Firms in the Global Economy: Export Decisions, Outsourcing, and Multinational Enterprises

Firms in the Global Economy: Export Decisions, Outsourcing, and Multinational Enterprises

• Economies of scale that are internal to the firm generate incentives for international specialization and trade.
• Internal economies of scale imply that a firm’s average cost of production decreases the more output it produces.

Imperfect Competition and Firm Behavior

• Modeling imperfect competition involves considering the behavior of individual firms.
• Two characteristics of firms in the real world:
  • Firms produce differentiated goods.
  • Performance measures vary widely across firms.
• Economic integration can lead to both winners and losers among firms.
• Better-performing firms thrive and expand, while worse-performing firms contract.
• Better-performing firms have a greater incentive to engage in the global economy through exporting, outsourcing, or becoming multinationals.

Learning Goals

• Understand how internal economies of scale and product differentiation lead to international trade and intra-industry trade.
• Recognize the new types of welfare gains from intra-industry trade.
• Describe how economic integration can lead to both winners and losers among firms in the same industry.
• Explain why economists believe that “dumping” should not be singled out as an unfair trade practice and why antidumping laws lead to protectionism.
• Explain why firms engaging in the global economy are substantially larger and perform better than firms that do not interact with foreign markets.
• Understand theories explaining the existence of multinationals and the motivation for foreign direct investment across economies.

The Theory of Imperfect Competition

• In a perfectly competitive market, firms are price takers.
• In imperfect competition, firms can influence the prices of their products.
• This occurs when there are few major producers or when firms produce differentiated goods.
• Economies of scale at the firm level lead to imperfect competition.
• Firms become price setters rather than price takers.

Monopoly: A Brief Review

• A monopolistic firm faces a downward-sloping demand curve (D).
• Marginal revenue (MR) is the extra revenue from selling an additional unit.
• For a monopolist, MR is always less than the price because selling an additional unit requires lowering the price of all units.
• The marginal revenue curve lies below the demand curve.

Marginal Revenue and Price

• The relationship between price and marginal revenue depends on:
  • How much output the firm is already selling.
  • The slope of the demand curve.
• If the demand curve is a straight line, the relationship between total sales and price is: Q = A - B * P , where:
  • Q is the number of units the firm sells.
  • P is the price per unit.
  • A and B are constants.
• Marginal revenue in this case is: MR = P - Q/B , implying P - MR = Q/B.
• The gap between price and marginal revenue depends on the initial sales Q and the demand curve slope parameter B.

Average and Marginal Costs

• Average cost (AC) is the firm’s total cost divided by its output.
• The downward slope of AC reflects economies of scale.
• Marginal cost (MC) is the cost of producing one extra unit.
• Total cost (C) can be written as: C = F + c * Q , where:
  • F is the fixed cost.
  • c is the marginal cost.
  • Q is the firm’s output.
• Average cost is: AC = C/Q = (F/Q) + c.
• Average cost is always greater than marginal cost and declines with output.
• The profit-maximizing output is where marginal revenue equals marginal cost.
• Monopoly profits occur when P > AC.

Monopolistic Competition

• Monopoly profits attract competitors, making pure monopoly rare.
• Competitors sell differentiated products, allowing firms to remain price setters for their brand.
• More competition implies lower sales and profits for each firm.
• New competitors enter as long as entry is profitable until long-run equilibrium is attained.
• Oligopoly occurs when a few firms have enough market share to influence market aggregates.
• Pricing decisions are interdependent in an oligopoly.
• Monopolistic competition arises when the equilibrium number of firms is large and no firm has substantial market share.
• Each firm sets its price, knowing that the response of any other firm would be inconsequential.

Assumptions of the Model

• Demand facing a typical firm is: Q = S * [1/n - b * (P - \bar{P})], where:
  • Q is the quantity of output demanded.
  • S is the total output of the industry.
  • n is the number of firms in the industry.
  • b is a positive constant.
  • P is the price charged by the firm.
  • \bar{P} is the average price charged by competitors.
• Total industry output S is unaffected by the average price \bar{P}.
• Total and average costs are described by C = F + c * Q and AC = (F/Q) + c.
• All firms are symmetric.

