Chapter 8. Firms in the Global Economy: Export Decisions,

Outsourcing, & Multinational Enterprises

Internal economies of scale imply that a firm’s average cost of production decrease the more

output it produces.

Two additional characteristic of firms can be addressed by modeling imperfect competition.

- In most sectors, firms produce goods that are differentiated from one another. (bottled water,

staples, cars, cell phones)

- Performance measures (such as size and profits) vary widely across firms.

First, internal economies of scale and product differentiation are combined in order to generate

some new sources of gains of trade via economic integration.

Second, differences across firms will be introduced so that we can analyze how firms respond.

Differently to international forces..

- We will see as production is concentrated toward better-performing firms, the overall

efficiency of the industry improves.

- We will see why better-performing firms have a greater incentive to engage in the global

economy, either by exporting, by outsourcing, by becoming multinationals and operating in

multiple countries.

8.1. The Theory of Imperfect Competition

<Monopoly>

MR & Price

Downward sloping Demand Curve

Q = a–bP (8-1)

P =

(a–Q)

TR = P∙Q

=

(aQ–Q

2)

MR =

(a – 2Q)

=

(a – Q – (a – bP))

PM

QM

AC

MR D

MC

Q

c

AC

C,

MR, P

Downward slope

economies of scale

<Fig 8-1: Monopolistic Pricing and Production Decisions>

Compare

the slopes

∴MR = P –

Q (8-2)

P – MR = Q/b: The difference between P & MR depends on the Q & the slope parameter of its

demand curve.

AC & MC

AC =

,

-

C(Q)

=

-

∴

=

∙(MC – AC). If

< 0, MC < AC.

C = F + cQ (8-3)

AC = F/Q + c (the fixed cost gives rise to economies of scale) (8-4)

MC = c

= (TR – TC

( = MR – MC = 0)

<Monopolistic Competition>

Importance of interdependence in oligopoly

Essentials of Monopolistic Competition

- Each firm can differentiate its product from that of its rivals.

- Each firm ignores the impact that change in its own price will have on the prices competitors

set

- Each firm takes the prices changed by its rivals as given.

Even though each firm is in reality facing competition from other firms, it behaves as if it were a

monopolist.

= -

=

( -

)

=

(c – (

+ c))

=

(MC – AC) < 0 always.

Contrast: 과점에서는 상호의존성

독점적 경쟁에서는 제품차별화

Assumptions of the Model

(8-5)

Q: firm’s sales

S: total sales of the industry (Market size)

: average price change by its competitors.

Assume that S is unaffected by in order to focus on the competition among firms. (market share)

Market Equilibrium (symmetric firms)

- If we assume symmetries in the demand function & cost function

We focus on How many firms & what price.

①more firms Q↓AC↑ ②n↑ P↓(P = ) ③P = AC(no profit; entry & exit)

1. The number of firms & average cost

From (8-5), all firms change the same price, P = , (8-5) becomes Q = S/n.

And from (8-4),

AC = F/Q + c

= nF/S +c (Q = S/n) (8-6)

(The more firms, the higher the average cost!)

2. The number of firms & the price

The more firms, the more intense the competition and hence the lower the price

From (8-5) the demand curve

(8-7)

compare to (8-1); Q = a - bP

TR = P∙Q

=

[

+ bS – Q]Q

MR =

(

+ bS – 2Q)

=

[

+ bS – Q – (

+ bS - )]

= P -

(8-8)

P =

[

+ bS – Q]

To maximize profit, MR = MC

P -

= c

P = c +

Q (8-9)

= c +

(Q = S/n if P = ) (8-10)

3. The eqm number of firms

Eqm: P = AC

+ c = nF/S +c

∴ n* = , P

* = c + , Q

* = S/n =

(Alternative)

The Effects of changes in market size on equilibrium in a monopolistically competitive industry

TC = F + cQ (8-1)

AC = F/Q + c (8-2)

Demand curve of each firm

(8-3)

n*

CC

PP

n

P*

C, P

<Fig 8-3: Equilibrium in a Monopolistically Competitive Market>

AC = nF/S +c

n↑ AC↑

P = c +

n↑ P↓

Each firm chooses its price to maximize profits.

