Firms in the Global Economy
Pierre-Louis Vézina
p.vezina@bham.ac.uk
Firm Responses to Trade
Which firms are the survivors from trade integration?
Firm Responses to Trade
• We need a theory to explain which firms
survive and expand following trade
integration…
Marc Melitz
Marc J. Melitz, 2003. "The Impact of Trade on Intra-Industry Reallocations and
Aggregate Industry Productivity," Econometrica, Econometric Society, vol. 71(6),
pages 1695-1725, November.
Marc Melitz
• A future Nobel Prize?
Marc J. Melitz, 2003. "The Impact of Trade on Intra-Industry Reallocations and
Aggregate Industry Productivity," Econometrica, Econometric Society, vol. 71(6),
pages 1695-1725, November.
Performance Differences Across Firms
• Last time we assumed all firms were
symmetric
– (same marginal costs, same market share)
• Now let’s assume some are more productive
then others (some have lower marginal costs)
Performance Differences Across Firms
Q = S[1/n – b(P – P)]
Performance Differences Across Firms
Q = S[1/n – b(P – P)]
• Firm 1 sets a lower price
and produces more
output
• Firm 1 also sets a higher
markup, P1-c1>P2-c2 (as the
MR curve is steeper than the D
curve)
• Firm 1 earns more profits
((P1-c1)× Q1) (We assume
fixed costs (F) are sunk and do
not enter profits)
Performance Differences Across Firms
Performance Differences Across Firms
A firm can make profits
as long as its marginal
cost is lower than c*,
where marginal cost =
price
Winners and Losers from Economic Integration
Trade integration  S increases, and n increases
Winners and Losers from Economic Integration
Trade integration  S increases, and n increases
Firms which had marginal costs
above c’* now have no
demand (the cut-off becomes
tougher)
c*
c’*
Firms which produced more
than Qi now face a more
“generous” demand
Firms which produced less
than Qi face a less “generous”
demand
Qi
Winners and Losers from Economic Integration
Trade integration  S increases, and n increases
c*
c’*
Qi
Winners and Losers from Economic Integration
Trade integration  S increases, and n increases
c*
c’*
Qi
Firms which produced more than Qi see their profits increase.
Firms which produced less than Qi see their profits fall.
Firms which had marginal costs above c’* do not survive.
Winners and Losers from Economic Integration
• Recap:
– The “worst” firms exit
– “Average” firms contract
– The “best-performing” firms expand
• Industry production becomes concentrated in
the best firms  the industry is now more
productive
Trade Costs and Export Decisions
• Most US firms do not report any exporting activity at
all — sell only to US customers.
– In 2002, only 18% of US 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% of firms export.
Trade Costs and Export Decisions
Trade Costs and Export Decisions
• Why would firms choose not to export?
– Trade costs are high
– Trade costs add to marginal costs and reduce profitability
– For some firms, that’s just too much!
Trade Costs and Export Decisions
• A firm must incur an additional cost t to
export one unit
• Due to t, firms will sell at different prices at
Home and Foreign
– This means different prices and profits in the 2
markets
Trade Costs and Export Decisions
• Firms will take 2 decisions:
– How much to sell at Home
– How much to export to Foreign
Export Decisions with Trade Costs
At Home, sales decisions are
unaffected by trade costs
Export Decisions with Trade Costs
In Foreign, the firms
marginal costs are
shifted up by t
Trade Costs and Export Decisions
• What are the effects of trade costs on export
decisions?
– The most profitable firms export
– The least profitable only sell at Home
Trade Costs and Export Decisions
• Trade costs add 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).
Trade Costs and Export Decisions
• Overwhelming empirical support for this prediction:
• Exporting firms are bigger and more productive than
firms in the same industry that do not export.
Trade Costs and Export Decisions
Exporter
premia
Trade Costs and Export Decisions
Note: Results are from ordinary least squares regression of the firm characteristic
listed on the left on a dummy variable equal to 1 for exporters.
Trade Costs and Export Decisions
• In Canada
Dumping
• Since markets are not perfectly integrated, i.e. trade costs
exist, firms can choose different prices in different markets
• Dumping is the practice of charging a lower price for exported
goods than for goods sold domestically.
Dumping
• Let PD and PX denote the prices a firm sets at Home and
Foreign
• Recall that a firm with higher marginal cost chooses a lower
markup above marginal cost:
• We have:
PD-c > Px-(c+t)
PD > Px-t
 The export price (net of trade costs) is lower
Dumping
• Let PD and PX denote the prices a firm sets at Home and
Foreign
• Recall that a firm with higher marginal cost chooses a lower
markup above marginal cost:
• We have:
PD-c > Px-(c+t)
PD > Px-t
 The export price (net of trade costs) is lower
This strategy is considered to be dumping, regarded by
most countries as an “unfair” trade practice.