Market Equilibrium

• The industry state is described by the number of firms n and the average price they charge \bar{P}.
• Three steps to determine n and \bar{P}:
  • Derive the relationship between the number of firms and the average cost of a typical firm (upward sloping).
  • Show the relationship between the number of firms and the price each firm charges (downward sloping).
  • Introduce firm entry and exit decisions based on profits (entry/exit drive profits to zero in the long run).

1. The Number of Firms and Average Cost:

• Average cost depends on the number of firms in the industry: AC = F/Q + c = (n * F/S) + c.
• The more firms there are, the higher the average cost because each firm produces less.

2. The Number of Firms and the Price:

• The more firms there are, the more intense the competition, and the lower the price.
  Q = [(S/n) + S * b * \bar{P}] - S * b * P
  Marginal revenue is MR = P - Q/(S * b).
  Profit-maximizing firms set marginal revenue equal to marginal cost: P = c + Q/(S * b).
  So, P = c + 1/(b * n); the more firms there are, the lower the price.

3. The Equilibrium Number of Firms:

• The intersection of the downward-sloping price curve (PP) and the upward-sloping average cost curve (CC) determines the equilibrium number of firms.
• When price equals average cost, profits are zero, establishing long-run equilibrium.

Monopolistic Competition and Trade

• Trade increases market size.
• Nations can specialize in a narrower range of products and increase the variety of goods available to consumers.

The Effects of Increased Market Size

• Larger markets lead to more firms and more sales per firm.
• Consumers in large markets are offered lower prices and greater variety.
• An increase in total industry output S reduces average costs: AC = F/Q + c = n * F/S + c.
• The price curve (PP) does not shift with changes in market size: P = c + 1/(b * n).

Gains from an Integrated Market: A Numerical Example

• Illustrates the effects of trade on prices, scale, and the variety of goods available with a specific numerical example for automobiles.
  The parameter values:
  Q = S * [(1/n) - (1/30,000) * (P - \bar{P})]
  C = 750,000,000 + (5,000 * Q)
  AC = (750,000,000/Q) + 5,000

Hypothetical Example of Gains from Market Integration

• The integrated market supports more firms, each producing at a larger scale and selling at a lower price.
• Trade leads to intra-industry trade: two-way exchanges of similar goods.
• Consumers benefit from a greater variety of models at a lower price.

The Significance of Intra-Industry Trade

• Intra-industry trade has steadily grown over the last half-century.
• Accounts for one-quarter to nearly one-half of all world trade flows.
• Plays a more prominent role in the trade of manufactured goods among advanced industrial nations.

Measuring Intra-Industry Trade

• The standard formula for calculating the importance of intra-industry trade within a given industry is
  I = \frac{min {exports, imports}}{(exports + imports)/2}, where:

  • min {exports, imports} refers to the smallest value between exports and imports.
  • If I=0 meaning trade flows in only one direction with no intra-industry trade.
  • If I=1 meaning a country’s exports and imports within an industry are equal, so 100% is intraindustry. trade

• Indexes of Intra-Industry Trade in the U.S., 2009 indicates that Intra-industry trade is an important component of trade for the United States in many different industries.

• Industries tend to be ones that produce sophisticated manufactured goods, such as chemicals, pharmaceuticals, and specialized machinery.

Measuring product variety

• A study estimates that the number of available products in U.S. imports tripled in the 30-year time span from 1972 to 2001.
• Increased product variety represents a welfare gain equal to 2.6% of U.S. GDP.

