Chapter 8
Firms in the
Global Economy:
Export Decisions,
Outsourcing, and
Multinational
Enterprises
Preview
• Monopolistic competition and trade
• The significance of intra-industry trade
• Firm responses to trade: winners, losers, and
industry performance
• Dumping
• Multinationals and outsourcing
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8-2
Introduction
• Internal economies of scale imply that a firm’s
average cost of production decreases the more
output it produces.
• Internal economies of scale causes large firms to
have a cost advantage over small firms, causing
the industry to become uncompetitive.
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8-3
Introduction (cont.)
• If internal economies of scale is present, then a perfectly
competitive firm would make loss. Why?
• Because P=MC (profit maximization condition)
• Also since AC decreases over output levels, then it has
to be the case that MC<AC for levels of output until
efficient scale. (see the figure on next slide)
• Then P<AC. Then Profit=PxQ-TC=Qx(P-AC)<0 implying
loss.
• As a result, perfect competition would force those firms
out of the market.
• The remaining firms would have more power in
controlling price. This would lead to imperfect
competition.
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Introduction (cont.)
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8-5
The Theory of Imperfect
Competition
• Example: Boeing (US) vs. Airbus (Europe) in
aircraft industry.
• Under imperfect competition, firms are aware that
they can influence the prices of their products and
that they can sell more only by reducing their price.
• This situation occurs when there are only a few
major producers of a particular good or when each
firm produces a good that is differentiated from
that of rival firms.
• Each firm views itself as a price setter, choosing the
price of its product.
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8-6
Monopoly: A Brief Review
• A monopoly is an industry with only one firm.
• In these industries, the marginal revenue
generated from selling more products is less than
the price charged for each unit.
– To sell more, a firm must lower the price of all units, not
just the additional ones. (See Figure on the next slide)
– The marginal revenue function therefore lies below the
demand function (which determines the price that
customers are willing to pay).
– TR=P(Q)xQ then MR=P(Q)+P’(Q)xQ. Since P’(Q)<0, then
MR<P(Q).
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8-7
Monopoly: A Brief Review (cont.)
since P ranges from 9 to 10
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Monopoly: A Brief Review (cont.)
• Assume that the demand curve the firm faces is a
straight line Q = A – BP, where Q is the number of
units the firm sells, P the price per unit, and A and
B are constants.
• Higher B implies flatter demand curve since slope of
demand curve is -1/B.
• P=(A-Q)/B is called inverse demand curve.
• Marginal revenue equals MR = P – Q/B. Why?
See next slide.
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8-9
Monopoly: A Brief Review (cont.)
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Monopoly: A Brief Review (cont.)
• P-MR=Q/B
• Higher Q implies higher gap? Why?
– A firm that is not selling very many units will not lose much
by cutting the price it receives on those units.
• Higher B implies lower gap? Why?
– Higher B implies a flatter (more elastic) demand curve.
Thus, the higher the B, the smaller the price cut needed to
increase sales by one unit. The smaller the price cut, the
smaller the fall in MR.
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Monopoly: A Brief Review (cont.)
• Suppose that total costs are TC = F + cQ, where F
is fixed costs, those independent of the level of
output, and c is the constant marginal cost.
• Total variable cost is cQ.
• Average cost is the total cost of production (TC)
divided by the total quantity of production (Q).
AC = TC/Q = F/Q + c
• Marginal cost is the cost of producing an
additional unit of output.
• A larger firm is more efficient because average cost
decreases as output Q increases: internal
economies of scale.
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8-12
Fig. 8-2: Average Versus Marginal
Cost (TC=5+Q)
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8-13
Monopoly: A Brief Review (cont.)
• The profit-maximizing output occurs where
marginal revenue equals marginal cost.
Why?
• Monopolist charges the price PM. (see the
Figure 8-1 next slide)
• The monopolist earns some monopoly
profits, as indicated by the shaded box in
Figure 8-1, since PM > AC. Why?
• Profit=(PM-AC)xQM
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Fig. 8-1: Monopolistic Pricing and
Production Decisions
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Example: Monopoly
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Example: Monopoly (cont.)
