestic industries and further strengthen the scale advantages of large countries, boding well for their economic and industrial development. On the one hand, scale advantages increase the income level of domestic consumers in large countries and drive them to shift to products of higher quality and high-end technological products.²⁵ Improvement on the demand side could drive upgrading of domestic industries and export sectors, and encourage producers and exporters to invest more in sci-tech innovation.²⁶ On the other hand, bigger countries have larger domestic markets and an increased number of larger-sized companies that can afford higher initial investments. Thus, they are better positioned to develop industries with a high degree of increasing returns to scale. As a result, we believe small countries can only export products with medium returns to scale, while large countries are more likely to develop and export products with high returns to scale.²⁷ Overall, the development paths of different countries could diverge going forward and show a core-periphery structure due to home market effects. Large countries could maintain competitive advantages in industrial and economic development leveraging their sizable domestic markets.

Large countries play a dominant role in the division of labor in global industry chains. Leveraging the large size of their domestic markets, large countries have a stronger ability to drive the development of their domestic industries, which has far-reaching implications for the development of division of labor in global industry chains. Economists Antonella Nocco et al. (2019)²⁸ believes that in a global welfare perspective, optimal multilateral trade policy should promote sales of low cost firms to all countries, trim sales of high cost firms to all countries, and reduce the entry of firms in all countries, especially in disadvantaged ones (countries with smaller domestic market scale, worse state of technology in terms of higher innovation and production costs, and worse geography in terms of closer proximity to other countries). Specifically, reducing the entry of firms means promoting the integration of cross-border industry chains while advancing sales of low cost firms means industry chain integration is premised on intensifying competition and driving out inefficient companies, which can help increase overall economies of scale. More importantly, scale advantages can reduce dependence of countries with larger domestic industrial capacity on other countries, while increasing other countries’ reliance on them.²⁹ Thus, large countries play a dominant role in organization of and participation in global industry chains, as evidenced by the integration of small countries into industry chains dominated by large countries. In particular, we believe small countries could be integrated into industry chains dominated by large countries to a greater extent due to lower trade costs and similar demand preference with large neighboring countries.

3.3 Status Quo of and Issues With Economies of Scale in China

3.3.1 China Has the Foundation for Leveraging Scale Advantages

China has the potential to leverage scale advantages backed by its large population and economy. China has long been one of the world’s most populous countries with a population of 1.41bn in 2022, and its population is much larger than that of the US (Fig. 3.2). China’s potential for scale advantages is also reflected in its large economy. In 2022, China's GDP at current prices reached US$17.96trn, ranking No.2 in the world. In terms of purchasing power parity (PPP), China's GDP reached Int$30.34trn in 2022, ranking No.1 in the world and nearly three times that of India (Int$11.90trn).³⁰ China has a large number of potential consumers and the world's largest GDP in PPP terms as of 2022, which also provide strong support for consumption in China. In addition, a higher total GDP also means stronger industrial development and more job opportunities in China, in our view, laying an important foundation for China to leverage its competitive advantages in total working population on the industrial side.

China shows even greater potential for sale advantages from the perspective of labor force. China’s population aged 15–64 totaled 984 mn in 2022, only 2.4% higher than 961 mn in India.³¹ However, China's labor force (working-age population * labor force participation rate) reached 782 mn, 49.2% higher than 524 mn in India, and largely equal to India, the US, and Pakistan combined (Fig. 3.2). China's labor force is much larger than those in other countries, mainly because women generally enjoy job opportunities in China, and the country can provide sufficient jobs for its large working-age population backed by its larger economy and better-developed industries. Although China's labor force participation rate has declined in recent years, it still equaled 68.1% in 2021, much higher than 41.6% in India.³² In general, China shows good potential for scale advantage in terms of labor force.

Fig. 3.2

Source World Bank, CICC Global Institute

China’s population size and labor force have been among the top of the world.