= TR – TC

= PQ – TC

= P∙

- [F + c

(8-4)

The first-order condition is

= 0;

Q – bSP + bcS = 0 (8-5)

All firms are symmetric in equilibrium P = & Q = S/n

Thus, (8-5) becomes

P =

+ c (8-6)

Since Q = S/n, AC is a ft of S & n,

AC = nF/S +c (8-7)

In zero-profit eqm, the price charged by a typical firm must also equal its average cost. (P = AC)

+ c = nF/S +c (8-8)

∴ n = (8-9)

The price is P* =

+ c = c + (8-10)

∴ Q* = S/n = (8-11)

Limitations of the monopolistic Competition Model

Two kinds of behavior are excluded

- Collusive behavior, Cartel: maintain prices or quantities agreed upon

- Strategic behavior: price leader - follower

S↑ AC↓

S↑ P↓

8.2. Monopolistic Competition & Trade

In industries where there are internal economies of scale, both the variety of goods that a

country can produce & the scale of its production are constrained by the size of the market.

- Trade offers an opportunity for mutual gain even when countries do not differ in their

resources technology

<The Effects of Increased Market Size>

S↑ higher sales, lower AC

<Numerical Examples>

, b = 1/30,000

F = $750,000,000 (FC)

c = $5,000 (MC)

C = F + cQ

C = 750,000,000 +5,000Q

AC =

+ 5,000 ∙∙∙(*)

P = c +

Q

P = 5,000 +

Q ∙∙∙(**)

n0

*

CC0 AC = nF/S +c

PP P = c +

n

P0

*

P, C

P1

*

n1

*

CC1

<Fig 8-4: Effects of a Larger Market>

Bigger S

In larger markets, more firms &

more sales per firm. (S goes up)

① Consumers are offered lower

prices & ② a greater variety of

products. (increased consumer

surplus)

Gains from trade

From (*) & (**),

Q* = 150,000

P* = 5,000

Adam Smith, “The wealth of Nations”, pin production specialization division of labor =>economy

of scale Market size matters

<Important Points in Monopolistic Competition & Trade>

Equilibrium before Trade

At n0, all firms obtain zero profit (i.e. P0 = AC0),

with no entry or no exit of firms.

Equilibrium After Trade

Effects of Trade

- Before trade, H & F markets were separated

- After trade, two markets are integrated into a bigger market. Thus, each industry is facing a

larger market

- A larger market means a bigger S, which causes CC curve to more to the right. n↑, P↓

In monopolistic competitive model, each firm is producing a differentiated product. The fact

that the number of firms has increased means a greater variety of products with a lower price.

Gains from trade for consumers

- Increase in the number of firms means a greater variety of differentiated products

- Each firm is producing at lower average cost, and consumers are buying more!

n0

CC0

PP

n

AC0 = P

0

C, P

P1

n1

CC1

Table 8-1: Hypothetical Example of Gains from Market Integration

Home before Trade Foreign Before Trade Integrated Market

After Trade

Sales of autos 900,000 1,600,000 2,500,000

Number of firms 6 8 10

Sales per firm 150,000 200,000 250,000

Average cost 10,000 8,750 8,000

Price 10,000 8,750 8,000

AC = F/Q + c & P = Q/bS + c b = 1/30,000 , F = $750,000,000, c = $5,000

Home before trade Foreign before trade Integrated Market

AC =

+ 5,000 AC =

+ 5,000 AC =

+ 5,000

P = 5,000 +

Q P = 5,000 +

Q P = 5,000 +

Q

Q* = 150,000 Q

* = 200,000 Q

* = 250,000

P* = $5,000 P

* = $8,750 P

* = $8,750

n* = 900,000/150,000 = 6 n

* = 1,600,000/200,000 = 8 n

* = 10

The integrated market supports more firms, each producing at a larger scale & selling at a lower

price.

