firms in the global economy pierre-louis vézina p.vezina@bham.ac.uk

Firms in the Global Economy

Pierre-Louis Vézinap.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 FirmsQ = S[1/n – b(P – P)]

Performance Differences Across FirmsQ = 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 IntegrationTrade integration S increases, and n increases

Winners and Losers from Economic IntegrationTrade integration S increases, and n increases

Qi

Firms which had marginal costs above c’* now have no demand (the cut-off becomes tougher)

Firms which produced more than Qi now face a more “generous” demand

Firms which produced less than Qi face a less “generous” demand

c*

c’*

Winners and Losers from Economic IntegrationTrade integration S increases, and n increases

Qi

c*

c’*

Winners and Losers from Economic IntegrationTrade integration S increases, and n increases

Qi

c*

c’*

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 CostsIn 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.

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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 “anti-

dumping 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.”

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 trade-off 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– Patent or property rights may be weak or nonexistent

2. 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!