We believe China currently has a window of opportunity to leverage its scale advantages as a large country. According to the Population Division of the United Nations Department of Economic and Social Affairs, China's population may decline over the next 20–30 years. In addition, a decline in total population is usually accompanied by population aging, which would add to the pressure on China’s economic growth. As a result, we believe that in addition to encouraging childbearing and raising the birth rate, China could also seize the important window of opportunity when it stands at a leading position in terms of population and labor force as well as the GDP around the world to leverage its scale advantages so as to offset the drag from shrinking demographic dividend and declining population on industrial and economic development.

3.3.2 China’s Export Sector Shows Economies of Scale

From the perspective of international trade, China has initially shown scale advantages. Since 2000, China has gradually become one of the centers of division of labor in global manufacturing and industry chains, accounting for 27.3% of the global manufacturing output in 2018.³³ Backed by the large scale of China’s domestic market and industries, 24 out of the 26 manufacturing industries in China have home market effects,³⁴ including chemicals, communications and electronics, transportation equipment, and machinery manufacturing. By industry, capital-intensive industries have the strongest home market effects, followed by technology-intensive industries, while resource-intensive and labor-intensive industries do not have home market effects.³⁵ As we previously mentioned, home market effects are more likely to exist in industries with large initial investment and high degrees of increasing returns to scale, which tend to be characteristics of capital-intensive and technology-intensive industries. In terms of export destinations, China's exports to Southeast Asia and Central Asia have stronger home market effects,³⁶ partly because of their geographical proximity and similar product preferences to China. Therefore, products designed and produced based on China's domestic demand could easily be marketed to these regions, in our view. On the contrary, China's exports to other developing countries do not have strong home market effects, in our opinion.

The rise of China's PV industry demonstrates the importance of home market effects. China has an enormous domestic market with strong photovoltaics (PV) demand—the country’s cumulative installed PV capacity reached 205MWh in 2019, accounting for 32.6% of the global total and far exceeding those of other countries (i.e., the US and Japan).³⁷ Leveraging the abundant supply of raw materials and strong market demand, Chinese PV companies accumulated scale advantages. Internally, Chinese companies feature a higher degree of automation and have worked to accelerate product standardization and streamline production processes, helping them reduce production costs. Externally, specialized clusters of producers and suppliers have been developed in China's PV industry, enabling domestic PV producers to obtain key inputs more easily and further improve their production efficiency. As a result, China has cultivated a highly competitive PV industry with a share of nearly 100% in the domestic market in 2021.³⁸ Generally speaking, the average size of Chinese PV companies is four times that of their US counterparts, helping them cut production costs and capture market share in Europe and even the global market. In 2019, China's PV industry gained a 76% share of the global market thanks to its competitive advantages backed by strong local market demand.³⁹

3.3.3 China’s Scale Advantages Have Not Been Fully Exploited

On the demand side, China’s sizable domestic consumer market still needs to be further cultivated. China had ranked No.1 in the world in terms of total population before 2022, and ranked No.1 in terms of GDP (at constant PPP prices in 2017), indicating that the country has a large number of potential consumers and strongest potential purchasing power in the world. However, it ranks No.3 in the world in terms of the share of total global private sector consumption in 2020, following the US and the EU. In addition, the share of other countries in the world’s total private sector consumption is usually higher than their share of the world’s total GDP or population, while the situation is the opposite in China, indicating that it has yet to fully translate its scale advantages in terms of total population and GDP into consumption,⁴⁰ in our opinion. From a structural point of view, compared with fast-moving consumer goods (FMCG) and discretionary consumer goods, China's luxury consumption outshines in terms of share of the world’s total and pace of growth.⁴¹ In 2019, China was the world's largest luxury goods market with a share of 33%.⁴² As we pointed out in our book, Building an Olive-shaped Society,⁴³ China's Gini coefficient declined steadily over the past decade, but it was 0.47 in 2020, still higher than the international warning level of 0.4. Consumption divergence caused by the income gap reduces the homogeneity of demand in China’s domestic market and is not conducive to the development of scale advantages as a large country on the demand side, in our opinion.