Automobile Intra-Industry Trade within ASEAN-4: 1998–2002

• ASEAN-4—Indonesia, Malaysia, the Philippines, and Thailand—experienced significant growth in the automobile industry due to deregulation and liberalization measures.
• Thailand assumed a leading role as an export hub, while other countries concentrated on automobile parts production.
• European countries were the main destination for automotive exports.
• Intra-industry trade in auto parts was seen to be on the rise in all the regions around the world. In 2001, intra-ASEAN-4 exports in automobile parts accounted for about 14 percent of total exports
• Automobile intra-industry trade reflects the standard dichotomy between quality differentiation (vertical differentiation) and attribute differentiation (horizontal differentiation).
• The rapid rise in vertical differentiation took place at the expense of one-way trade.
• Economies of scale explain a good part of intra-industry trade in automobiles and automobile components for the ASEAN-4 countries.
  *Deeper economic integration was not a determinant of intra-industry growth as market and industry size characteristics (economies of scale) were the major determinants of automobile intra-industry growth during the 1998–2002 period.

Firm Responses to Trade: Winners, Losers, and Industry Performance

• Economic integration leads to increased competition between firms.
• Better-performing firms expand, while worse-performing firms contract or exit.
• This improves overall industry performance.

Productivity Gains due to increased trade

• Canada’s trade agreement with the U.S. led to consolidation and efficiency gains in Canadian manufacturing sectors.
• Productivity in the most affected Canadian industries rose dramatically.
• The contraction and exit of the worst-performing firms accounted for half of the productivity increase.

Performance Differences across Producers

• Firms have different cost curves due to different marginal cost levels.
• Firms face the same demand curve.
  Relative performance when there are a variance is marginal cost:
  Compared to a firm with a higher marginal cost, 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.

Increased competition is summarized in the equation

Q = S * [1/n - b * (P - \bar{P})]

• The vertical intercept of this demand curve is P + [1/(b * n)], while its slope is 1/(S * b).
• Increased competition (a higher number of firms n) holding market size S constant lowers the vertical intercept for demand, leaving its slope unchanged: This is the induced inward shift from more competition.
• The direct effect of increased market size S flattens the demand curve (lower slope), leaving the intercept unchanged: This generates an outward rotation of demand.

The Effects of Increased Market Size

• The demand curve moves from D to D’ due to increased size and increased trade.
• With market integration, high cost firms are not longer able to compete and forced to exit.
• Low cost firms thrive with integration by lowering cost and increasing market share.
• Overall productivity in the industry increases as higher cost firm’s exit the market in concentrated among the more productive(lower cost) firms.
• Big economies, such as the U.S., leads to important composition effects and productivity gains through increased integration via lower trade costs.

Trade Costs and Export Decisions

• These border costs drastically cut down the number of firms willing or able, to reach customers across the boarder.

Export Stats for the US

• In 2007, only 4% of the 5.5 million firms operating in the United States reported any export sales.
• 35% of manufacturing firms export.
  *This highlights one major reason why trade costs associated with national borders reduce trade so much: Those costs drastically cut down the number of firms willing or able to reach customers across the border.
  This reduces the export sales of firms that do reach those customers across the border.

Trade cost Impact with Domestic V Foreign Market

To analyze trade cost impacts, we consider the response of firms in a world with two identical countries (Home and Foreign) with the following assumptions.
Q = S * [1/n - b * (P - \bar{P})]
C = 750,000,000 + (5,000 * Q)
AC = (750,000,000/Q) + 5,000
The impact is a cost for each unit sold to customers across the boarder, Trade cost t. t has the following impacts

• Firms will set different prices in their export market relative to their domestic market
• Leads to different quantities sold in each market and ultimately to different profit levels earned in each market.

Trade Costs Impact

• Reduces profitability of exporting for all firms, and makes exporting unprofitable for some.
• The lowest-cost firms with ci ≤ c* - t export
• The higher-cost firms with c* - t < ci ≤ c* still produce for their domestic market but do not export, *The highest cost firms with ci > c*cannot profitably operate in either market and thus exit.
  Empirical analyses of firms’ export decisions from numerous countries have provided overwhelming support for this prediction that exporting firms are bigger and more productive than firms in the same industry that do not export.
  *Exporters are larger and more productive
  *In the U.S, exporting firms are 2x on average, as large as firms that do not export.
  *The exporting firm produces 11% more value. (output minues intermediate inputs) per worker, than the average non-exporting firm.

