Export Decisions, Outsourcing, and Multinational Enterprises

Question 1

What is the market structure in internal economies of scale?

Answer 1

Imperfect competition

Question 2

What are the assumptions?

Answer 2

Product differentiation

Performance measures do not differ

Question 3

Who are price takers and who are price setters?

Answer 3

• In perfect competition, firms are price takers (External economies of scale)
• In imperfect competition, firms are price setters (Internal economies of scale)

Question 4

Which two market structures can have imperfect competition?

Answer 4

• Oligopoly: There are only a few major producers of a specific good
• Monopoly: Each firm produces a good that is differentiated

Question 5

What are the characteristics of a monopoly?

Answer 5

• A market where the firm faces no competition
• Demand curve: Downward sloping, which means that the firm can sell more by decreasing the price
• Marginal revenue is ALWAYS less than the price, because to sell more the firm must lower its prices of all units. It is also smaller than the demand curve.

Question 6

How much smaller is the MR compared to the Demand?

Answer 6

• It depends on 2 factors:
o 1: The output the firm is already selling  If a firm does not sell much, then it will not lose much by cutting the price
o 2: The gap between the price and marginal revenue depends on the slope of the demand curve. It tells us how much the price must be cut to sell one more unit. –> A flat demand curve indicates a small price cut.

Question 7

How does the demand curve function look like if the demand is a straight line?

Answer 7

Q=A-B·P
Q= Number of units sold
P= Price per unit
A & B=Constants

Question 8

What is the function of the gap between the price and marginal revenue?

Answer 8

P-MR=Q/B
Here it depends on:
Q=Number of units sold
B=The slope parameter of D-curve

Question 9

What is the marginal cost?

Answer 9

• It is the cost of producing an additional unit
• If it is constant (flat), then the economies of scale must come from a fixed cost that is not related to scale of production.

Question 10

Which way is the slope of the AC and why?

Answer 10

•The slope of the average cost is downward sloping, due to the assumption that there are economies of scale, so the larger the firms output, the lower its cost per unit.

Question 11

What is the formula of average cost in a monopoly?

Answer 11

AC=C/Q=F/Q+c

Question 12

What is highest, Marginal costs or Average costs? Show the relationship.

Answer 12

• Average costs are always greater than the marginal costs. It declines with output Q
• The relationship is illustrated in fig. 8.2, where the y-axis has “Cost per unit” and the x-axis has output. The marginal costs are constant. The average costs are declining when output rises.

Question 13

How is the competition in monopoly?

Answer 13

• Even when there are many competitors, product differentiation allows firms to remain price setters for their own individual product. Anyhow, increased competition will also lower the sales for alle firms at any price. It means a shift in the demand curve.
• Competitors will keep coming as long as entry is profitable.

Question 14

What are the characteristics of oligopoly?

Answer 14

• There are only a small number of competing firms in the market, so a single firm has enough market share to influence the output and average price
• Price decisions are independent, which means that the price decision of an individual firm will not affect the demand of other firms.

Question 15

What are the assumptions for monopolistic competition?

Answer 15

• Demand:
Increase in demand and higher prices from competitors will increase sales in a firm. The opposite is also possible.
• If all firms charge the same price, each will have a market share 1/n. If a firm charges more than the average, their market share will be smaller.

Question 16

What are the 3 steps to find n and P?

Answer 16

1. CC function : AC
AC=c+F/S n 
Insert the numbers, isolate n and then calculate AC. 
2. PP function : P
P=c+1/nb  
	P=AC
3. P=AC
If Price is above the Average cost, there are a profit.

Question 17

Graph the equilibrium is a monopolistic competitive market.

Answer 17

• Look at fig. 8.3: Here the x-axis has “Cost and Price”, the y-axis has “Number of firms”. Then the PP is downward sloping, and the CC is upward sloping.
o CC is the average costs, which is upward sloping, the more firms enter the market.
o PP is downward sloping, which says that the more firms that are in the market, the smaller is the average price.
o Equilibrium is at the number of firms where there are no profit.

Question 18

What are the advantages of trade in a monopolistic competition?

Answer 18

• Trade increases the market size.

o Market size determines the variety of goods that a country can produce and the scale of production.

Question 19

What are the benefits and consequences by an increased market?

Answer 19

• Consequence: There are more firms

* Benefit: More sales per firm, consumers get lower prices and more variety of products

Question 20

Graph the effect of a larger market inside the equilibrium market.

Answer 20

• Look at fig. 8.4: The x-axis is C & P, the y-axis is n. The PP is downward sloping, and the CC is increasing. CC starts the same places but becomes less steep in the case of a bigger market.
• Effect: More firms  Lower prices

Question 21

What are the two new features about trade with a monopolistic competition, compared to Ch. 3-6?