- Consumers have a wider range of choice: yet each produces more and is therefore able to

offer its products at a lower price.

- Each from must concentrate its production in one country - either Home or Foreign

Economies of Scale & Comparative Advantage

The above discussions on a monopolistic competition says little about the pattern of trade that

results from economies of scale.

Assumption - The cost of production is the same in both countries

- Trade is costless

Thus, we need integration of economy of scale & Comparative advantage.

Assumptions again

- H & F, cloth & food, H has a higher capital-labor ratio

- Cloth is not a perfectly competitive industry, but is a monopolistically competition industry

(Because of economies of scale, neither country is able to product the full range of cloth

products by itself)

Pattern of trade: Cloth is a monopolistically competitive sector

- Home is a net exporter of cloth and an importer of food

- Foreign firms in the cloth sector will produce products different from those that Home firms

produce.

Four important points about the pattern

- Inter-industry trade reflects comparative advantage

(Home, the capital-abundant, is a net exporter of capital-intensive cloth & a net importer of

labor-intensive food)

- Intra-industry trade does not reflect comparative advantage

(Economies of scale can be an independent source of international trade)

- The pattern of intra-industry trade is unpredictable

(History & accident determine the details of the trade pattern)

- The relative amount of intra-industry & inter-industry trade depends on how similar

countries are.

The more similar capital-labor ratio The more intra-industry trade dominant

The more different 〃 inter-industry trade dominant

Inter-industry

trade Intra-industry

trade

Cloth Cloth Food Food Home

capital-a Home

capital-a

Foreign

labor-a Foreign

labor-a

The length of the arrows

indicates the value of trade

in each direction

Trade w/o Increasing Returns Trade w/ Increasing Returns & Monopolistic Competition

<The significance of Intraindustry Trade>

About one-fourth to nearly one-half of world trade consists of intraindustry trade

(two-way exchanges of goods in the same industry)

Since the major trading nations have became similar in technology & resources, there is no

clear comparative advantage within an industry, and much of trade takes the form of two-way

exchange within industries.

Why Intraindustry Trade Matters

Intraindustry trade produces extra gains from trade, over and above those from comparative

advantage, because intraindustry trade allows countries to benefit from larger markets.

- By producing fewer varieties, a country can produce each at a larger scale, with higher

productivity & lower costs. At the same time, consumers benefit from the increased range of

choice.

Intraindustry trade can be the dominant source of gains from trade

- Where countries are similar in their relative factor supplies

- Where scale economies and product differentiation are important

- In this circumstance, the income distribution effects of trade will be small

- Trade without serious income distribution effects, is most likely to happen in manufactures

trade between advanced industrial industries.

Postwar experiences

- Western Europe, The growth in trade was almost entirely intraindustry

- The trade b/w very dfferent countries remain politically problematic

8.3. Firm Responses to Trade: Winners, Losers & Industry Performance

After integration, the better-performing firms expand and the worse-performing ones contract or

exit, then overall industry performance improves.

- Trade & economic integration can have a direct impact on industry performance.

- It is as if there was technological growth at the level of the industry.

<Performance Differences Across Producers>

Relax the symmetry assumption of the monopolistic competition model so that we can examine

how competition from increased market size affects firms differently.

From the symmetry assumption, C = F +cQ (8-3)

(the same cost curve)

(8-5)

(the same demand curve)

Now, suppose that firms have different cost curves (different MC, ci)

From (8-5), P =

[

+ bS – Q]

(8-8), MR = = P -

Let Q=0, P =

(8-5)’

MR = P (8-8)’

(a) Firm 1 has a lower MC than firm2: c1 < c2.

Both firm face the same demand curve and MR curve.

Relative to firm 2, firm 1 sets a lower price and produces more output.

The shaded areas represent operating profits for both firms. (Before the fixed cost is deducted).

(b) Operating profits as a function of a firm’s marginal cost ci.

Operating profits decrease as MC increases.

