Open Economy Macroeconomics: Global Value Chains & The Firms

Learning Objectives

• Understand how internal economies of scale and product differentiation lead to international trade and intra-industry trade.
• Recognize 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 the enforcement of antidumping laws leads to protectionism.
• Understand foreign direct investment and global value chains.

Market Structures & Intra-Industry Trade

Internal Economies of Scale

• Internal economies of scale result when large firms have a cost advantage over small firms, causing the industry to become uncompetitive.
• Internal economies of scale imply that a firm’s average cost of production decreases the more output it produces.

Perfect competition

• Perfect competition that drives the price (P) of a good down to marginal cost (MC) would imply losses for those firms because they would not be able to recover the higher costs incurred from producing initial units of output.
• As a result, perfect competition would force those firms out of the market.
• In most sectors, goods are differentiated from each other, and there are other differences across firms.

Monopoly

• Monopoly is an industry with only one firm.
• Oligopoly is an industry with only a few firms.
• In these industries, the marginal revenue (MR) generated from selling more products is less than the uniform price (P) charged for each product.
• To sell more, a firm must lower the price of all units, not just the additional ones.
• Marginal revenue (MR) function therefore lies below the demand function (which determines the price (P) that customers are willing to pay).
• Assume that firm’s demand curve is a straight line (linear): Q = A – B(P)
  • Q: number of units the firm sells, P: price per unit, and A and B are constants.
• Marginal revenue (MR) equals: MR = P - \frac{Q}{B}
• Suppose the total cost (C) function: C = F + c(Q)
  • F is fixed costs (independent of the level of output) and c is the constant marginal cost (MC).
• Average cost (AC) is the total cost of production (C) divided by the total quantity of production (Q).
  AC = \frac{C}{Q} = \frac{F}{Q} + c
• Marginal cost (MC) is the cost of producing an additional unit of output.
• Larger firm is more efficient because AC decreases as output (Q) increases: internal economies of scale.

Average versus Marginal Cost

• Figure illustrates average cost (AC) and marginal cost (MC) corresponding to total cost function: C = 5 + x. Marginal cost is always 1. Average cost declines as output rises.
• Profit-maximizing output occurs where Marginal Revenue (MR) equals Marginal Cost (MC).
  MR = MC
• So, revenue gained from selling an extra unit equals the cost of producing that unit.
• Monopolist earns some monopoly profits when P > AC.

Monopolistic Competition

• Monopolistic competition is a model of an imperfectly competitive industry that assumes that each firm:
  • (1) can differentiate its product from the product of competitors, and
  • (2) takes the prices charged by its rivals as given.
• In 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.
• Firm in a monopolistically competitive industry is expected to sell
  • (a) more as total sales in the industry increase and as prices charged by rivals increase.
  • (b) less as the number of firms in the industry decreases and as the firm’s price increases.
• These concepts are represented by function: Q = S[\frac{1}{n} - b(P - \bar{P})]
  • Q: individual firm’s sales
  • S: total sales of the industry
  • n: number of firms in the industry
  • b: constant term representing the responsiveness of a firm’s sales to its price. It measures the sensitivity of each firm's market share to the price it charges.
  • P: price charged by the firm itself
  • \bar{P}: average price charged by its competitors
  • All firms have equal (constant) share of the market.

Q = S[\frac{1}{n} - bP + b\bar{P}]
Q = \frac{S}{n} - bP + b\bar{P}
Q = (\frac{S}{n} + b\bar{P}) - bP

• Eqn (7) is in the same form as Eqn (1), with (\frac{S}{n} + b\bar{P}) in place of A, and b in place of the slope coefficient B.
• 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.
  Q = \frac{S}{n}
• By substituting the value of Q from equation (8) into Eqn (4), AC can be written as:
  AC = \frac{C}{Q} = \frac{F}{Q} + c = \frac{nF}{S} + c
• So, AC depends on size/sale (S) of the market and number (n) of firms.
  AC = (\frac{n}{S})F + c
• As the number of firms (n) in the industry increases, the AC increases for each firm because each produces less.
• As total sales (S) of industry increase, the AC decreases for each firm because each produces more.
• Recall from Eqn (1), monopolistic firms face linear demand functions: Q = A – B(P)
• Also recall from Eqn (5) that firms maximize profits when they produce until MR = MC. So, we have:
  MR = P - \frac{Q}{B} = c
• By substituting the value of B = \frac{S}{n} into Eqn (11), we have:
  P - \frac{Q}{\frac{S}{n}} = c
• Eqn (8) can be solved to get \frac{S}{Q} = n. So, Eqn (12) becomes:
  P - \frac{Q}{\frac{S}{n}} = c
  P = c + \frac{Q}{ \frac{S}{n}}
  P = c + \frac{Qn}{S}
  P = c + \frac{1}{b n}
• As number of firms (n) increases (↑) in the industry, the price (P) that each firm charges decreases (↓) due to increased competition.
• Each firm’s markup [P - c] over marginal cost (c) decreases (↓) with the increase (↑) in number (n) of competing firms.
  P - c = \frac{1}{bn}
• Equilibrium number of firms: At some number of firms, the price that firms charge (which decreases in n) matches the average cost that firms pay (which increases in n).
• At this long-run equilibrium number of firms in the industry, the firms have no incentive to enter or exit the industry.
• If the number of firms is greater than or less than the equilibrium number, then the firms have an incentive to exit or enter the industry.
• Firms have an incentive to exit industry when P < AC.
• Firms have an incentive to enter industry when P > AC.

