The role of the firm Chapter 4

Trade and Imperfect Competition Intra-industry trade Relevance to international business –MNEs and assumption of imperfect competition –The concept of competitive advantage Grubel-Lloyd index (Box 4.1)

Beugelsdijk, Brakman, Garretsen, and van Marrewijk International Economics and Business © Cambridge University Press, 2013Chapter 4 – Modern trade theory: the role of the firm

Figure 4.1 Intra-industry trade: Grubel-Lloyd index for different income groups Source: based on data from Bruehlhart (2009); countries are classified according to the World Bank’s income groups; index per country is 5-digit weighted average Grubel-Lloyd index; average per group

Characteristics of intra-industry trade (IIT) 1.Horizontally-differentiated trade or vertically differentiated trade? (problems of aggregation) 2.IIT tends to be high in sophisticated manufactured products. 3.IIT levels are high in more open economies. 4.IIT levels are high where inward FDI levels are high.

Internal increasing returns to scale are the underlying main cause for most international trade models of imperfect competition (Fig. 4.2).

Monopoly Power  Concentration ratios: Sum of the market shares of the top 4, 5 or 8 firms.  Herfindahl index: sum of the squared market shares of all firms in the market.  where s i is the market share of firm i in the market, and N is the number of firms. Thus, in a market with two firms that each has 50 percent market share, the Herfindahl index is = 0.5. A market with 10 firms (with equal shares) will have an index equal to 0.1. (the possible value of the index is between 1/N and 1)

Figure 4.2 Increasing returns to scale and perfect and imperfect competition, demand and costs

The Trading Equilibrium Assumption: The foreign firm assumes the home firm will continue to produce the same quantity as in autarky. The entry of the foreign firm causes the price to fall (increased competition) Consumers in the home and foreign country gain. (Fig. 4.3)

Figure 4.3 A trading equilibrium: monopoly versus duopoly, demand and costs

 Strategic interaction between firms: Airbus and Boeing.  Imperfect competition in international business: Fuji versus Kodak (Box 4.3)

Figure 4.4 Intra-industry trade as a result of transportation costs

Monopolistic competition Three assumptions (for Fig. 4.6) 1.Number of sellers is sufficiently large so that firms take the price as given. 2.Products are heterogeneous. 3.Free entry and exit of firms.

Figure 4.5 The varieties approach of monopolistic competition

Figure 4.6 Monopolistic competition, demand and costs

 Sequence of events (Fig. 4.7) 1.Increased competition leads to higher demand elasticity. 2.Price falls and the firm has a loss. 3.The loss drives some firms out of the market so demand increases for the remaining firms until zero profits are reached. 4.In the trade equilibrium, the remaining firms produce a larger quantity and lower average cost (internal economies of scale). 5.In the trade equilibrium, consumers benefit from lower prices and larger range of varieties. 6.In the trade equilibrium, the two countries engage in IIT. Trade with monopolistic competition

Figure 4.7 Monopolistic competition and foreign trade pressure, demand and costs

What does the monopolistic competition model add? 1.Another explanation of IIT (with non-identical products – close substitutes ). 2.The number of suppliers is large but limited. 3.The model implies that after trade opens consumers will also buy varieties from foreign suppliers (leading to IIT) 4.More competition causes the demand curve for individual firms to become more elastic and shift downward. Each firm will produce more and charge a lower price.

IIT: Empirical Evidence IIT between two countries will be high if:  per-capita incomes are high  differences in levels of development are low  the average of the countries’ GDP is high  barriers to trade are low  the two countries share a common language or border.  if the countries are part of a preferential trade agreement (PTA)  the level of product differentiation within sectors is high  transaction costs are low  trade barriers for the industry are low  scale economies are present.

Beugelsdijk, Brakman, Garretsen, and van Marrewijk International Economics and Business © Cambridge University Press, 2013Chapter 4 – Modern trade theory: the role of the firm

Beugelsdijk, Brakman, Garretsen, and van Marrewijk International Economics and Business © Cambridge University Press, 2013Chapter 4 – Modern trade theory: the role of the firm

Figure 4.8 Export orientation of US manufacturing firms, 2002 Source: van Marrewijk (2012), based on Bernard et al. (2007, Table 2).

Figure 4.9 Distribution by number of products and export destinations; USA, 2000 Source: van Marrewijk (2012), based on data from Bernard et al. (2007, Table 4).

Figure 4.10 Simultaneous exporting and importing; US manufacturing, 1997 Source: van Marrewijk (2012, based on data from Bernard et al. (2007, Table 7).

q3q3 profit demand mr c1c1 c2c2 c3c3 p1p1 p2p2 q2q2 q1q1 quantity price, mc, mr mc p3p3 (p 3 -c 3 )q 3 (p 2 -c 2 )q 2 (p 1 -c 1 )q 1 (p 2 -c 2 )q 2 E1E1 E2E2 E3E3 Figure 4.11 Firm heterogeneity, prices, and profits

profit demand before trade quantity pricemc firms exit firms make lower profits firms make higher profits demand after trade c3c3 c4c4 c5c5 profit before trade profit after trade Figure 4.12 Firm heterogeneity and trade

Figure 4.13 Productivity and firm type in Latin America, 2006 Source: Chang and van Marrewijk (2013).

Beugelsdijk, Brakman, Garretsen, and van Marrewijk International Economics and Business © Cambridge University Press, 2013Chapter 4 – Modern trade theory: the role of the firm