Dumping
• Price discrimination via 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.
Protectionism and Dumping
• A firm may appeal to the Commerce
Department of its Home country to investigate
if dumping by foreign firms has injured it
– The Commerce Department may impose an “antidumping duty” (tax) to protect the 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.”
8-34
Protectionism and Dumping
• Most economists believe that the
enforcement of dumping claims is misguided.
– Dumping naturally occurs as trade costs induce
firms to lower their markups in export markets.
– Antidumping may be used excessively as an
excuse for protectionism.
Protectionism and Dumping
Protectionism and Dumping
Protectionism and Dumping
Protectionism and Dumping
Multinationals and Outsourcing
• Foreign direct investment 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.
Multinationals and Outsourcing
• 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.
• Greenfield FDI has tended to be more stable,
while cross-border mergers and acquisitions
tend to occur in surges.
Foreign Direct Investment, 1980-2009
Developed countries have been
the biggest recipients of FDI
Foreign Direct Investment, 1980-2009
Developed countries have been
the biggest recipients of FDI
It’s been much more volatile
than FDI going to developing
and transition economies.
Foreign Direct Investment, 1980-2009
FDI to developing countries accounted for half
of worldwide FDI flows in 2009
Foreign Direct Investment, 2007-2009
Source: UNCTAD, World Investment Report, 2010.
Foreign Direct Investment
Multinationals and Outsourcing
• 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.
– Vertical FDI when the production chain is broken
up, and parts of the production processes are
transferred to the affiliate location
Multinationals and Outsourcing
• 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.
Multinationals and Outsourcing
• Horizontal FDI is dominated by 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.
Multinationals and Outsourcing
• Vertical FDI
– Intel builds a chip plant in Costa Rica to export
back to the US
• Horizontal FDI
– Volkswagen builds a plant in Mexico to sell cars in
Mexico
The Firm’s Decision Regarding FDI
• 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.
The Firm’s Decision Regarding FDI
•
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.
–
•
Should I export or build a plant abroad?
If t(Q) > F, it costs more to pay trade costs t on Q units
sold abroad than to pay fixed cost F to build a plant
abroad.
–
When foreign sales large Q > F/t, exporting is more expensive
and FDI is the profit-maximizing choice.
The Firm’s Decision Regarding FDI
• Multinationals tend to be much larger and
more productive than other firms (even
exporters) in the same country.
The Firm’s Decision Regarding FDI
The Firm’s Decision Regarding FDI
• The vertical FDI decision also involves a tradeoff between cost savings and the fixed cost F
of setting up an additional production facility.
– Cost savings related to wages make some stages of
production cheaper in other countries.
The Firm’s Decision Regarding FDI
• Foreign outsourcing or offshoring occurs
when a firm contracts with an independent
firm to produce in the foreign location.
– In addition to deciding the location of where to
produce, firms also face an internalization
decision: whether to keep production done by one
firm or by separate firms.
The Firm’s Decision Regarding FDI
•
Internalization occurs when it is more profitable to conduct
transactions and production within a single organization.
Reasons for this include:
1.
Transfer of knowledge or technology may be easier and safer within a
single organization
–
2.
Patent or property rights may be weak or nonexistent
Consolidating an input within the firm using it can avoid holdup
problems and hassles in writing complete contracts
The Firm’s Decision Regarding FDI
•
FDI should benefit countries for reasons similar to
why international trade generates gains.
– FDI is very similar to the relocation of production that
occurred across sectors when opening to trade.
– Relocating production to take advantage of cost differences
leads to overall gains from trade.
The Firm’s Decision Regarding FDI
• Read more:
• James R. Markusen, 1995. "The Boundaries of
Multinational Enterprises and the Theory of
International Trade," Journal of Economic
Perspectives, American Economic Association,
vol. 9(2), pages 169-189, Spring.
Recap
• Which firms survive trade integration?
– Increased competition from trade integration tends to hurt
the worst-performing firms — they are forced to exit.
– The best-performing firms take the greatest advantage of
new sales opportunities and expand the most.
– Industry production becomes concentrated in the best
firms  the industry is now more productive
Recap
• Export decisions:
– The most profitable firms export
– The least profitable only sell at Home
Recap
• FDI
– Can be vertical or horizontal
– Driven by high trade costs or costs differences between countries
And that’s all you need to know for the 8 Dec test!