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Monopolistic Competition
•
Monopoly is rare. Positive profits would attract
more firms.
•
An oligopoly is an imperfectly competitive
industry with only a few firms where firms sell
differentiated products and prices are set
strategically. Difficult to analyze.
•
Monopolistic competition is a simpler model of
an imperfectly competitive industry (with free
entry & exit) which assumes that each firm
1.
can differentiate its product from the products of
competitors, and
2.
takes the prices charged by its rivals as given and sets
its own price.
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8-18
Monopolistic Competition (cont.)
• Example: Automobile industry, private school
market, restaurants (Chinese, Japanese,
etc…)
• We have several assumptions characterizing
a monopolistically competitive market.
• Different varieties are substitutes.
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Monopolistic Competition (cont.)
• Each variety is produced by a single firm.
Why? If two different firms produce the same
variety, they will earn less profit due to
competition.
• Assume firm X produces varieties A and B.
Then, firm Y producing only variety B will cut
price of variety B. Then, Firm X will also cut
price of variety B. Since varieties A and B are
substitutes then firm X will not be able to sell
variety A as much as before. Eventually,
profit of firm X will fall.
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8-20
Monopolistic Competition (cont.)
• No firm has an incentive to produce more
than one variety. Why?
• Assume firm X produces variety A.
• If firm X also starts producing another
variety B, then its price setting power will fall
for variety A since A and B are substitutes.
• Thus, its profit from variety A will fall.
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8-21
Monopolistic Competition (cont.)
• A firm in a monopolistically competitive
industry is expected to sell
– more as total sales in the industry increase and
as prices charged by rivals increase.
– less as the number of firms in the industry
increases and as the firm’s price increases.
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Monopolistic Competition (cont.)
These assumptions are represented by the
demand function:
QJ = S x [1/n – b x (PJ – P)]
– QJ is an individual firm J’s sales (demand for firm’s output)
– S is the total sales of the industry (total demand for the
industry)
– n is the number of firms in the industry
– b is a constant term representing the responsiveness of a
firm’s sales to its price
– PJ is the price charged by the firm J itself
– P is the average price in the market
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Monopolistic Competition (cont.)
Is this a well-defined demand function?
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Monopolistic Competition (cont.)
• If PJ=P, then QJ=S/n
• If PJ>P, then QJ<S/n
• If PJ<P, then QJ>S/n
• The above demand formulation assumes industry
sales (S) is independent of average industry price.
This is not realistic but it simplifies the analysis.
• How to find the number of firms (n) and price
charged by each firm in equilibrium? First, we
analyze symmetric equilibrium then asymmetric
equilibrium.
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8-25
Monopolistic Competition (cont.)
• Assume that firms are symmetric: all firms face the
same demand function and have the same cost
function.
– Thus all firms should charge the same price and have equal
share of the market QJ=Q=S/n
– Average costs should depend on the size of the market and
the number of firms:
AC = C/Q = F/Q + c = n x (F/S) + c
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8-26
Monopolistic Competition (cont.)
AC = n x (F/S) + c
• As the number of firms n in the industry increases
(holding other things constant), the average cost
increases for each firm because each produces less
and there exists internal economies of scale. (see
CC curve in Figure 8-3)
• As total sales S of the industry increase (holding
other things constant), the average cost decreases
for each firm because each firm produces more and
there exists internal economies of scale.
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Fig. 8-3: Equilibrium in a
Monopolistically Competitive Market
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Monopolistic Competition (cont.)
• If Q = S[1/n – b(P – P)], then MR=P-(Q/(Sb)).
Why?
• Remember MR=P(Q)-(Q/B) for a monopolist. The
same applies here as well with B=Sb.
• When firms maximize profits, they should produce
until marginal revenue equals marginal cost:
MR = P – (Q/(Sb)) = c
• Then P=c+(Q/(Sb))
• Since Q=S/n at the equilibrium, then P=c+(1/(bn))
• As the number of firms n increases (holding other
things constant), the price that each firm charges
decreases due to increased competition.
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8-29
Monopolistic Competition (cont.)
• As b rises, the price decreases. Why? As b rises,
demand curve and MR curve becomes flatter. The
equilibrium quantity rises implying lower prices.