On the industrial side, China's scale advantages have not been fully reflected in high-end technological products. According to Harvard University’s Economic Complexity Index (ECI), China ranked 18th in the world in 2021, up six places in the past decade.⁴⁴ However, at the product level, China only accounted for 13.0% and 0.4% of the world’s net exports of products with a Product Complexity Index (PCI) greater than 1.3 or 1.8, well below Germany's 19.5% and 5.2%, and Japan's 21.6% and 11.6%. More notably, although China's share of the world’s total net exports of products with PCI greater than 1.3 is much higher than the US's 4.9%, its share of net exports of products with PCI greater than 1.8 equals only one-sixth that of the US (2.3%).⁴⁵ This both highlights the risk to China’s access to key technologies, and indicates that China has not fully leveraged its scale advantages in driving corporate and industrial upgrading and the transition towards high-end technological industries, in our opinion.⁴⁶

For example, China’s high-end equipment sector is still characterized by an emphasis on complete equipment rather than parts and components, as well as a lack of mid-range and high-end equipment. As discussed in Chapter 11, China's high-end equipment industry focuses on the R&D of complete equipment but attaches insufficient importance to core parts and components from our point of view, resulting in a relatively low share of domestically manufactured core components in the domestic market. Specifically, despite of China’s large demand for industrial robots, Japan enjoys a dominant position in both core components such as controllers and reducers in the upstream, as well as large-scale industrialization and system integration in the midstream and downstream. In addition, on account of strong demand underpinned by domestic real estate and infrastructure investment, China's excavator industry has developed advanced processes and witnessed rapid growth, and Chinese manufacturers have become world-leading in some market segments. However, in the field of industrial lathes in which trial and error costs are relatively high, the strong demand from domestic manufacturing industries has not been successfully converted into robust growth momentum of related industries.

The status quo of China's high-end equipment industry shows that China has yet to fully leverage the large size of its domestic market to facilitate the division of labor among industries, improve integration among different parts of industry chains, and increase the supply of core components. In particular, we believe increased effort is needed to leverage scale advantages to help domestic industries shift to higher-end technological products with stronger economies of scale.

3.3.4 Factors Constraining China From Leveraging Scale Advantages

As mentioned previously, China's enormous domestic consumer market still has room for improvement, and the positive impact of scale advantages on China’s industrial development has not been fully reflected. The reason is that externalities and monopoly, the two potential defects of the market system, have been two obstacles hindering China from effectively transforming its large scale into competitive advantages, in our opinion. Specifically, we believe income gaps, the drag from land sectors,⁴⁷ and a monopoly caused by integration of financial and industrial businesses are three domestic constraints that need to be addressed to better leverage scale advantages.

Income gap is not conducive to the formation of a market with strong demand. Large countries have sizable populations and economic prowess, which lay a basis for advancing mass production and leveraging economies of scale to facilitate industrial and economic development. However, prerequisites exist for large countries to leverage their scale advantages. Specifically, only when income generated by the leading sectors benefit most people and consumer demand is relatively homogeneous can the consumer buying power of a large country be effectively translated into strong market demand for domestically manufactured goods, which we believe is key to triggering economies of scale.⁴⁸ On the contrary, the experience of countries such as the UK shows that the wealth gap has led the country's affluent class to buy imported luxury goods. In this case, the gains from economic development could not be absorbed by the domestic industrial sector, making it nearly impossible for the UK to leverage scale advantages as a large country. As mentioned earlier, China still faces problems such as consumption divergence and insufficient translation of gains from economic growth into consumption.⁴⁹ Looking ahead, greater attention is needed regarding equitable income distribution, in our view, so as to lay a foundation for leveraging scale advantages on the demand side.