P2

Q1

Intercept = + 1/bn

MR

D

MC1

Q

c1

C, P

MC2 c

2

P1

Q2

2

slope = 1/bS c

*

Marginal

cost, ci

c1

Operating

profit

c2

(P2 – c

2)∙Q

2

c*

(P1 – c

1)∙Q

1

<Fig 8-6: Performance Differences Across Firms>

F (fixed cost) cannot recovered and does not enter into operating profits

We can thus summarize all the relevant performance differences based on marginal cost

differences across firms.

A firm with a lower marginal cost will

(1) set a lower price, but at a higher markup over marginal cost

(2) produce more output, and

(3) earn higher profits.

We assume that entrants face some randomness about their future production cost ci. This

randomness disappears only after F is paid and is sunk. Thus some firms will regret their entry

decision if their overall profit (operating profit minus F) is negative.

- There are profit differences between firms, and entry occurs until expected profits across all

potential cost levels ci are driven to zero.

<The Effects of Increased Market Size>

A larger market can support a larger number of firms with more competition.

Intercept = + 1/bn n↑ intercept↓

slope = 1/bS S↑ slope↓

Firms with marginal cost between the old cutoff, c*, and the new one, c

*’, are forced to exit.

Some firms with the lowest marginal cost levels gain from integration and their profits increase.

Intercept = + 1/bn

Q

C, P

slope = 1/bS c

*

D

D’

c*

’

Marginal

cost, ci

Operating

profit

c*

c*

’

Winners Losers

Exit

<Fig 8-7: Winners and Losers from Economic Integration>

8.4. Trade Costs & Export Decisions

Up to now, economic integration as an increase in market size without trade costs.

We introduce trade costs to explain why firms actually do care about the location of their

customers, and why so many firms choose not to reach customs in another country.

A world with two identical countries ( Home & Foreign)

- Market size: S 2S with no trade costs.

But two markets are not perfectly integrated due to trade costs.

- Still with the constant marginal cost and the trade cost t, those decisions regarding pricing

and quantity sold in each market can be separated.

Firms 1 & 2 both operate in their domestic (Home) market.

Only firm 1 chooses to export to the Foreign market. It is not profitable for firm 2 to export

given the trade cost t.

Those costs explain why only a subset of firms export, and they also explain why this subset of

firms will consist of relatively larger and more productive firms(with lower marginal cost ci)

- In U.S., an exporting firm is on average more than twice as large as a firm that does not

export, and produces 11% more value added par worker than the average non-exporting firm.

Q

C, P

c*

D

MC1

MC2

c1

c2

Q

C, P

c*

D

MC1

MC2

c1

c2

c1+t

c2+t

Home Foreign

<Fig 8-8: Export Decision with Trade Costs>

8.5. Dumping

A firm with a higher marginal cost will choose to set a lower markup over marginal cost.

- This means that an exporting firm will respond to the trade cost by lowering its markup for

the export market.

P1D P1

D – c1

P1X

P1X – (c1 + t):

- Thus, P1X – t < P1

D

Firm 1 sets an export price ( net of trade costs) that is lower than its domestic price.

- This is considered dumping by firm 1, and is regarded by most countries as an “unfair” trade

practice.

Dumping is a controversial issue in trade policy.

- In Foreign market, firm 1 sets exactly the same markup over marginal cost as Foreign firm 2

with marginal cost c2 = c1 + t

- Firm 2’s pricing behavior is perfectly legal, so why is firm 1’s export pricing decision

considered to represent an “unfair” trade practice?

Our model of monopolistic competition highlighted how trade costs have a natural tendency to

induce firms to lower their markups in export markets, where they face more intense

competition due to their reduced market share.

- This makes it relatively easy for domestic firms to file a dumping complaint against

exporters in their markets.

8.6. Multinationals & Outsourcing

When is a corporation multinational?

- In U.S. statistics, a U.S. company is considered foreign-controlled, and therefore a subsidiary

of a foreign-based multinational, if 10 percent or more of its stock is held by a foreign

company.