Dumping

• Markets are no longer perfectly integrated and firms can charge different proces in different markets.
• Lower market share leads to firms to reduce Markups for export sales.
• The higher marginal cost leads export to lower the markup. PX - (c+t) on the export market has to be lower than it’s Markup PD - con the domestic market, therefore
  PX - t < PD set an export price lower than it’s domestic market.
• Is typically filed as ”unfair” trade practice.
  *Many economists believe that the enforcement of dumping claims is misguided, and that there is no good economic justification for dumping to be considered particularly harmful
  *antidumping laws can then be used to erect barriers to trade by discriminating against exporters in a market.

Antidumping as Protectionism

*Economists have never been very happy with the idea of singling out dumping as a prohibited practice.
*Setting different prices for different can be a legitimate business strategy.
Dynamic considerations include normal business practice and firms can chose to sell a product for a loss while they are lowering their costs, and breaking into a new market.
*dumping falls under the jurisdiction of the European Commission and the Directorate General Trade and various Committees. In India, dumping falls under the purview of the Customs and Tariffs Acts and the Anti-Dumping Rules.
*formal complaints about dumping have been filed with growing frequency since about 1970 most of the complaints are directed at developed countries.
China has attracted particularly large number of complaints due large massive export growth and pricing practices.

Multinationals and Outsourcing

• In U.S. statistics, a U.S. company is considered foreign-controlled if 10% or more of its stock is held by a foreign company.
• A U.S.-based company is considered multinational if it owns more than 10% of a foreign firm.
• The controlling (owning) firm is called the multinational parent, while the “controlled” firms are called the multinational affiliates.
• When a U.S. firm buys more than 10% of a foreign firm, or when a U.S. firm builds a new production facility abroad, that investment is considered a U.S. outflow of foreign direct investment (FDI).
  *The latter is called greenfield FDI, while the former is called brownfield FDI or mergers and acquisitions.
  Investments by foreign firms in production facilities in the United States are considered U.S. FDI inflows.
• Worldwide FDI flows more than quintupled in the mid- to late-1990s.
  Looking at the distribution of FDI inflows across groups of countries, the richest OECD countries have been the biggest recipients of inward FDI however, there has been steady expansion in the share of FDI that flows to those countries outside the OECD accounting for roughy half of worldwide FDI Flows since 2009 and the BRICS countries have accounted for a increase.

Measuring FDI

• FDI outflows are still dominated by developed economies, developing countries, most notably China are playing an increasingly vital role.
  British Virgin Islands would not figure in that top 25 list were it not for its status as an international tax haven. FDI flows are not the only way to measure presence of multinationals in the world economy.
  *The types of activities associated with multinational firms can be broken down into two main categories.(1) The affiliate replicates the production process elsewhere in the world; and (2) The production chain is broken up, and parts of the production processes are transferred to the affiliate location.
  Horizontal FDI investing in affiliates that replicate the production process while Vertical FDI involves investing in the affiliate that does the production chain.
  *Vertical FDI is mainly driven by production cost differences between countries the theory of comparative advantage
  Intel (the world’s largest computer chip manufacturer) has broken up the production of chips into wafer fabrication, assembly, and testing, Wafer fabrication and the associated research and development are very skill-intensive, Intel performs most of activities in the United States as well as in Ireland and Israel on the other hand, chip assembly and testing are labor-intensive Intel has moved those production processes to countries where labor is relatively abundant, such as Malaysia, the Philippines, Costa Rica, and China.

*Horizontal FDI, is dominated by Flows Between developed countries due to locating production near the firms customers.. Trade and transport costs play much more important than production cost differences
Toyota, Toyota replicates production process throughout The world, specifically for the Corolla model is in 15 contries including assembly plants in Brazil, Canada, China, India, Japan, Canada and the U.S.
Trade barrier’s and cost lead them to replicate models in different countries

Factors When a Firm Chooses Foreign Direct Investment

*Trade costs with exporting incentivizes a firm to location production near to the customers.
*There are also increasing returns to scale in production this is called the proximity-concentration trade-off for FDI.
*Empirical evidence shows to that Multinationals are substantially larger and tend to be be more productive than firms
Vertical FDI decisions will also involve a trade off for per-unit and fixed costs firms will use The scale of the firms activity level to determine this decision this stems from comparing cost differentials/comparative advantage VS fixed cost for the foreign operations.