Answer 21

1. It shows how product differentiation and internal economies of scale lead to trade between similar countries with no comparative advantage between them. Both home and foreign exports autos to one another  Intra industry trade: Two-way exchanges of similar goods
2. It highlights two new channels for welfare benefits from trade: More choices for customers at a lower price and more production for companies, who can take advantage of economies of scale.

Question 22

How much does inter-industry trade account for of the world trade flow?

Answer 22

It accounts for ¼- ½ of the world trade flows. It is especially important for manufacturing goods in advanced industrial nations (US).

Question 23

Who gains most from trade integration? A small country or a big country?

Answer 23

• A small country gain ore, because the gains from integration are driven by the increase in market size.
• Before integration, production was inefficient, since the economy could not take advantage of economies of scale in production due to the country´s small size.

Question 24

How do you calculate the importance of intra-industry trade within an industry?

Answer 24

I=min{exports,imports}/((exports+imports)/2)
min{exports,imports}=The smallest value between exports and imports
I=0→Only one way trade
I=1→Export=Import
(Se Q.24)

Question 25

If the good-performing firms expands and the worst-performing one’s contract, what happens to the overall industry performance?

Answer 25

• The overall performance increases. It is due to improvements in the industry productivity.

Question 26

What are the assumptions when performance differ across producers?

Answer 26

• Firms have different cost curves, since they produce with different marginal cost levels.
• Firms have the same demand curve
• Product qualities differ among firms

Question 27

Show the performance differences between firm 1 and 2, when marginal cost of firm 1 is smaller than of firm 2.

Answer 27

• Look at fig. 8.6.
o First graph shown is the equilibrium graph, where C & P is on the x-axis, and Q is on the y-axis. Then there are a downward sloping demand curve and MR curve. At last, there are 2 constant lines of MC. The highest one is for firm 2 and the small one for firm 1.
o The second graph shows the relationship between operating profit and marginal costs. Here it is a downward sloping curve, where the Profit for firm 1 is higher and the costs lower. For firm 2 the profit is lower and the marginal costs higher.

Question 28

Look at fig. 8.6 - How will firm 1 gain higher profit?

Answer 28

Firm 1 sets a lower price –> Produce more –> Have a steeper marginal revenue curve than the demand curve –> Set a higher markup over marginal cost –> Earn higher profit

Question 29

How long can a firm earn profit when performance differ among firms?

Answer 29

As long as the marginal costs are below the intercept of the demand curve on the vertical axis.

Question 30

What are the cost cutoff?

Answer 30

• It is the level at which a firm’s costs cannot exceed.
• If a firm have marginal cost above the cutoff, it is effectively “Priced out” of the market earning negative profit at any output. They would shut down.

Question 31

What does the assumption “Firm faces randomness” mean?

Answer 31

Firms face randomness about their future production marginal cost. The randomness disappears AFTER the fixed costs have been paid and thereby are sunk

• -> Some firms will regret entering
• -> Some firm will discover that their marginal cost is low and earn high positive profit

Question 32

What will happen when economies integrate into a single larger market?

Answer 32

The number of firms will increase, since a larger market can support a larger number of firms than a smaller market. It also increases competition.

Question 33

Show how an increased market size generates both winners and losers among firms in an industry. (When performance differs among producers)

Answer 33

Fig. 8.7.
o Panel a: Here we have different demand curves for each firm. An increase in competition shifts the demand of each firm. A bigger market size moves the demand out/rotates it to the right.
o Panel b: Here it shows the consequences of the demand change in profit when firms have different cost levels. A decrease in demand of smaller firms will create new lower cost cutoff, so firms with high costs cannot survive. When the demand decreases/flatter, the firms with low costs can lower their markup and gain more market share. The profit increases for the best-performing firms with lowest costs.

Question 34

Who are the winners of economic integration in fig. 8.7?

Answer 34

• Winners are the low-cost firms, who increase their profit and market shares
• Losers are the high-cost firms who contract and exit

Question 35

Which industries are most likely to export?

Answer 35

Manufacturing (35% in the US)

Question 36

Why does trade costs associated with national borders reduce trade so much?

Answer 36

They cut down the number of firms willing or able to reach customers across borders. Also, they reduce the export sales of firms that do not reach the customers across borders.

Question 37

Will prices in an export market and a domestic market differ due to trade costs?

Answer 37

Yes, goods will be cheaper in the domestic country

Question 38

Show how trade costs affect the decision of whether to export or not.

Answer 38

See fig. 8.8. Here the two firms have the same demand curve, but their marginal costs increased in the export market due to trade costs. It is only firm 1 who chooses to export, since the costs for firm 2 is above the cost cutoff.

Question 39

Which predictions can trade costs add to our model of monopolistic competition and trade?

Answer 39

• Trade costs explains why only a subset of firm’s export
• Trade costs explains why this subset consist of larger and more productive firms, who has a lower marginal cost. In the US the exporting firms are on average more than twice as big as large firms that does not export.

