Theory Lecture 6

Question 1

The puzzle of home bias in trade:

Answer 1

people have a strong preference for their home goods (home

bias in trade) → The int’l goods markets are far more segmented than theory predicts

Question 2

Gravity model (Tinbergen ’62)

Answer 2

fits the bilateral trade very well. This model suggested that there is a positive correlation between trade and economic size of a country, but an inverse relation between trade and distance (transportation costs for example).

Question 3

Why has globalisation increased?

Answer 3

• Reduction of costs of transport and communications
• Financial integration outpaced real (trade) integration (note: mainly among advance. econ)
• Emergence of multination corporations
  - Operating activities often separated form financing activities
  - Companies establish complex international business structures in order to: i) manage
  the cultural, administrative, geographic, and economic distances; ii) reduce tax burdens; and iii) avoid regulation

Question 4

Companies establish complex international business structures in order to

Answer 4

1) manage the cultural, administrative, geographic, and economic distances (Pankaj Ghemawat, a Harvard strategy professor);
2) reduce tax burdens;
3) avoid regulation.

Question 5

Friedman defined three periods of globalization

Answer 5

• Globalization 1.0: led by countries and governments.
• Globalization 2.0: global integration led by multinational companies and global
brands such as Microsoft, Apple, Google, Sony, McDonalds.
• Globalization 3.0: further “flattening” of the world due to complex global
supply/value chains (GVC), enabled by the workflow software, outsourcing,
offshoring, the Internet, etc.

Question 6

WHAT DOES Classic trade theory explains

Answer 6

Classic trade theory explains the inter-industry trade.

• > Comparative advantage (relativeproductivity among various goods )
  1) in technology (A) and
  2) in absolute or relative abundance of “specific” factors (K,L,land)

Question 7

What does Modern trade theory explain?

Answer 7

Modern trade theory explains the intra-industry trade (Fords vs BMWs) and which
firms become multinationals.
1) (Micro) model of monopolistic competition:
2) A single firm has some market power

Question 8

What is Free entry is possible?

Answer 8

Free entry is possible until the monopoly profits (P-AC) are zero, as in perfect
competition.

Question 9

Key insights of Modern trade theory:

Answer 9

Increasing returns to scale (IRS) F(aK,aL)>aF(K,L) are essential to generate imperfect competition and possible positive profits

Question 10

Gains from trade to consumers in Modern trade theory

Answer 10

1. a drop in price: surviving firms have higher productivity due to increasing returns to scale;
2. a larger variety: fewer firms overall but more product variety from home and foreign firms.

Question 11

Focusof the theory of multinational activity is on organizing production, through:

Answer 11

Exporting/Importing, ((inter-industry trade))
Horizontal MNC (Markusen’84REStud), ( (market seeking))
Vertical MNC (Helpman’84). (intra-firm trade)

Question 12

Two types of multinational activity

Answer 12

horizontal and vertical

Question 13

To rationalize existence of MNCs, it is crucial to have

Answer 13

imperfect competition and increasing returns to scale:
 Home (H)and Foreign (F)markets are segmented (no arbitrage; can price differently).
 Otherwise, markets are symmetric.

Question 14

4 types of costs for firms

Answer 14

firm-specific fixed cost of R&D or invention, F“ownership advantage” to firm (at HQ);
plant-specific fixed cost of setting up the production, P;
marginal cost of production, MC;
transport cost to move 1 unit of good internationally, t.

Question 15

Horizontal MNC (market seeking) vs. Exporting (inter-industry trade)

Answer 15

Work of Markusen’84REStud; Horstmann& Markusen‘92JIE; Brainard’93;
• A tradeoff: benefits of economies of scale from horizontal MNC (area C+D) vs. costs of shipping cross border with direct exporting (area A+B).

• Other (“strategic”) factors:
 Presence in an important market;
 Follow suppliers or customers.

Question 16

Hybrid strategies emerge

Answer 16

1. Export-platform MNC: market + efficiency seeking (Ekholm, Forslid, Markusen’07JEEA; Mrázová&
   Neary‘18JEEA; Tintelnot’16QJE).
   Export to Germany via NL (Schiphol, R’damPort).
2. Strategic asset seeking MNC.
   Not natural resources (as in vertical MNC) but crucial (tech) knowledgeor market position in the local market
   • Market size (Arkolakis, Ramondo, Rodriguez-Clare, Yeaple‘18AER.)and its interaction with fixed costs F
   and P (Tintelnot’17QJE)matter for choice export / horiz. MNC