• Each firm’s markup over marginal cost
P - c = 1/(bn)
decreases with the number of competing firms.
• Then what is equilibrium n*? What is equilibrium
P* ?
• Find intersection of CC and PP curves. Why? In the
long-run, profit=0 for any firm because of free
entry and free exit ➔ P=AC
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8-30
Monopolistic Competition (cont.)
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8-31
Monopolistic Competition (cont.)
• At equilibrium, the price that firms charge
(which decreases in n) matches the average
cost that firms pay (which increases in n).
– At the long-run equilibrium, firms have no
incentive to enter or exit the industry. Long run
profit of any one firm is zero since P=AC.
– If n*=6.37, then we take it as 6. The 7th firm will
not enter the market since it will make loss.
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8-32
Monopolistic Competition (cont.)
• If the number of firms is greater than or
less than the equilibrium number of firms,
then firms have an incentive to exit or enter
the industry.
– Firms have an incentive to exit the industry when
price < average cost.
– Firms have an incentive to enter the industry
when price > average cost.
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8-33
Monopolistic Competition and
Free Trade
• Free trade integrates markets in different countries
into a single market.
• Because trade increases market size, trade is
predicted to decrease average cost in an industry
described by monopolistic competition.
– Industry sales increase with trade leading to decreased
average costs: AC = n(F/S) + c
• Because trade increases the variety of goods that
consumers can buy under monopolistic competition,
it increases the welfare of consumers.
– And because average costs decrease, consumers can also
benefit from a decreased price.
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Fig. 8-4: Effects of a Larger
Market
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Monopolistic Competition and Trade
(cont.)
• As a result of trade, the number of firms in
the integrated world market is predicted to
to be higher than the number of firms in
each national market.
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8-36
Gains from an Integrated Market: A
Numerical Example
• Automobile industry
• Suppose that b = 1/30,000, fixed cost F =
$750,000,000 and a marginal cost of c =
$5,000 per automobile.
• Q = S[1/n – (1/30,000)(P – P)]
• The total cost is
C = 750,000,000 + (5,000*Q).
• The average cost is therefore
AC = (750,000,000/Q) + 5,000.
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8-37
Gains from an Integrated Market: A
Numerical Example (cont.)
• Suppose there are two countries, Home and
Foreign.
• Home has annual sales of 900,000
automobiles; Foreign has annual sales of
1.6 million. (see Figure 8-5)
• The two countries are assumed (for now) to
have the same costs of production.
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Gains from an Integrated Market: A
Numerical Example (cont.)
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Gains from an Integrated Market: A
Numerical Example (cont.)
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Fig. 8-5: Autarky Equilibrium in the
Automobile Market
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Gains from an Integrated Market: A
Numerical Example (cont.)
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Fig. 8-5: Equilibrium in the
Automobile Market (cont.)
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Gains from an Integrated Market: A
Numerical Example (cont.)
• The integrated market supports more firms, each
producing at a larger scale and selling at a lower
price than either national market does on its own.
• After integration, consumers have a wider range
of choices.
• After integration, each firm produces more and is
therefore able to offer its product at a lower
price.
• Home benefits more from integration since price
decreases more. Why? The country that is initially
smaller benefits from a bigger increase in market
size after integration.
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8-44
Gains from an Integrated Market: A
Numerical Example (cont.)
• From the perspective of a specific firm, the
number of firms it competes will rise. But
the rise in the number of firms is smaller
than the rise in market size since
n*=(S/(bF))0.5 . Thus, output per firm will
rise and AC will fall.
• Mathematically, the number of firms in the
world decreases since
(Shome)0.5+(Sforeign)0.5>(Shome+Sforeign)0.5
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Table 8-1: Hypothetical Example of
Gains from Market Integration
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Monopolistic Competition and Trade
(cont.)
• After integration, 4 firms exit the market.
We don’t know the names of these firms
from the model since firms face the same
cost. One drawback of symmetric
equilibrium.
• Why do some firms exit from the industry?
• Assume no firm exits after integration.
Then we have 14 firms.
• Given new market size of 2,500,000, the
output per firm is approximately 178,000.
