FIRMS AND MARKETS:

FROM LOCAL TO GLOBAL

BA Festival of Science 2005, Trinity College Dublin

Section F (Economics) Presidential Session

9.00 a.m. – 5.30 p.m., 7 September 2005

A one-day conference organised by the Geary Institute (UCD)and the Institute for International Integration Studies (TCD)

FROM LOCAL TO GLOBAL:

FIRMS AND MARKETS

IN INTERNATIONAL TRADE

J. Peter Neary

University College Dublin and CEPR

BA Festival of Science 2005, Trinity College Dublin

7 September 2005

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Introduction

Globalisation

General Equilibrium• Key: Interactions between goods and factor markets

Market Structure• Competition: Perfect or Monopolistic

Neary (JEL 2001, 2003a)

• Oligopoly: Large Firms, entry barriers, strategic interaction

=> “GOLE”: General Oligopolistic EquilibriumNeary (JEEA 2003)

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Plan

Market Structure:• Perfect Competition

• Monopolistic Competition

• Oligopoly

Extensions of GOLE:• Endogenous mode of competition

• Heterogeneous firms and endogenous market structure

Implications for Policy:• Fostering entrepreneurship

• Foreign direct investment (FDI) and trade costs

5

Plan

Market Structure:• Perfect Competition

• Monopolistic Competition

• Oligopoly

Extensions of GOLE:• Endogenous mode of competition

• Heterogeneous firms and endogenous market structure

Implications for Policy:• Fostering entrepreneurship

• Foreign direct investment (FDI) and trade costs

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Traditional benchmark:• “Small” firms

• Homogeneous goods

• Production costs independent of firm scale

Pro:• Very adaptable

Con:• Unrealistic

• No allowance for increasing returns, product differentiation, etc.

• e.g., Implausible implications for international production patterns

Perfect Competition

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Equilibrium Production Patternsin Perfect Competition

c

c*a'

a'

O: No home orforeign production

F: Foreign production only

H: Homeproduction only

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Chamberlin (1933)

• “Small” firms

• Differentiated goods

• Declining average costs /Increasing returns to scale

• No perceived interdependence

Pro:

Monopolistic Competition

U x z x z dz[{ ( )}] ( )

0

11

p z Ax z( ) , 1

1

• Precise, tractable, versatile

Con:• Unrealistic

Dixit-Stiglitz (1977) preferences:

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Extensions:• Internal organisation of firms

• Heterogeneous firms

Monopolistic Competition (cont.)

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Oligopoly

Perceived interdependence central

Firms large in their own market• Progress delayed by difficulties of modelling firms large relative to the

economy

• Resolution: Assume many sectors, all small

• So: firms themselves are small in the economy

Demand: “Continuum-quadratic” preferences:

U x z ax z bx z dz[{ ( )}] [ ( ) ( ) ] 12

2

0

1

p z a b x z( ) ' ' ( )

11

Oligopoly (cont.)

Simple model to illustrate effects of trade liberalisation

Heterogeneous sectors in 2 countries:• Integrated world market

• Given numbers of firms at home & abroad: n, n*

• Firms in each country have identical costs: c, c*

• Cost configurations consistent with profitability:

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Equilibrium Production Patternsfor Arbitrary Home and Foreign Costs

c

c*

O: No home orforeign production

F: Foreign production only

H: Homeproduction only

a'

a'

HF: Homeand foreignproduction

a

n

'* 1

a

n

'

1

13

To embed this in general equilibrium: • Costs depend on technology and wages• Wages (at home and abroad) determined in the

labour markets

Oligopoly (cont.)

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Equilibrium Production Patternsfor a Given Cost Distribution

c

c*

O

HF: Homeand foreignproduction

F: Foreign production only

H: Homeproduction only

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Oligopoly (cont.)

• Specialisation patterns determined as shown• Wages and threshold sectors determined together in

general equilibrium

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Plan

Market Structure:• Perfect Competition

• Monopolistic Competition

• Oligopoly

Extensions of GOLE:• Endogenous mode of competition

• Heterogeneous firms and endogenous market structure

Implications for Policy:• Fostering entrepreneurship

• Foreign direct investment (FDI) and trade costs

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Endogenous Mode of Competition(joint work with Joe Tharakan, Natl. Univ. of Ireland, Maynooth)

“Cournot”/quantity-setting vs. “Bertrand”/price-setting

2-stage capacity-price duopoly game:[Kreps/Scheinkman (BJE 1983), Maggi (AER 1996)]

• Investment in capacity commits a firm to charge higher prices

• The credibility of the commitment depends on , the cost premium of producing above capacity

• If is sufficiently high, then the outcome is “as if” competition was Cournot

Embed this in general equilibrium:• Assume a continuum of sectors z[0,1], with different values of • Assume production (variable costs) uses unskilled labour and investment in

capacity uses (z) skilled labour; wages: w and r

• Threshold sectors are then determined jointly with factor prices

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Heterogeneous Firms and Endogenous Market Structure

Firm heterogeneity in monopolistic competition:[Melitz (Em 2003), Helpman-Melitz-Yeaple (AER 2004)]

• Firms pay a sunk cost to reveal their productivityDraw c from a distribution g(c)

• Given their productivity, they calculate their expected profits and choose to produce or exit

Exit if c < ce where (ce) = 0 or r(ce) = f .

