Minimum Efficient Scale, Exchange Rates, and Purchasing Power Parity Explained

Understanding Minimum Efficient Scale (MES)

The Minimum Efficient Scale (MES) represents the level of production where economies of scale are fully realized, and unit costs are at their lowest possible point. For production levels lower than q*, unit costs are not at their minimum. If production increases, businesses can still benefit from economies of scale.

MES and Economies of Scale

Gains from an integrated market, which are closely related to MES, depend on:

• The difference between production before integration (q) and MES (assuming q > q*). The larger this difference, the greater the potential gain.
• The fall in unit cost as production moves towards MES.

Optimal Firms and Product Differentiation

The optimal number of firms in an integrated market (n*) is calculated as: n* = Market Size / MES. If, before the removal of trade barriers (TB), there are more firms than n* across different countries, a strategic decision must be made regarding which firms to consolidate or close.

Production Differentiation: Consumers may prefer a wider variety of products than n* firms might provide. Applying only MES criteria could lead to a loss of product variety, as it prioritizes efficiency over consumer choice.

Understanding Exchange Rates

Spot and Forward Exchange Rates

The Spot Exchange Rate (e) is the price for immediate currency exchange, typically settled within two working days of the agreement.

The Forward Exchange Rate is a price set now for an exchange that will take place at a specified future date.

Interest Rate Differentials

The Interest Rate Differential (i_f - i) refers to the difference between foreign (i_f) and domestic (i) interest rates. Changes in the expected future spot exchange rate (e_ex) can lead to an increase in the exchange rate value of a foreign currency (e).

A currency is expected to appreciate or depreciate by an amount proportional to its interest rate being lower or higher, respectively, than the interest rate in another country.

Role of Expected Future Spot Exchange Rate

The expected future spot exchange rate (e_ex) plays a crucial role:

• If e_ex > e, there is an increase in currency demand, leading to currency appreciation.
• If e_ex < e, there is a decrease in currency demand, leading to currency depreciation.

Factors Influencing Spot Exchange Rates

The Spot Exchange Rate (e), representing the price of the foreign currency in units of our currency, increases under specific conditions:

• An increase in our money supply relative to the foreign money supply (M_s / M_{s_f}).
• An increase in foreign real GDP relative to our real GDP (Y_f / Y).

Conversely, a decrease in money supply typically leads to currency appreciation (e increases). An increase in money supply, often due to excess supply, leads to currency depreciation (e decreases).

Purchasing Power Parity (PPP)

Absolute Purchasing Power Parity

Absolute Purchasing Power Parity (PPP): States that a basket of tradable products should have the same cost in different countries when the cost is stated in the same currency. This is represented by the formula: P = e x P_f, where P is the domestic price level, e is the spot exchange rate, and P_f is the foreign price level. Therefore, e = P / P_f provides an estimate of the spot exchange rate consistent with absolute PPP.

Relative Purchasing Power Parity

Relative Purchasing Power Parity: States that differences in changes over time in product price levels between two countries will be offset by the change in the exchange rate over that same period. The exchange rate changes over time at a rate equal to the difference in the two countries' inflation rates: e_t / e₀ = (P_t / P₀) / (P_{f_t} / P_{f_0}).

Inflation and Currency Value

Countries with relatively low inflation tend to see their currency appreciate, while those with high inflation tend to see their currency depreciate.