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8-47
Monopolistic Competition and Trade
(cont.)
• At the current price (8750), the foreign
firms will make loss since their output is
lower and thus average cost is higher.
• Then foreign firms will start exiting the
market.
• As firms exit, the output per firm will rise
and loss will fall. Exiting will end up at
some point. Market will reach equilibrium
number of firms.
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8-48
Monopolistic Competition and Trade
(cont.)
•
Product differentiation and internal economies of
scale lead to trade between similar countries with
no comparative advantage differences between
them.
– This is a very different kind of trade than the
one based on comparative advantage, where
each country exports its comparative advantage
good.
– Different countries trading similar goods is
known as intra-industry trade.
– Ex) South Korea and Japan trade Hyundai and
Toyota.
– Consistent with data?
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8-49
The Significance of IntraIndustry Trade
•
Intra-industry trade refers to two-way
exchanges of similar goods.
•
Two new channels for welfare benefits
from trade:
–
Benefit from a greater variety at a lower price.
–
Firms consolidate their production and take
advantage of economies of scale.
•
A smaller country stands to gain more
from integration than a larger country.
•
Ex) Canada and US after NAFTA. Canada gains
more.
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8-50
The Significance of Intra-Industry
Trade (cont.)
• About 25–50% of world trade is intraindustry.
• Most prominent is the trade of
manufactured goods among advanced
industrial nations, which accounts for the
majority of world trade.
– For the United States, industries that have the
most intra-industry trade—such as
pharmaceuticals, chemicals, and specialized
machinery—require relatively larger amounts of
skilled labor, technology, and physical capital.
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The Significance of Intra-Industry
Trade (cont.)
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8-52
Table 8-2: Indexes of Intra-Industry
Trade for U.S. Industries, 2009
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Asymmetric Firm Responses
under Autarky
• Up to now, we concentrated on symmetric
equilibrium. We could not predict which firms exit
the market after integration.
• Now we relax symmetry assumption and assume
firms differ by costs faced.
• After integration, because of increased competition,
the high cost firms will leave the market and low
cost firms will survive. Thus, average cost in the
industry will fall and average productivity will rise.
• The effects of integration is similar to technological
growth.
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8-54
Asymmetric Firm Responses
under Autarky (cont.)
• Assume firms differ by only marginal cost now.
They still face the same demand curve and same
fixed cost.
• Denote the marginal cost of firm j with cj.
• Let’s arbitrarily pick two firms with c1<c2.
• The mark up for first firm is
P1-c1=(1/2bn)+(P/2)-(c1/2) Why? (See next
slide)
• The mark up for second firm is
P2-c2=(1/2bn)+(P/2)-(c2/2) Why? (See next
slide)
• So mark up rises as MC falls since MR is steeper
than demand curve. (see Figure 8-6a)
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8-55
Asymmetric Firm Responses
under Autarky (cont.)
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8-56
Asymmetric Firm Responses
under Autarky (cont.)
• Firms face uncertainty in terms of marginal cost.
• Marginal cost is known by firm only after paying the
fixed cost. Thus, fixed cost is sunk and cannot be
recovered.
• Operating profit of firm j=OPj
• OPj=TRj-VCj=(Pj-cj)Qj
• Operating profit for first firm is
[(1/2bn)+(P/2)-(c1/2)]x[(S/2n)+(SbP/2)-(Sbc1/2)]
• Operating profit for second firm is
[(1/2bn)+(P/2)-(c2/2)]x[(S/2n)+(SbP/2)-(Sbc2/2)]
• Which firms survive in the market and which firms
not?
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8-57
Asymmetric Firm Responses
under Autarky (cont.)
survives in the market
not survive in the market
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Fig. 8-6: Performance Differences
Across Firms
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Fig. 8-6: Performance Differences
Across Firms
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Fig. 8-6: Performance Differences
Across Firms
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8-61
Asymmetric Firm Responses
under Trade
• Trade increases S and n.
• Two effects on demand.
• As S rises, slope of demand falls. So demand shifts
up. Mathematically why? (size effect) Remember
slope of demand curve is -1/(Sb).