Foreign Direct Investment(FDI): purchases more than 10% of a foreign firm or builds a new

production facility abroad.

Markup “Higher markup”

“Lower markup” in the export market

since it faces a higher marginal cost

c1+ t in the Foreign export market.

- Horizontal FDI: dominated by flows b/w developed countries (the affiliate replicates the

production process elsewhere in the world)

- Vertical FDI: mainly driven by production cost differences (ex) chips(wafer fabrication(skill-

intensive), assembly(labor intensive) & testing) comparative advantage

<The Firms Decision Regarding Foreign Direct Investment>

Proximity-concentration trade-off for FDI

- FDI activity is concentrated in sector where trade costs are high (such as the automobile

industry); however, when increasing returns to scale are important and average plant sizes

are large, one observes higher export volumes relative to FDI

Empirical evidence also shows that there is an even stronger sorting pattern for FDI at the firm

level within industries: Multinationals tend to be substantially large and more productive than

non-multinationals in the same country.

Horizental FDI Decision

A firm’s export versus FDI choice will involve a trade-off between the per-unit export cost t and

the Fixed cost F of setting up an additional production facility.

- Is the firm sells Q units in the foreign market, then it incur a total trade-related cost Q t to

export.

- This is weighed against the alternative of the fixed cost F.

- Is Q > F/t, then exporting is more expense, & thus FDI!

- Proximity-concentration trade-off: Higher trade costs on one hand, and lower fixed

production costs on the other hand, both lower the FDI cutoff.

(A firm with low enough cost ci will want to sell more than Q units to foreign customers

Build an affiliate in Foreign & Become a multinational!

Vertical FDI Decision

A firm’s decision to break up its production chain and move parts of that chain to a foreign

affiliate will also involve a trade-off between per-unit and fixed costs.

When it comes to vertical FDI, the key cost saving is not related to the shipment of goods

across borders; rather, it involves production cost differences for the parts of the production

chain that are being moved.

<Outsourcing>

Internalization motive:

As a substitute for horizontal FDI, a parent could license an independent firm to produce and

sell its products in a foreign location; as a substitute for vertical FDI, a parent could contract

with an independent firm to perform specific parts of the production process in the foreign

location with the best cost advantage.

Offshoring represents the relocation of parts of the production chain abroad and group together

both foreign outsourcing and vertical FDI

- Offshoring is one of the major drivers of the increased worldwide trade and over 40 percent

of U.S. trade.

What are the key elements that determine internalization choice?

- Control over a firm’s proprietary technology offers are clean advantage for internalization.

- Horizontal FDI is widely favored over the alternative technology licensing to replicate

production process.

The trade-off between outsourcing and vertical FDI is much less clean-cut.

An independent firm could produce some pars at lower cost.

- An independent firm can specialize in exactly that narrow part of the production process &

can have the advantages of local ownership in the alignment and monitoring of managerial

incentives at the production facility.

But internalization(vertical FDI) also provides its own benefits when it comes to vertical

integration between a firm and its suppliers of a critical input to production.

Different trade-offs between production cost saving and the fixed cost of moving parts of the

production process abroad.

Relative to no offshoring, both vertical FDI and foreign outsourcing involve lower production

costs combined with a higher fixed cost.

- Thus, only the larger firms will choose either offshoring option and import some of their

intermediate inputs.

Only a subset of relatively more productive firms will choose to offshore (input intermediate

goods) and export (reach foreign customers).

<Consequences of Multinationals & Foreign Outsourcing>

In this chapter, internal economies of scale, product differentiation and performance differences

across firms combined to deliver some new channels for the gains from trade: increased product

variety, and higher industry performance as firms move down their AC curve and production is

concentrated in the larger, more productive firms.

- Like the relocation of production according to comparative advantage in chapter 3 through 6,

relocating production to take advantage of cost differences leads to overall gains from trade

and to income distribution effects that leave some wore off.

- The best policy response to this serious concern is still to provide an adequate safety net to

unemployed workers without discriminating based on the economic force that induce their

involuntary unemployment.