Question 17

Key stylized facts about the multinational firms

Answer 17

1. Large and economically important
2. Have strong national identity and are subject to forces of “gravity”
3. Select certain industries to operate
4. Are on the top of the “pecking order” by firm productivity
5. Follow a clear division of tasks between HQ and affiliates
6. Are “smart” on how to enter host markets

Question 18

Monopolistic competition, Assumptions

Answer 18

1: Most goods are differentiated goods, there are buyers for each variety.
A2: There are many firms in the industry (N), each takes behavior of others as given,
as with perfect competition.
▪Each captures D/N of industry demand if they charge the same price.
▪If one firm undercuts price, its demand d is flatter (this firm “steals” more
consumers than an “average” firm which complies with the “rules of the game”).
A3: Firms enjoy increasing returns to scale: F(aK,aL)>aF(K,L) for a>1, or the average
costs for a firm AC=(FC+MC)/Q fall when more output is produced.
A4: Free entry until the monopoly profits (P-AC) are zero, as in perfect competition.

Question 19

Modern vs. Classical trade theory.

Answer 19

1. New trade theory tells that trade may emerge in similar, or even identical, goods, between
   similar (identical) countries –unlike in classical trade theories where we would need
   difference in productivity (Ricardo) or factor endowments (Heckscher-Ohlin).
2. Increasing returns to scale are essential to generate imperfect competition and possible
   positive profits.
   • This generates entry by foreign firms and intra-industry trade.
   • This results in one firm-one variety production (larger firms can always undercut a
   smaller one due to IRS).
3. Gains from trade to consumers come from
   i) a drop in price (due to higher productivity of the surviving firms generated by IRS);
   ii) larger variety (fewer firms overall but more product variety from H and F firms).

Question 20

Fact 1: MNCs are large (economic importance of MNC)

Answer 20

MNCs account for a large share of global production and sales.
•25% of global GDP and 1/3 of int’l trade in 2011.
•Sales of the foreign affiliates of US MNCs were 5X larger of the U.S. exports in 2009.

Most MNC activity is among developed countries.
•82% of the outward FDI stock, 66% of the inward stock are “North-North” in 2011.
•73% of the VA of the U.S. MNCs was in developed countries;
•75% of VA by foreign affiliates in the U.S. was by the MNCs from 7 developed countries.
•Developing country MNCs are more likely to invest in other developing countries.

Question 21

Fact 2: Strong national identity and subject to forces of “gravity”
(Geographic structure of global production within MNCs)

Answer 21

Most economic activity within MNCs is in the parent country
-> U.S. MNCs HQs account for 68% of employment (2009) but decreasing (79% in 1989).

Gravity matters for the location of affiliates.
•MNC production activities drop rapidly in distance from the parent.
•The volume of export sales drops with distance a bit faster.
•Affiliate sales are less geographically concentrated than are export.

Question 22

Fact 3: MNCs “select” certain industries

Cross-industry variation in the importance of MNCs

Answer 22

MNCs prefer capital-intensive and R&D-intensive industries
•This evidence is mostly based on developed country data (BEA, OECD).

This preference is less pronounced among developing country MNCs
•MNCs with HQs in developing countries “prefer” the unskilled labor-intensive industries.

Question 23

Fact 4: MNCs are on the top of the “pecking order” by firm productivity
(Within-industry differences between MNCs and other firms)

Answer 23

There are relatively few MNCs

But they are larger, more productive, more export oriented than domestic firms
•True for HQs and affiliates

Even among the MNCs a relatively small number of MNCs account for a large share of
multinational activity
-> In 1999, 1% of US MNCs (in terms of the size of their global operations) accounted for 38% of all affiliate sales, 45% of HQ exports to, 53% imports from affiliates

Question 24

Fact 5: HQs design, affiliates –sell.

“Division of labor” within MNCs

Answer 24

Within the MNC, parents are relatively specialized in R&D
•U.S. MNCs HQs take a large 68% of employment, but the R&D spending is even larger 85%
•61% of the sales of the foreign affiliates of US MNCs were made in their host country (sell where produce).

Affiliates are specialized in serving foreign markets rather than exporting to their
parent country
•HQs exported only 11% of their output.
•39% of sales of affiliates were outside their host country markets.

Question 25

Fact 6: MNCs are choosy on how to enter and when selecting a local firm to acquire.
(The mode of entry of the MNCs)

Answer 25

Cross-border M&As account for a large portion of global FDI, esp. into developed
countries
•In 2011, 70% of FDI inflows for advanced, <20% for developing countries

More productive firms are more likely to enter through Greenfield investment

Affiliates acquired through a cross-border M&A are more productive than average in the target country.
•But it is challenging to empirically establish the “effects of” MNCs.