International Economics ECON 390
Lotta Moberg
Lecture notes - 8 September 26-29: Firms in the Global Economy, and
Internal Economies of Scale
1. We want to understand why better-performing firms have a greater incentive
to engage in the global economy.
Imperfect Competition
2. Firms can influence the prices of their products.
3. There are either only a few major producers of a particular good, or each firm
produces a good that is differentiated from that of rival firms.
4. Remember:
 A monopoly is an industry with only one firm.
 An oligopoly is an industry with only a few firms.
Internal economies of scale
5. Adam Smith on the pin factory
 A group of men working together can make many more pins than when
working alone
 They improve their “dexterity”
 They save time by not switching tasks
 They find technical improvements for their individual tasks
6. Smith on how economic specialization is limited by the extent of the market
 Division of labor happens when one can trade with places far away
 Civilization has therefore often appeared near waters
Monopolistic Pricing and Production Decisions
7. Average cost: AC = C/Q = F/Q + c
8. Profit-maximizing output occurs where marginal revenue equals marginal cost.
(Check that you can illustrate the monopoly profits, average and marginal cost)
International Economics ECON 390
Lotta Moberg
Monopolistic Competition
9. Imperfectly competitive industry where each firm:
 can differentiate its product from the product of competitors, and
 takes the prices charged by its rivals as given.
10. A firm in a monopolistically competitive industry sells…
 more as total sales in the industry increase and as prices charged by rivals
increase.
 less as the number of firms in the industry decreases and as the firm’s price
increases.
11. Monopolistic Competition Output
12. Q = S[1/n – b(P – P)]
 Q is an individual firm’s sales
 S is the total sales of 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
 P is the price charged by the firm itself
 P is the average price charged by its competitors
13. If all firms face the same demand function and have the same cost function:
 All firms charge the same price and have equal share of the market 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 F/S + c
 As the number of firms n in the industry increases, the average cost
increases for each firm because each produces less.
 As total sales S of the industry increase, the average cost decreases for each
firm because each produces more.
14. Demand function: Q = A – B(P),
 for each firm: Q = S[1/n – b(P – P)]
15. Firms produce until marginal revenue equals marginal cost.
International Economics ECON 390
Lotta Moberg
16. As the number of firms n in the industry increases, the price that each firm
charges decreases because of increased competition.
17. At some number of firms, the price that firms charge matches the average cost
that firms pay.
 At this long-run equilibrium number of firms in the industry, firms have no
incentive to enter or exit the industry.
Monopolistic Competition and Trade
18. Trade increases market size, so decreases average cost in the industry:
AC = n(F/S) + c
19. Trade also increases the welfare of consumers, by increasing the variety of
goods.
 And because average costs decrease, consumers also benefit from a lower
price.
20. Trade increases the number of firms in a new international industry relative to
each national market.
Intra-industry Trade
21. Product differentiation and internal economies of scale lead to trade between
similar countries with no comparative advantage differences between them.
22. Two new channels for welfare benefits from trade: greater variety at a lower
price.
Firm Responses to Trade
23. Increased competition hurts the worst-performing firms, which must exit.
24. The best-performing firms take the greatest advantage of new sales
opportunities and expand.
25. Overall industry performance improves.
Trade Costs and Export Decisions
26. Trade costs add two important predictions to our model of monopolistic
competition and trade:
International Economics ECON 390
Lotta Moberg
 Why only a subset of firms export
 Why exporters are larger and more productive (lower marginal costs).
27. Empirics show that exporting firms are bigger and more productive than firms
in the same industry that do not export. (Learn to illustrate export decisions
with trade costs for high and low MC firms)
Dumping
28. Charging a lower price for exported goods than for goods sold domestically.
29. One form of price discrimination: charging different prices from different
customers.
30. Price discrimination and dumping only occur with:
 imperfect competition: firms are able to influence market prices.
 segmented markets, so that goods are not easily bought in one market and
resold in another.
31. Dumping is rational:
 A firm with a higher marginal cost sets a lower markup over marginal cost.
 Therefore, an exporting firm, facing transportation costs, lowers its markup
for the export market.
 Dumping is regarded by most countries as an “unfair” trade practice.
Multinationals and Outsourcing
32. Foreign direct investment (FDI): A firm directly controls or owns a subsidiary in
another country.
33. 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.
34. Developed countries have so far been the biggest recipients of inward FDI.
Two main types of FDI
35. Horizontal FDI: The affiliate replicates the production process of the company
elsewhere in the world.
 Mainly driven by transportation costs
 Locating production near a firm’s large customer bases
International Economics ECON 390
Lotta Moberg
 Dominated by flows between developed countries
36. Vertical FDI: The production chain is broken up and parts of the production
processes are transferred to the affiliate location.
 Mainly driven by production cost differences between countries
The Proximity-concentration trade-off
37. Lessons from Economic Geography:
 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.
 So, when increasing returns to scale are important and average plant sizes
are large, we observe higher export volumes relative to FDI.
38. Within industries, multinationals tend to be much larger and more productive
than other firms (even exporters) in the same country.
39. 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.
40. If t(Q) > F, FDI is the profit-maximizing choice
 Low costs make more apt to choose FDI due to larger sales.
41. The vertical FDI decision also involves a trade-off between cost savings and the
fixed cost F of setting up an additional production facility.
Foreign outsourcing and offshoring
42. When a firm contracts with an independent firm to produce in the foreign
location.
 Besides decisions about the location of production, firms also face an
internalization decision: whether to keep production done by one firm or by
separate firms.
43. Offshoring is any relocation of parts of the production chain abroad.
 It includes both foreign outsourcing and vertical FDI
International Economics ECON 390
Lotta Moberg
Benefits of Internalization
44. Technology transfers
 Weak or nonexistent patent or property rights.
 Knowledge may not be easily packaged and sold.
45. Vertical integration involves consolidation of different stages of a production
process.
 Avoiding holdup problems and hassles in writing complete contracts.
 On the other hand, an independent supplier benefits from economies of
scale if it performs the process for many parent firms.
Foreign direct investment and out-sourcing benefit the countries involved
46. They are very similar to the relocation of production that occurs across sectors
when opening to trade.
47. Relocating production to take advantage of cost differences leads to overall
gains from trade.
48. Multinationals and firms that outsource take advantage of cost differentials
and can lower costs.