• If exporting and/or FDI require an additional fixed cost, only high-productivity firms will engage in them

• Predictions are consistent with micro-empirical evidence

Extend to a continuum of sectors:• Firms draw a productivity and a sector: {c, z}• Sectors differ in their fixed costs: f(z), f ´ > 0• In equilibrium, sectors have different expected firm numbers

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Equilibrium Expected Market Structure

E(ln2n)

z 1

Monopoly

0

Oligopoly

Monopolistic Competition

1

2

3

4

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Plan

Market Structure:• Perfect Competition

• Monopolistic Competition

• Oligopoly

Extensions of GOLE:• Endogenous mode of competition

• Heterogeneous firms and endogenous market structure

Implications for Policy:• Fostering entrepreneurship

• Trade costs and foreign direct investment (FDI)

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Fostering Entrepreneurship

How to encourage new (indigenous) firms?Monopolistic Competition:• All entrants are de novo and identical

(Melitz: ex ante identical)

• Spillovers from multinationals encourage indigenous entryTheory: Markusen and Venables (EER 1999)

Empirical evidence: Görg and Strobl (EER 2002)

Oligopoly: Entry by diversification much more likely• Successful entrants are frequently incumbents in a related

industry. Theory: Gilbert and Newbery (AER 1982)

Empirical evidence: Geroski (IJIO 1995); Davies, Rondi and Sembenelli (IJIO 2001)

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Dominant view of FDI:– Theory has focused on “greenfield” case

– Mostly horizontal (i.e., concerned with market access)

– Relative to exporting, encouraged by trade costs

– This view consistent with much evidence

– But: counter-factual implication: falls in trade costs should reduce FDIc.f. Ireland in 1990s: huge increase in FDI while trade costs in EU fell

Resolutions:– Export-platform FDI: Falls in internal EU trade costs

– Cross-border mergers: brown not green-field

How to explain cross-border mergers?– M&A’s a huge % of all FDI

– A high % of mergers are cross-border

– Cross-border merger waves linked to market integration[EU Single Market; Mercosur]

Trade Costs and FDI

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How does trade liberalisation affect merger incentives?• No incentive if the 2 merging firms are identical

[Salant, Switzer, Reynolds (QJE 1983): “Cournot merger paradox”]

• BUT: If firms differ in cost, a low-cost/high-cost takeover may be profitable

Trade Costs and FDI (cont.)

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c

c*

Incentives for home firms to

take over foreign

Home firms face similar incentives:

Takeover Incentives

OF

HF

H

Incentives for foreign firms totake over home

25

Wage adjustment in general equilibrium:• Assume symmetric countries

• Expanding and contracting firms in both

• BUT: High-cost firms contract by more

• So: Wages fall

Trade Costs and FDI (cont.)

26

Cross-Border Mergers Tend to Reduce Wages(unlike greenfield FDI)

c

c*

OF

HF

H

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Conclusion

Different approaches to modelling globalizationHere: Oligopoly in general equilibrium [GOLE]• Continuum of sectors avoids problems of firms being “too large” in the economy

Theoretical Applications:• Endogenous Mode of Competition [Bertrand vs. Cournot]• Heterogeneous Firms and Endogenous Market Structure

• Level of fixed costs determines equilibrium expected number of firms

Policy Applications:• Fostering Entrepreneurship• Trade Costs and FDI

• Standard model predicts that trade liberalisation will lower FDI• Oligopoly model avoids this

More work needed!

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Further ReadingNeary, J.P. (2001): “Of hype and hyperbolas: Introducing the new economic geography," Journal of Economic Literature, 39:2,

June, 536-561.

Neary, J.P. (2002): “"Foreign direct investment and the single market," The Manchester School, 70:3, June, 291-314.

Neary, J.P. (2003a): “Globalization and market structure,” Journal of the European Economic Association, 1:2-3, April-May, 245-271.

Neary, J.P. (2003b): “The road less travelled: Oligopoly and competition policy in general equilibrium,” in R. Arnott, B. Greenwald, R. Kanbur and B. Nalebuff (eds.): Economics for an Imperfect World: Essays in Honor of Joseph E. Stiglitz, Cambridge, Mass.: MIT Press, 485-500.

Neary, J.P. (2003c): “Monopolistic competition and international trade theory,” in S. Brakman and B.J. Heijdra (eds.): The Monopolistic Competition Revolution in Retrospect, Cambridge: Cambridge University Press, 159-184.

Neary, J.P. (2005): “Trade costs and foreign direct investment,” presented at CESifo Summer Institute Workshop on Recent Developments on International Trade: Globalization and the Multinational Enterprise, Venice, July 2005.

[All these papers available at www.ucd.ie/economic/staff/pneary/neary.htm]

 

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European Trade Study Group (ETSG)7th Annual Conference

University College DublinThursday 8th – Saturday 10th September

www.etsg.org