1. Firms in the Global Economy
Pierre-Louis Vézina

2. Firm Responses to Trade
Which firms are the survivors from trade integration?

3. Firm Responses to Trade
We need a theory to explain which firms survive and expand following trade integration…

4. Marc Melitz
Marc J. Melitz, "The Impact of Trade on Intra-Industry Reallocations and Aggregate Industry Productivity," Econometrica, Econometric Society, vol. 71(6), pages , November.

5. Marc Melitz A future Nobel Prize?
Marc J. Melitz, "The Impact of Trade on Intra-Industry Reallocations and Aggregate Industry Productivity," Econometrica, Econometric Society, vol. 71(6), pages , November.

6. 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)

7. Performance Differences Across Firms
Q = S[1/n – b(P – P)]

8. Performance Differences Across Firms
Q = 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)

9. Performance Differences Across Firms

10. Performance Differences Across Firms
A firm can make profits as long as its marginal cost is lower than c*, where marginal cost = price
If a firm has a marginal cost higher than c*, it enters the market but doesn’t survive long
A firm can make profits as long as its marginal cost is lower than c*, where marginal cost = price
If a firm has a marginal cost higher than c*, it is priced out of the market
It enters the market but doesn’t survive long
Firms will enter the market until expected profits are driven to zero

11. Winners and Losers from Economic Integration
Trade integration  S increases, and n increases

12. Winners and Losers from Economic Integration
Trade integration  S increases, and n increases
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’* Qi

13. Winners and Losers from Economic Integration
Trade integration  S increases, and n increases c*
c’* Qi

14. Winners and Losers from Economic Integration
Trade integration  S increases, and n increases c*
c’* Qi
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.

15. 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

16. 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.

17. Trade Costs and Export Decisions

18. 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!

19. 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

20. Trade Costs and Export Decisions
Firms will take 2 decisions:
How much to sell at Home
How much to export to Foreign

21. Export Decisions with Trade Costs
At Home, sales decisions are unaffected by trade costs

22. Export Decisions with Trade Costs
In Foreign, the firms marginal costs are shifted up by t

23. 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

24. 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).

25. 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.
In the US, in a typical manufacturing industry, an exporting firm is on average more than twice as large as a firm that does not export.
Differences between exporters and nonexporters are even larger in many European countries.

26. Trade Costs and Export Decisions

27. Exporter premia

28. 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.

29. Trade Costs and Export Decisions
In Canada

30. 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.

31. 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

32. 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.

33. 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.

34. 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.”

35. 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.

36. Protectionism and Dumping

37. Protectionism and Dumping

38. Protectionism and Dumping

39. Protectionism and Dumping

40. 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.

41. 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.

42. Foreign Direct Investment, 1980-2009
Developed countries have been the biggest recipients of FDI

43. 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.

44. Foreign Direct Investment, 1980-2009
FDI to developing countries accounted for half of worldwide FDI flows in 2009

46. Foreign Direct Investment, 2007-2009
Source: UNCTAD, World Investment Report, 2010.

47. A big reason for its fast economic growth is that China has been a magnet for the world’s investment capital. Over the past two decades, China attracted more foreign direct investment (FDI) than any country save America. So the recent prediction made by the Centre for China and Globalisation, a Beijing think-tank, that this year China’s outbound investments would exceed its inbound ones, is noteworthy (see chart).
This is not—yet—because China is becoming less attractive to multinationals, which are squeezed by local rivals and targeted by overzealous regulators and the state media. Inward investment has topped $100 billion a year in the past five years. Rather, Chinese firms are increasingly venturing abroad. Earlier waves of investors were led by state-owned enterprises in search of resources in Africa and Latin America. Today’s pioneers are often private firms. They seek brands, talent and technology to bring back to the Chinese market.

48. Foreign Direct Investment

49. 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

50. 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.

51. 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.

52. 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

53. 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.

54. 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.

55. The Firm’s Decision Regarding FDI
Multinationals tend to be much larger and more productive than other firms (even exporters) in the same country.

56. The Firm’s Decision Regarding FDI

57. 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.

58. 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.

59. 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:
Transfer of knowledge or technology may be easier and safer within a single organization
Patent or property rights may be weak or nonexistent
Consolidating an input within the firm using it can avoid holdup problems and hassles in writing complete contracts

60. 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.

61. The Firm’s Decision Regarding FDI
Read more:
James R. Markusen, "The Boundaries of Multinational Enterprises and the Theory of International Trade," Journal of Economic Perspectives, American Economic Association, vol. 9(2), pages , Spring.

62. 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

63. Recap Export decisions: The most profitable firms export
The least profitable only sell at Home

64. Recap FDI Can be vertical or horizontal
Driven by high trade costs or costs differences between countries

65. And that’s all you need to know for the 8 Dec test!