• Size effect pushes up demand for a firm’s product.
• As n rises, competition rises, so demand shifts
down. Mathematically why? (competition effect)
Remember the cutoff of demand curve on y-axis is
P+[1/(bn)]
• Competition effect pushes down the demand for a
firm’s product.
• So new demand is D’. (see Figure 8-7a)
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8-62
Asymmetric Firm Responses
under Trade
• Assume D and D’ intersects at Q*.
• Smaller firms producing less than Q*, face a decline
in quantity demanded after trade. Competition
effect dominates size effect.
• Larger firms producing more than Q*, face a rise in
quantity demanded after trade. Size effect
dominates the competition effect.
• Large firms with low MC (high mark up) can
decrease their mark up more than small firms. So
consumers demand more of large firm’s product.
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8-63
Asymmetric Firm Responses
under Trade
• Increased competition tends to hurt the worstperforming firms — they are forced to exit. (see
Figure 8-7b)
• The best-performing firms take the greatest
advantage of new sales opportunities and expand
the most. (see Figure 8-7b)
• Smaller firms face a decrease in operating profit
whereas larger firms face a rise in operating profit.
Why? (see Figure 8-7b)
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8-64
Asymmetric Firm Responses
under Trade
• OP=(P-c)xQ
• Q rises because of size effect and P falls because of
competition effect.
• As Q rises OP rises and as P falls OP falls.
• For large firms with low MC, size effect dominates
competition effect so OP rises.
• For small firms with high MC, competition effect
dominates size effect so OP falls.
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8-65
Fig. 8-7: Winners and Losers from
Economic Integration
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8-66
Asymmetric Firm Responses
under Trade (cont.)
• When the better-performing firms expand and the
worse-performing ones contract or exit, overall
industry performance improves.
– Trade and economic integration improve industry
performance as much as the discovery of a better
technology does.
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8-67
Trade Costs and Export Decisions
• Most U.S. firms do not report any exporting activity at all —
sell only to U.S. customers.
– In 2002, only 18% of U.S. manufacturing firms reported any
sales abroad.
• Even in industries that export much of what they produce,
such as chemicals, machinery, electronics, and transportation,
fewer than 40 percent of firms export. (see Table 8-3)
• Why? Because of trade costs (such as transportation cost).
• A major reason why trade costs reduce trade so much is that
they drastically reduce the number of firms selling to
customers across the border.
– Trade costs also reduce the volume of export sales of firms selling
abroad.
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8-68
Table 8-3: Proportion of U.S. Firms
Reporting Export Sales by Industry, 2002
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8-69
Trade Costs and Export Decisions
• Assume two identical countries: Home vs. Foreign
• Assume a firm incurs additional cost t if it exports.
• Pick two arbitrary firms at home with different
MC’s.
• Assume c1<c2<c*
• Both firms supply the domestic market. (see Figure
8-8)
• But only first firm exports since c1+t<c* but
c2+t>c*.
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8-70
Fig: 8-8: Export Decisions with Trade
Costs
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8-71
Trade Costs and Export Decisions
(cont.)
• Trade costs added two important predictions to our
model of monopolistic competition and trade:
– Why only a subset of firms export, and why exporters are
relatively larger and more productive (lower marginal
costs).
• Overwhelming empirical support for this prediction
that exporting firms are bigger and more
productive than firms in the same industry that do
not export.
– In the United States, in a typical manufacturing industry,
an exporting firm is on average more than twice as large
as a firm that does not export.
– Differences between exporters and nonexporters are even
larger in many European countries.
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8-72
Dumping
• Trade costs cause firms to set different prices in
different markets.
• MC in export market is c+t.
• Mark-up is smaller in export market than in domestic
market. Why? (see Figure 8-8)
• Denote price set by a firm in domestic market as PD and
export market as PX.
• Since mark-up is smaller in export market then:
PX-(c+t)<PD-c ➔ PX-t<PD
• Dumping is the practice of charging a lower price for
exported goods than for goods sold domestically.
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8-73
Dumping
• Assume Toyota charges 10,000 dollars for an
automobile in Japan. The cost of transporting the
same car to Germany is 2000 dollars. Dumping
occurs if Toyota charges less than 12000 dollars in
German market.
