Chapter 8: Firms in the Global Economy: Export Decisions, Outsourcing, and Multinational Enterprises

  • Internal economies of scale imply that a firm’s average cost of production decreases the more output it produces
  • Imperfect competition
  • Firms produce goods that are depreciated from one another
  • Performance measures across vary widely across firms
  • Perfectly competitive market is where there are many seller and buyers but none of them represents a large part of the market so they are price takers
  • In imperfect competition firms are aware that they can influence prices of their products and they can sell more only by reducing their piece… price setters
  • When there are only a few major producers of a particular good
  • Each firm produces a differentiated good
  • Monopoly = imperfect competition no competition

Monopoly

  • Has negative sloping demand curve – indicating that firm can sell more units of output only if the price of output falls
  • Marginal revenue (MR) = demand curve = gain from selling an additional good
  • In monopoly to sell one more unit firm must lower price MC is below demand curve
  • Output should be chosen at MR=MC
  • We know MR is less than Price but by how much?
  • Depends on how much output the firm is already selling
  • Depends on slope of demand curve
  • if curve = flat then firm can sell additional unit at a small price cut MR will be close to the price per unit
  • Formula MR = P-Q/B
  • Equation says gap between price and MR depends on initial sales Q and the slope B of the demand curve
  • If Q = higher MR is lower
  • The higher the B the more sales fall for any given increase in price and the closer then MR is to the price of good
  • Average Cost = AC = total cost divided by its output
  • ATC = F/Q + C
  • This average cost = greater than MC and declines with output produced Q meaning ATC declines as output rises
  • Downward slope represents that there are economies of scale
  • The larger the firm’s output the lower its cost per unit
  • Marginal cost = MC = we assume its flat
  • Economies of scale must then come from fixed cost (unrelated to production)
  • This fixed cost pushes the AC above the constant MC
  • The gap between them is constantly decreasing as the fixed cost is spread over an increasing number of output units

Monopolistic Competitions

  • Differentiated products allows firms to remain price setter for their own individual product
  • Demand curve shifts when there is more demand
  • Once competition reaches a certain level, additional entry would no longer be profitable long run equilibrium is achieved

Assumptions of the Monopolistic Market Model

  • Q = S X (1/n – b X (P – P*))
  • we must look for n and P*
  • derive relationship between number of firms and the AC
  • this relationship is upward sloping bcuz more firms = lower output of each firms = higher firm’s cost per unit of output
  • relationship between number of firms and the price each firm charges which must equal P* in equilibrium
  • this relationship is downward sloping bcuz more firms = more competition = lower price they can charge
  • firm’s entry and exit decisions
  • price > AC = entry
  • price < AC = exit
  • in the long run entry and exit processes drives profits SO P* should = AC
  • Since firms charge one price we know that P = P*
  • AC = F/Q + C where Q = S/n
  • More firms in the industry = higher average cost
  • CC curve is the relationship between n and AC

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  • P = C + Q/ (S X B) P = C + 1/ (b X n)
  • The more firms the lower price each firm will charge
  • Known as the downward sloping PP Curve

Monopolistic Competition and Trade

  • Large markets = more sales per firm… CC curve with the larger market = below smaller market curve
  • Increase in S = CC curve flatter so shift to the left
  • Decrease in S = CC curve steeper = shift right but not more than Autarky
  • But PP curve does not shift since the size of market doesn’t effect
  • Integration results in everyone being better off – integration means international trade
  • product differentiation and internal economies of scale lead to trade between similar countries with no comparative advantage differences between them
  • intra-industry trade = two way exchanges of similar goods where a country both imports and exports some products
  • two channels of welfare benefits from trade
  • we observe gains from trade in the form of greater product variety and consolidated production at lower average cost

Significance of Intra-Industry Trade

  • intra-industry trade counts towards 25-50% of world trade
  • measure of 0 = for an industry in which country is only an exporter or only an importer
  • measure of 1 = for an industry in which country’s exports = imports
  • the gains from integration generated by economies of scale were most pronounced for the smaller economy

Multinationals and Outsourcing

  • the controlling (owning) firm is called the multinational parent
  • the firm that is controlled is called the affiliates