Land sectors squeeze other industries as a natural monopoly, leading to diseconomies of scale. First, compared with other industries, labor productivity growth in industries closely related to land (i.e., the construction industry) is usually slower, which may hinder the improvement in overall productivity and transition towards high-tech industries. Labor productivity in the construction sector rose only 21% over 1995–2014, lower than the 70% growth in overall productivity and the 97% growth in productivity of the manufacturing sector over the same period.⁵⁰ In addition, we believe the uneven distribution of land ownership leads to a widening income gap, which results in insufficient demand for domestic manufacturing industries and a shift to a non-technology-intensive development path, becoming a drag on growth. At the macro level, such a process manifests itself as land sectors squeeze benefits from economic development and cause negative externalities to the development of other industries.⁵¹

Second, spending on plants, machinery, and equipment, and on R&D can be shared as scale expands, and the spreading of fixed costs drives unit costs down. However, when expanding the use of land, investment in infrastructure (such as roads and hydropower facilities, etc.) must increase proportionately, making it difficult for fixed costs to be shared. Such a characteristic suggests that land could be the “shortest board” in scale expansion, which we believe may lead to price premiums and monopoly. Therefore, land sectors themselves are also characterized by diseconomies of scale. China's real estate industry has experienced rapid growth over the past decade, and is one of the areas that we believe merits special attention as China works to leverage its scale advantages as a large country.

The integration of financial and industrial businesses undermines competitive fairness and impairs economies of scale. With the integration of financial and industrial businesses, financial groups hold controlling stakes in both financial institutions and real-economy companies, and extend the government’s credit guarantees for them to real economy sectors. Such real-economy companies can more easily win over competitors and gain market share. Furthermore, with the help of low-cost funds backed by the government’s credit guarantees, some inefficient real-economy companies can survive or even thrive for a long period of time. The non-competitive nature of their monopolies leads to stronger crowding-out effects on domestic industries and scale advantages. For example, the integration of financial and industrial businesses caused by excessive global financialization in the past few decades has reduced overall economic efficiency and led to diseconomies of scale.⁵² In China, the “blind expansion” of a small number of companies to the financial sector has led to continuous accumulation of risks and problems.⁵³ To fundamentally address the non-competitive monopoly caused by the integration of financial and industrial businesses, we believe the key is to restrict the government’s credit guarantees for financial institutions from extending to real-economy industries, and advance the separation of the financial sector from industrial sectors and separation of various financial sub-sectors from each other, which is in fact a fundamental principle to which the US has adhered since enactment of financial regulatory reform via the Glass-Steagall Act in 1933.⁵⁴

3.4 Thoughts and Implications: How to Better Leverage China’s Scale Advantages?

3.4.1 Correcting Defects in Market Mechanisms and Expanding the Domestic Market

Attaching importance to scale advantages on the demand side and promoting internal market competition. Economies of scale come from specialized division of labor and transactions, for which the key foundation lies in a large scale, well-developed market economy mechanism. On the one hand, China has a large population and economy, but its scale advantages on the demand side still have upside potential. The experience of many countries shows that prioritizing income equity is the foundation for the formation of a large consumer base. At present, China is working to build an olive-shaped society. Accelerating the formation of an income distribution structure “with large middle and small ends” is conducive to the formation of a robust domestic market with abundant demand for domestic products, which could lay a basis for China to leverage scale advantage as a large country.

On the other hand, in addition to the scale of population and consumer markets, another key factor for leveraging scale advantage is the development of a market economy. A well-developed market economy can facilitate division of labor and transactions, and enable large countries to more effectively translate their large populations and economies into competitive advantages. This is particularly evident in the comparison of growth between the US and the former Soviet Union. However, there are two potential challenges with the market economy—i.e., externalities and monopoly, which are correlated to each other. In view of these two issues of market mechanisms, efforts could be made to promote internal market competition, reduce the negative impact of externalities and monopoly, and effectively coordinate the relationship between economies of scale and the market economy, in our opinion.