• Dumping is an example of price discrimination:
the practice of charging different customers
different prices.
• Price discrimination and dumping may occur only if
– imperfect competition exists: firms are able to influence
market prices.
– markets are segmented so that goods are not easily
bought in one market and resold in another.
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8-74
Dumping (cont.)
• Dumping can be a profit-maximizing
strategy:
– A firm with a higher marginal cost chooses to set
a lower markup over marginal cost.
– Therefore, an exporting firm will respond to the
trade cost by lowering its markup for the export
market.
– This strategy is considered to be dumping,
regarded by most countries as an “unfair” trade
practice.
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8-75
Protectionism and Dumping
• A U.S. firm may appeal to the Commerce
Department to investigate if dumping by
foreign firms has injured the U.S. firm.
– The Commerce Department may impose an
“anti-dumping duty” (tax) to protect the U.S.
firm.
– Tax equals the difference between the actual and
“fair” price of imports, where “fair” means “price
the product is normally sold at in the
manufacturer's domestic market.”
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8-76
Protectionism and Dumping
(cont.)
• Next, the International Trade Commission
(ITC) determines if injury to the U.S. firm
has occurred or is likely to occur.
• If the ITC determines that injury has
occurred or is likely to occur, the antidumping duty remains in place.
• A new anti-dumping law in Azerbaijan.
Read…
https://www.azernews.az/business/92618.html
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8-77
Protectionism and Dumping
(cont.)
• Most economists believe that the
enforcement of dumping claims is
misguided.
– Trade costs have a natural tendency to induce
firms to lower their markups in export markets.
– Such enforcement may be used excessively as
an excuse for protectionism.
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8-78
The rest of Chapter 8
is not included in the
final exam.
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8-79
Multinationals and Outsourcing
• Foreign direct investment (FDI) refers to
investment in which a firm in one country
directly controls or owns a subsidiary in
another country.
• If a foreign company invests in at least 10%
of the stock in a subsidiary, the two firms
are typically classified as a multinational
corporation.
▪ 10% or more of ownership in stock is deemed to
be sufficient for direct control of business
operations.
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Multinationals and Outsourcing
(cont.)
• Greenfield FDI is when a company builds a
new production facility abroad.
• Brownfield FDI (or cross-border mergers
and acquisitions) is when a domestic firm
buys a controlling stake in a foreign firm.
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Fig. 8-9: Inflows of Foreign Direct
Investment, 1970-2012
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Multinationals and Outsourcing
(cont.)
• Developed countries have been the biggest
recipients of inward FDI.
– much more volatile than FDI going to developing
and transition economies.
– volatility caused by increasing share of
Brownfield FDI.
• Steady expansion in the share of FDI
flowing to developing and transition
countries.
– Accounted for half of worldwide FDI flows since
2009.
• Sales of FDI affiliates are often used as a
measure of multinational activity.
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Fig. 8-10: Outward Foreign Direct
Investment for Top 25 Countries, 20092011
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Multinationals and Outsourcing
(cont.)
• Two main types of FDI:
– Horizontal FDI when the affiliate replicates the
production process (that the parent firm
undertakes in its domestic facilities) elsewhere
in the world. (ex. Toyota produces Corolla in
Japan, Turkey, US, UK.)
– Vertical FDI when the production chain is
broken up, and parts of the production
processes are transferred to the affiliate
location. (ex. Toyota produces parts of the
engine in China.)
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Multinationals and Outsourcing
(cont.)
• Vertical FDI is mainly driven by production
cost differences between countries (for
those parts of the production process that
can be performed in another location).
– Vertical FDI is growing fast and is behind the
large increase in FDI inflows to developing
countries.
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Multinationals and Outsourcing
(cont.)
• Horizontal FDI is dominated by trade flows
between developed countries.
– Both the multinational parent and the affiliates
are usually located in developed countries.
• The main reason for this type of FDI is to
locate production near a firm’s large
customer bases.
– Hence, trade and transport costs play a much
more important role than production cost
differences for these FDI decisions.