Foreign Direct Investment

  • foreign direct investment – when a foreign firms buys more than 10% of a domestic firm or builds a new production facility
  • greenfield FDI Vs. brownfield FDI
  • growth of FDI is very uneven and has many peaks and troughs
  • worldwide flows of FDI have significantly increased since the mid 1900’s
  • the richest OECD countries = beigest recipients of inward FDI
  • FDI outflows are dominated by developed countries mostly by China
  • Fasting growing FDI is from developing countries to developed countries
  • Other than FDI you can measure presence of multinationals in the world economy by economies activities such as sales (benchmark), value added (sales- purchase of intermediate goods) (GDP) and employment
  • Why should a firm choose to operate an affiliate in a foreign location?
  • Depends on activities the affiliate carries out… two main categories
  • Replicates production of parent = HORIZONTAL FDI
  • Horizontal FDI = dominated by flows between developed countries… purpose of this is to locate production near a firm’s large customer base trade and transport costs play an important role
  • Production chain is broken up in parts… some parts done by affiliates = VERTICLE FDI
  • Vertical FDI = mainly driven by cost differences between countries… cost differences come from comparative advantages in countries and labour/capital intensities

Firm’s decision regarding FDI

  • Horizontal FDI → consider increasing returns to scale in production
  • Proximity-concentration trade-off for FDI = it is not cost effective to replicate production too many times and operate facilities that produce too little output to take advantage of those increasing returns
  • FDI activity is concentrated in sectors where trade costs are high (like automobile industry) however when increasing returns to scare are important and plant sizes = large → one observes higher export volumes relative to FDI
  • FDI within industries → multinationals tend to be larger and more productive than non-multinationals in the same country

Horizontal FDI Decision

  • A firm could avoid trade costs by building production facility in foreign
  • That would lead to incurring a fixed cost F for the affiliate
  • The fixed cost doesn’t have to equal the fixed cost of building a firm’s original production facility at home
  • BUT LET’S ASSUME home and foreign = same marginal cost to build one unit of good
  • There is a CHOICE between EXPORT and FDI
  • There will be a trade-off between per unit cost T and fixed cost F
  • If firm sells Q units
  • Then total trade related cost = Q X T to export
  • That cost ^ is compared to F
  • If Q X T > F then exporting is more expensive CHOOSE FDI (profit maximizing)
  • This leads to a scale cut-off for FDI higher trade costs and lower fixed production costs both lower the FDI cut-off
  • A firm’s scale depends on its performance measure

Conclusions of this method – most effective way to reach foreign customers

  • Firm with low enough cost wants to sell more Q units to foreign consumers … do this by building affiliate in foreign and become a multinational
  • Firm with intermediate cost levels still want to serve foreign customers their intended Q are low enough that exports rather than FDI will be better

Vertical FDI

break up production chain

  • Remember that cost differences steams mostly from comparative advantage forces
  • Requires a substantial fixed cost investment in a foreign affiliate in a country with appropriate characteristics
  • Scale cut-off depends on the production cost differentials and fixed cost of operating a foreign affiliate
  • Only those firms operating at a scale above that cut-offf will chose to perform vertical FDI

Outsourcing

  • Internalization motive = reasons why the parent firm chooses to own the foreign affiliate and operate as a single multinational firm rather than engage in transactions with independent firms
  • Substitute for horizontal FDI = parent could license an independent firm to produce and sell its products in a foreign location
  • Substitute for vertical FDI = parent could contract with an independent firm to perform specific parts of the production process in a foreign location with the best cost advantage AKA foreign outsourcing
  • Offshoring = relocation of parts of production process chain abroad and groups together both foreign outsourcing and vertical FDI
  • When intermediate goods are produced within a multinational’s affiliate network, the shipments of those goods are classified as intra-firm trade
  • What key elements determine this make or buy internalization choice?
  • Firms proprietary technology = clear advantage
  • Horizontal FDI has substantial risk of the loss of proprietary technology
  • There are no clear reasons why an independent firm should be able to replicate that production process at a lower cost than the parents
  • This gives internalization a strong advantage… so horizontal FDI is favoured over the alternative of technology licencing to replicate the production process
  • Vertical FDI is much less clear cut
  • Independent firm can specialize in exactly that narrow part of the production process
  • Can benefit from economies of scale if it performs those process for many different parent’s firms
  • Internalization decreases the potential for a costly renegotiation conflict after an initial agreement has been reached
  • Both vertical FDI and foreign outsourcing involve lower production costs combined with a higher fixed cost … implied a scale cut-off for a firm to choose either offshoring option
  • Larger firm will choose offshoring option and import some of their intermediate inputs
  • The firms that offshore and import intermediate goods are the same set of firms that also export


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