Monopolistic Competition & Trade

• Because trade increases market size (S), trade is predicted to decrease average cost in an industry described by monopolistic competition.
• Industry sales increase with trade leading to decreased average costs [See Eqn (9)]:
  AC = (\frac{n}{S})F + 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.

Gains of Integration

• Integration causes the better-performing firms to thrive and expand, while the worse-performing firms to contract.
• Additional source of gain from trade: As production is concentrated toward better-performing firms, the overall efficiency of the industry improves.
• These better-performing firms have a greater incentive to engage in the global economy.
• Monopolistic competition predicts intra-industry trade but does not predict changes in income distribution within a country.

Gains from an Integrated Market: A Numerical Example

• Suppose b = 1/30,000, fixed cost F = $750,000,000 and a marginal cost c = $5,000 per automobile. Total cost (C) is:
  C = 750,000,000 + (5,000 * Q)
• Therefore, AC is:
  AC = (\frac{750,000,000}{Q}) + 5,000
• Suppose there are two countries, Home and Foreign.
• Home has annual sales of 900,000 automobiles; Foreign has annual sales of 1.6 million.
• Two countries are assumed (for now) to have the same costs of production.
• 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.
• Everyone is better off as a result of the larger market with integration:
  • Consumers have a wider range of choices, and
  • Each firm produces more and is therefore able to offer its product at a lower price.

Hypothetical Example of Gains from Market Integration

Monopolistic Competition & Trade

• 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.

Significance of Intra-Industry Trade

• Intra-industry trade refers to two-way exchanges of similar goods.
• Two new channels for welfare benefits from trade:
  • (1) Benefit from a greater variety at a lower price.
  • (2) Firms consolidate their production and take advantage of economies of scale.
• A smaller country stands to gain more from integration than a larger country.
• About 25%–50% of world trade is intra-industry.
• Most prominent is the trade of manufactured goods among advanced industrial nations, which accounts for the majority of world trade.
• For the U.S., 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.

Firm Responses to Trade

• Increased competition tends to hurt worst-performing firms — they are forced to exit.
• Best-performing firms take the greatest advantage of new sales opportunities and expand the most.
• When better-performing firms expand and worse- performing firms contract or exit, overall industry performance improves.
• Trade and economic integration improve industry performance as much as the discovery of a better technology does.
• Before 1965, tariff protection by Canada & the United States produced a Canadian auto industry that was largely self-sufficient, neither importing nor exporting much.
• Canadian auto industry was about 1/10 the size of the United States and had a labor productivity about 30 percent lower than that of the United States.
• Most Canadian plants produced several different things, requiring the plants to shut down periodically to change over from producing one item to producing another, to hold larger inventories, to use less specialized machinery.

Intra-Industry Trade in Action: North American Auto Pact of 1964 and North American Free Trade Agreement (NAFTA)

• United States & Canada agreed in 1964 to establish free trade in automobiles.
• Both exports and imports increased sharply.
• By the early 1970s, Canadian industry was comparable to the U.S. industry in productivity.
• Later on, this transformation of automotive industry was extended to include Mexico.
• This process continued with the implementation of NAFTA (North American Free Trade Agreement between the United States, Canada, and Mexico).
• For each model of car, there is typically a plant in one of these three countries that sells to the whole North American market.

Protectionism and Dumping

Dumping

• Dumping is the practice of charging a lower price for exported goods than for goods sold domestically.
• Dumping is an example of price discrimination: the practice of charging different customers different prices.
• Price discrimination and dumping may occur only if
  • (a) Imperfect competition exists: firms are able to influence market prices.
  • (b) Markets are segmented so that goods are not easily bought in one market and resold in another.
• Dumping can be a profit-maximizing strategy:
  • Firm with higher marginal cost (MC) 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, and is regarded by most countries as an “unfair” trade practice.
• Dumping may be a profitable strategy when a firm faces little competition in its domestic market and faces heavy competition in foreign markets.