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The Firm’s Decision Regarding Foreign
Direct Investment
• Proximity-concentration trade-off:
– High trade costs associated with exporting
create an incentive to locate production near
customers.
– Increasing returns to scale in production create
an incentive to concentrate production in fewer
locations.
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The Firm’s Decision Regarding Foreign
Direct Investment (cont.)
• Horizontal FDI activity concentrated in
sectors with high trade costs.
– When increasing returns to scale are
important and average plant sizes are large,
we observe higher export volumes relative
to FDI.
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The Firm’s Decision Regarding Foreign
Direct Investment (cont.)
•
•
•
The horizontal FDI decision involves a trade-off
between the per-unit export cost (t) and the fixed
cost (F) of setting up an additional production facility.
Assume marginal cost of production is same at home
and at foreign.
If tQ+cQ > F+cQ, costs more to pay trade costs t on
Q units sold abroad than to pay fixed cost F to build a
plant abroad.
–
–
–
When Q > F/t (sales in foreign location large), exporting is
more expensive and horizontal FDI is the profit-maximizing
choice.
If F is large, a huge amount of output should be produced at
foreign location so that horizontal FDI is chosen.
The higher the trade cost t, the lower the output should be
produced at foreign location so that horizontal FDI is chosen.
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The Firm’s Decision Regarding Foreign
Direct Investment (cont.)
• The vertical FDI decision also involves a
trade-off between cost savings and the
fixed cost F of setting up an additional
production facility.
• A firm chooses vertical FDI if
cQ>F+c’Q+t’Q ➔ Q>F/(c-c’-t’)
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The Firm’s Decision Regarding
Foreign Direct Investment (cont.)
• In addition to deciding the location of
where to produce, firms also face an
internalization decision: whether to own
affiliate or not.
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The Firm’s Decision Regarding
Foreign Direct Investment (cont.)
• As a substitute for horizontal FDI, a firm
could license another firm to produce and
sell its products in a foreign location.
• This requires sharing the technology with a
different firm which is risky.
• Horizontal FDI is favored over licensing
another firm to replicate the production
process.
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The Firm’s Decision Regarding
Foreign Direct Investment (cont.)
• As a substitute for vertical FDI, a firm could
contract with another firm to perform
specific parts of the production process in
the foreign location.
• This is known as foreign outsourcing or
offshoring.
• Outsourcing leads to lower costs than
vertical FDI.
• Outsourcing may cause conflict among
parent and affiliate firms which does not
arise in vertical FDI.
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The Firm’s Decision Regarding Foreign
Direct Investment (cont.)
• Offshoring leads to importing intermediate
goods or services.
• The firm enjoys lower costs in turn.
• As a result, the firm charges lower price
which increases competitiveness and in turn
exports.
• Does offshoring lead to shipping jobs
overseas?
• Not necessarily. (See Figure 8-11)
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Fig. 8-11: U.S. International Trade in
Business Services, 1986–2011
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Summary
1. Internal economies of scale imply that more
production at the firm level causes average costs
to fall.
2. With monopolistic competition, each firm can raise
prices somewhat above those on competing
products due to product differentiation but must
compete with other firms whose prices are
believed to be unaffected by each firm’s actions.
3. Monopolistic competition allows for gains from
trade through lower costs and prices, as well as
through wider consumer choice.
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Summary (cont.)
4.
Monopolistic competition predicts intra-industry
trade, and does not predict changes in income
distribution within a country.
5.
Location of firms under monopolistic competition
is unpredictable, but countries with similar
relative factors are predicted to engage in intraindustry trade.
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Summary (cont.)
6. Dumping may be a profitable strategy when a firm
faces little competition in its domestic market and
faces heavy competition in foreign markets.
7. Multinationals are typically larger and more
productive than exporters, which in turn are larger
and more efficient than firms that sell only to the
domestic market.
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Summary (cont.)
8.
Multinational corporations undertake foreign
direct investment when proximity is more
important than concentrating production in one
location.
–
Firms produce where it is most cost-effective — abroad
if the scale is large enough. They replicate entire
production process abroad or locate stages in different
countries.
–
Firms also decide whether to keep transactions within
the firm or contract with another firm.
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