Correcting externalities, increasing the supply of high-quality public goods, and strengthening financial regulation. On the one hand, the supply in areas such as transportation and commercial infrastructure, education, healthcare, and sci-tech innovation are crucial to improving the level of integration of the domestic market. However, these areas have strong positive externalities, making it difficult for the private sector to effectively provide related goods or services. It may lead to additional inequality as private sector market agents could charge high premiums. Therefore, as a large country, public spending can be more widely spread in China. Leveraging such an advantage, China could increase public investment to make up for the shortcomings of the market system. In addition, experience from the PV and communications industries shows that the government can create considerable market demand for related industries and promote mass production while it increases the supply of public goods. In fact, this is what the US government did in the nineteenth century, including accelerating the construction of a nationwide railway network and establishing institutions such as the United States Geological Survey (USGS) to train much-needed talent.

On the other hand, financial institutions may leverage the government's credit guarantee to promote the integration of financial and industrial businesses and seek higher returns by taking greater risks. The integration of financial and industrial businesses not only results in non-competitive monopoly but also frees institutions from market incentives and constraints, bringing negative externalities to the entire market economy. At present, a small number of enterprises are blindly expanding into the financial sector in China, leading to continuous accumulation of risks.⁵⁵ According to the US experience and that of other countries since 1933, to resolve risks associated with these financial groups, measures could be taken to strengthen regulation and reduce negative externalities—i.e., promoting the separation of the financial sector from industrial sectors, and separation of various financial sub-sectors from each other.

Adhering to anti-monopoly measures and participating in international competition to mitigate obstacles to innovation from large knowledge-based companies. A key feature of the knowledge economy, especially the digital economy, is stronger economies of scale and scope. China can better coordinate the relationship between scale and monopoly, and leverage its enormous domestic market to cultivate large-sized digital companies to help domestic industries outperform in international competition. However, that also means leading companies may accumulate market power, hindering market competition, industrial innovation, and economic efficiency. To address this, we believe China can first adhere to anti-monopoly measures, regulate against unfair competition, improve the competitiveness of knowledge-based industries, and mitigate the damage to innovation and economic efficiency caused by leading companies. In addition, measures could also be taken to encourage leading companies to move toward globalization, benefiting the domestic market and improving economic efficiency by engaging in more extensive competition.

However, stronger economies of scale of the knowledge economy also means that governments in various countries might have a tendency to restrict access of companies from other countries. For example, they may erect trade barriers such as technology standards, cross-border digital governance, and privacy protection, among others. In order to address this problem, China can actively explore rules-based cooperation with other countries via trade agreements and industrial policies, among others, so as to create a fairer and more favorable international environment for its knowledge-based industries to explore the international market and drive the development of the knowledge economy, in our opinion.

Diseconomies of scale in land sectors come from the intertwining of externalities and monopoly. As mentioned earlier, land sectors may cause a squeeze on the real economy at the macro level. For example, slow productivity growth in land sectors drags down overall productivity, and real estate prices could negatively affect households’ purchasing power. At the micro level, land leads to diseconomies of scale as it is a natural monopoly. Moreover, the externality and monopoly of land sectors are entangled with each other, as the natural monopoly of these sectors reinforces the squeeze on other industries, which in turn strengthens the monopoly position of such sectors. The aforementioned characteristics of land sectors mean that they impose severe constraints on economies of scale. Therefore, related departments could consider containing the excessive development of land sectors, especially excessive land financialization. In addition, while abiding by the principle of “houses are for living in, not for speculation”, measures could be taken to address reasonable housing demand—e.g., by increasing the supply of government-subsidized housing, to unleash the vitality of the market economy.