Question 40

What is dumping?

Answer 40

• When exporting firms respond to the trade costs by lowering its markup for the export market.
• A firm faces higher costs (c+t) in the export market –> Lower their markup on the export market –> Export price without trade is lower than the domestic price –> Dumping! (fig. 8.8 firm 1)

Question 41

Is dumping legal?

Answer 41

• No, it is considered as unfair trade practice. There are antidumping laws used for regulating this.
• Economists do although believe that there is no good economic explanation for not doing it. They think it is okay

Question 42

When is a corporation multinational?

Answer 42

• a U.S. company is considered foreign-controlled, and therefore a subsidiary of a foreign-based multinational, if 10 percent or more of its stock is held by a foreign company; the idea is that 10 percent is enough to convey effective control
• a U.S.-based company is considered multinational if it owns more than 10 percent of a foreign firm.

Question 43

What is outflow of foreign direct investment (FDI)?

Answer 43

When a U.S. firm buys more than 10 percent of a foreign firm, or when a U.S. firm builds a new production facility abroad.

Question 44

What is U.S. FDI inflows?

Answer 44

Investments by foreign firms in production facilities in the United States are considered.

Question 45

Why would a firm choose to operate an affiliate in a foreign country (Multinational parent)?

Answer 45

It depends on the production activities that the affiliate carries out.

Question 46

Which two categories can production activities be divided into?

Answer 46

• Horizontal FDI: The affiliate replicates the production process another place in the world. It is only in developed countries. The goal is to locate production near customers. Transportation costs are very important.
• Vertical FDI: Here the production chain is broken up into parts and the production process are transferred to the affiliate location. It is due to differences in production costs.

Question 47

What are the pro and cons in horizontal FDI?

Answer 47

• Pro: There are high trade costs associated with exporting, which therefore would encourage the company to be near customers.
• Cons: It is NOT cost effective to replicate the production process too many times. Then you will not be able to achieve economies of scale.
• The firm´s export vs. FDI choice will involve a trade-off between per-unit export cost t and the fixed cost F of setting up an additional production facility.

Question 48

What is Proximity-concentration tradeoff for FDI?

Answer 48

When a company replicate the production process too many times and operate facilities that produce too little output to take advantage of those increasing returns.

Question 49

What does the decision on whether to do vertical FDI depends on?

Answer 49

A firm´s decision to break up its production chain and move part of that chain to a foreign affiliate involves a trade-off between per-unit and fixed costs, so the scale of the firm´s activity. You know you want the production in another country, so it is all about finding the cheapest one.

Question 50

What is the internalization motive?

Answer 50

It the motive for why the parent firm choose to own the affiliate in that location and operate as a single multinational firm.

Question 51

What is a substitute for horizontal FDI?

Answer 51

A parent could license an independent firm to produce and sell its production in a foreign location.

Question 52

What is a substitute for vertical FDI?

Answer 52

A parents could contract with an independent firm (supplier) to performance specific parts of the production process in the foreign location with the best cost advantage. It is also called outsourcing.

Question 53

What is offshoring?

Answer 53

It is the relocation of parts of the production chain abroad and groups together both foreign outsourcing and vertical FDI. It is the main driver of increased worldwide trade in services.

Question 54

What are the key elements that determine this make-or-buy internalization choice (Horizontal FDI)?

Answer 54

It is the control over a firm´s proprietary technology. Here horizontal FDI is widely favored over the alternative of technology licensing to replicate the production process.

Question 55

What is the trade-off between outsourcing and vertical FDI?

Answer 55

• It is a much less clear-cut. There are many reasons why a firm choose to produce some of its parts of the production process at lower cost than the parent firm in the same location.
o An independent firm can specialize in a narrow part of the production process.
o There is a benefit of economies of scale if the firm performs those processes for many different parent firms.
o The chance of local ownership in the alignment and monitoring of managerial at the production facility.

Question 56

Does vertical FDI and foreign outsourcing involve lower or higher production costs and lower of higher fixed costs?

Answer 56

They both include lower production costs and higher fixed costs.

Question 57

Empirically, are the firms that offshore and import intermediate goods the same set of firms that also export?

Answer 57

Yes

Question 58

What is the effect of offshoring on the overall employment?

Answer 58

It is either neutral or positive.

Question 59

What are the consequences for welfare of the expansion in multinational production and outsourcing?

Answer 59

• Relocating production to take advantage of cost differences leads to overall gains from trade, but it is also likely to induce income distribution effects that leave some people worse off.
• Short run: some firms expand employment while others reduce employment in response to increased globalization.
• The costs associated with displacements linked to offshoring are just as severe for workers with similar characteristic
o Solution: Provide an adequate safety net to unemployed workers
• Policies that makes it difficult can prevent short run costs, but in the long run it gives gains.