Outsourcing

*A parent could license an independent firm to produce and sell it’s product in a foreign location or a parent could contract with an independent firm (supplier) to perform specific parts of the production process in a foreing location with the best cost advantage known as foreign outsourcing
*Offshoring is relocation of parts of the production chain abroad both aspects are included as a group.
*Trade in intermediate goods accounted for 40 percent of worldwide trade in 2008
Intra-firm: ⅓ of worldwide trade and 40% of US Trade.

Choice Trade-off Decision

*Control over propriety Technology- Often licensing another firm poses a substantial risk to loosing a propriety technology it is typically internalized as a strategic decision.
A cost analysis between outsourcing vs vertical FDI for the best trade-off decisions
Internalization also provides own benefits when it comes to vertical integration between a firm and it’s supplier of a critical input to production, that avoids (or at Least lessens) The potential Costly renegotiation conflict. After initial agreement has Reached, such conflicts can arise regarding many specific attributes of the input that cannot be specified(or enforced By) a Legal contract Written AT Time of the initial agreement. This can Lead Hold up of production Either party , For EX a Buying firm can claim that quality of PT Does not meet standard and demand a smaller price to offset.
*Ultimately, many of those theories boil down to different tradeoffs between production cost savings and fixed Cost of Moving parts of Production process abroad, the larger firms will have will to choose Offshoring.

Shipping Jobs Overseas? Offshoring and Labor Market Outcomes in Germany

*The study results show that overall the economy-wide labor market of offshoring's is neutral. From the study in Germany, manufacturing medium-skilled workers seem to be the most prone to be pushed to the world if nonparticipation as a result of offshoring In a service sector those workers who benefit most from these effects are the high-skiled.
*The studies show there is a mix of positive and neutral affects and an overall boost to economy.
*The idea the shipping jobs is too simple of a view.
While it will replace some specific jobs for a portion of the job market there is often an equal amount of creation.
This comes from new jobs being created due to the business expansion/growth.

Consequences of Multinationals and Foreign Outsourcing

*Multinationals take advantage of cost locations, and that can lead to overall gains from trade.
This creates a redistribution effect what some companies are doing well others can be impacted negatively.
One visible effect is in the short run is when some firms Expand , Which can impact other who will lose people for the increased globalization , displaced workers are still severe for the characteristic workers.
These are both costly in short run (lower skills and lack of alternative jobs)
The best policy response is to provide a safety net to unemployed workers and policies that impact the ability to relocate

Summary Points

1 increasing returns or economies of scale, that is, from a tendency of unit costs to be lower with larger output., can lead countries to specialize and trade even in the absence of differences between countries in their resources or technology.
2 Internal scale economies internal to firms lead to a breakdown of perfect competition, or imperfect competition model.
3 monopolistic competition model, Equilibrium is impacted by Market size , A Large Market will support a number of firms .
4 International trade Allows the consumer to access greater , Lower value

5. When the firms Differ interms , Economic integration generate losers and Winners
   The high cost will contract and the Less of the productive firms will be forced to the market.
   ,Only a subset of more productive for markets. These prices reflect trade costs as well as the level of competition perceived by the firm. . The remaining firms Will serve only what .
   6 Dumping When the firmness lower the price
   In Export market that if firms have , The higher marketShares can be used to descriminate. and erect markets.
6. Some multinationals , Replicate processes With foreign based Near larger customer .
   Can be used has a horizontal FDI . Only a scale A larger enough . The smaller the. The scale will be a . Options over exports and FDI
7. Some multinationals , can Perform parts if 8.that chain in their foreign facilities the cost savings or more specifically This often depends Vertical . If . Only if The from operations
8. multinational and firms that outsource parts of production to foreign countries what with is similar the cost there are determine at differences in determine by there so and that also it the level what there differences for more for and in as The or and by the well: is production that to to or by