3.4.2 Taking Advantage of the Domestic Market and Strengthening Cooperation in Cross-Border Industry Chains

Deglobalization has strengthened the dominant position of large countries in global industry chains. Compared with the round of deglobalization between the two world wars, the current round of deglobalization is less ubiquitous and intrusive, and various countries have not yet returned to a state of erecting barriers to trade or immigration.⁵⁶ However, similar to historical experience, the current round of deglobalization has increased the importance of domestic markets, as evidenced by various countries’ move to partially replace the global market with their domestic markets. In other words, the new round of deglobalization requires countries to strengthen cross-border economic and trade cooperation within closely connected countries and regions on the basis of facilitating economic flows in the domestic market. As a result, the division of labor in global industry chains features “multipolarity”, with different “major powers” interconnected and competing with each other. From such a perspective, we believe China can leverage the scale advantages of its domestic market to play a more proactive role in organizing, coordinating, and even reshaping transnational industry chains.

Building advantageous domestic industry chains and enhancing integration among different parts of industry chains. First, China can build competitive industry chains to address demand in the domestic market. While supporting leading domestic companies to expand operations and gain dominant positions in industry chains, measures could also be taken to encourage these companies to lead the upstream and downstream of the domestic industry chains to grow together. Second, the experience of the US and other countries shows that large countries’ scale advantages can help strengthen integration among different parts of their industry chains. Given this, China could encourage domestic industries to expand to upstream industries (i.e., R&D and design as well as key parts and components) or to downstream industries (i.e., sales and after-sales services) so as to leverage industry chains and consolidate their competitive advantages in more links. Third, backed by its enormous domestic market, China has the ability to develop more industrial clusters, in our view, which constitutes a competitive advantage. Therefore, China can also encourage the development of multiple industry chains and complete industry chains in different regions, and eventually form a differentiated regional industrial landscape based on local characteristics.

Strengthening in-depth industry chain cooperation with other countries based on domestic advantages. With a focus on the domestic industry chain, China can strive to coordinate the relationship between its domestic industry chain and regional and global industry chains. First, China could proactively encourage other countries (especially those with close ties with China and located in neighboring regions) to deeply integrate into China's advantageous industry chain, form a regional industry chain, and amplify and share economies of scale through in-depth intraregional cooperation. Second, China can also take the lead in strengthening ties with other regional industry chains and lead countries in those regions to integrate into global competition and cooperation. In particular, as global industry chains develop towards multipolarity, large countries play a more prominent role in leading cross-border cooperation—China, as a large country, could also play a key role. For example, leveraging its large domestic market with strong demand, the US not only strengthened its industry chain integration with its neighboring countries Canada and Mexico through the United States-Mexico-Canada Agreement (USMCA), but also strengthened industry chain cooperation within the country itself, the region in which it is located, and other regions of the world by signing trade agreements such as the Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS) and the Indo-Pacific Economic Framework for Prosperity (IPEF).

Encouraging domestic industries to move up the industry chain through cross-border cooperation and enhancing the leading role of large countries. In the context of deglobalization, large countries focus more on their domestic markets. However, this does not mean that they should revert to being closed economies. Instead, large countries such as China could leverage their enormous domestic markets to drive industrial development, then give a boost to the development of domestic industries by participating in international competition, in our opinion. For China to achieve this goal, efforts can be made on at least three fronts. First, encouraging domestic companies to actively participate in innovation and international competition to leverage industry chains, or even become chain leaders, so as to consolidate China’s advantages. Second, leveraging cross-border industry chain integration to promote domestic industrial upgrading and expand the number of advantageous domestic industries. More specifically, the country could leverage its enormous domestic market and cross-border cooperation to encourage and help domestic industries access high-end technological areas, make key breakthroughs in areas such as core components, and serve the development and upgrading needs of domestic industries. Third, given its scale advantages as a large country, China is characterized by more specialized division of labor among industries, making it more necessary to deepen exploration in industrial segments with smaller size and higher complexity in the global markets. We believe this will help enhance the core position of Chinese industries in regional and global industry chains, and help it lead countries in the region to participate in international competition. In practice, policy support can be provided to reduce the costs of trial and error, and create favorable conditions for industrial development and upgrading.