Protectionism & Dumping

• If a dumping by foreign firms causes damage to domestic firm, then the government may impose an “anti -dumping duty” (tax) to protect the domestic 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.”
• 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.
• In the early 1990s, the bulk of anti-dumping complaints were directed at developed countries.
• But since 1995, developing countries have accounted for the majority of anti-dumping complaints.
• Among those countries, China has attracted a particularly large number of complaints.
• Nonmarket economy with substantial export growth, China has been subject to antidumping duties on:
  • TVs, furniture, crepe paper, hand trucks, shrimp, ironing tables, plastic shopping bags, iron pipe fittings, saccharin, solar panels, tires, and cold- rolled steel.
  • These duties are as high as 78% on color TVs, 266% for cold-rolled steel, and 330% on saccharin.

Foreign Direct Investment (FDI) & Global Value Chains (GVCs)

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.
• Foreign Direct Investment (FDI) activity concentrates in sectors with high trade costs.
• 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.
• FDI should benefit the countries involved for reasons similar to why international trade generates gains.
• Multinationals and firms that outsource take advantage of cost differentials that favor moving production (or parts thereof) to particular locations.
• FDI is very similar to the relocation of production that occurred across sectors when opening to trade.
• There are similar welfare consequences for the case of multinationals and outsourcing: Relocating production to take advantage of cost differences leads to overall gains from trade.

Global Value Chains

• International production sharing, a phenomenon where production is broken into activities and tasks carried out in different countries. They can be thought of a large-scale extension of division of labour (Adam Smith).
• Companies used to make things primarily in one country. That has all changed.
• Today, a single finished product often results from manufacturing and assembly in multiple countries, with each step in the process adding value to the end product.
• Full range of activities (design, production, marketing, distribution and support to the final consumer, etc) that are divided among multiple firms and workers across geographic spaces to bring a product from its beginning to its end use and beyond.
• Through GVCs, countries trade more than products; they trade know-how, and make things together.
• GVCs integrate the know-how of lead firms and suppliers of key components along the stages of production and in multiple offshore locations. The international, inter-firm flow of know-how is the key distinguishing feature of GVCs.
• Cross-border production has been made possible by the liberalization of trade and investment, lower transport costs, advances in information and communication technology, and innovations in logistics (e.g. containerization).
• Manifest example of relocation is the offshoring of labour- intensive stages of production from industrialized economies to low-wage, labour-abundant developing countries. Business operations are, however, also reshuffled among industrialized economies.
• Countries can participate in GVCs by engaging in either backward or forward linkages.
• Backward linkages are created when country A uses inputs from country B for domestic production. Firms in country A can source inputs from country B through direct as well as indirect imports.
• Forward linkages are created when country A supplies inputs that are used for production in country B. The goods produced in foreign countries may be final products (for local consumption and investment) or intermediate products which are exported further elsewhere for use as inputs.
• GVCs are important for economic growth:
  • International fragmentation of production, can lead to increased job creation and economic growth.
  • GVCs are a powerful driver of productivity growth, job creation, and increased living standards.
  • Countries that embrace them grow faster, import skills and technology, and boost employment.

Summary

• Internal economies of scale imply that more production at the firm level causes average costs to fall.
• 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.
• Monopolistic competition allows for gains from trade through lower costs and prices, as well as through wider consumer choice.
• Monopolistic competition predicts intra-industry trade, and does not predict changes in income distribution within a country.
• Location of firms under monopolistic competition is unpredictable, but countries with similar relative factors are predicted to engage in intra-industry trade.
• Dumping may be a profitable strategy when a firm faces little competition in its domestic market and faces heavy competition in foreign markets.
• Foreign Direct Investment (FDI) activity concentrates in sectors with high trade costs.
• Global value chains (GVCs) involve International sharing of production.
• GVCs are a powerful driver of productivity growth, job creation, and increased living standards.
• Countries that embrace them grow faster, import skills and technology, and boost employment.

References

• International Economics: Theory and Policy; Global Edition; Krugman, Obstfeld and Melitz; Chapter 8.
• The World Bank, “Global Value Chains”, https://www.worldbank.org/en/topic/global-value-chains
• Adnan Seric and Yee Siong Tong (2019), “What are global value chains and why do they matter?” https://iap.unido.org/articles/what-are-global-value-chains- and-why-do-they- matter#:~:text=Global%20value%20chains%20(GVCs)%20 refer,back%20to%20Adam%20Smith's%20time.