Econ452 Learning Unit 11 - Part 2 - 2020 fall

Learning Unit 11
New Trade Model
Part 2: Internal Economies of Scale
ECON452
International Economics

Objectives
1. Explain how internal economies of scale and product differentiation
lead to international trade and intra-industry trade
2. Identify “dumping” and its effects
3. Describe the new types of welfare gains from intra-industry trade.
4. Explain how economic integration can lead to both winners and
losers among firms in the same industry.
5. Describe multinational corporations and the foreign direct
investment

Introduction
• Internal economies of scale imply that a firm’s average cost of production
decreases the more output it produces.
• Internal economies of scale result when large firms have a cost advantage over
small firms, causing the industry to become the imperfect competition.
• A cost advantage causes the better-performing firms to thrive and expand, while
the worse-performing firms contract.
• Those better-performing firms have a greater incentive to engage in the global
economy.

Imperfect Competition
• In imperfect competition, firms are aware that they can influence the prices of
their products and that they can sell more only by reducing their price.
• This situation occurs when there are only a few major producers of a particular
good (monopoly or oligopoly) or when each firm produces a good that is
differentiated from that of rival firms (monopolistic competition).
• Each firm views itself as a price setter, choosing the price of its product.

Imperfect Competition and Pattern of Trade
The imperfect competition model can explain
• In most sectors, goods are differentiated from each other.
– Recent trades among developed countries are characterized as intra-industry
trade, trading similar goods to each others.
• Additional source of gain from trade
– As production is concentrated toward better-performing firms, the overall
efficiency of the industry improves.
– Consumers enjoy more variety of goods.

Monopolistic Competition
• Monopolistic competition is a simple model of an imperfectly competitive
industry that assumes that each firm
– can differentiate its product from the product of competitors, and
– takes the prices charged by its rivals as given.
• A firm in a monopolistically competitive industry
– acts like monopoly in own brand market and makes profits in short-run
– competes with rivals which introduce similar products and makes zero
economic profit in long-run

Short Run Equilibrium under Monopolistic
Competition
• In short-run, a firm under monopolistic
competition uses brand loyalty as barrier to
entry and makes economic profits.
– Act like monopoly in own brand market.
– The firm operates where its marginal cost is
equal to its marginal revenue.
• Economic profits in short run give an incentive
to rival firms to introduce products similar to
the firm.
– Rival firms take customers away.
– The firm’s demand decreases.
– Firm’s profits decrease.

Long Run Equilibrium under Monopolistic
Competition
• In long-run, a firm under monopolistic
competition makes zero economic profits.
– The firm operate where its demand curve is
tangent to its long-run average cost curve.
– Price = Average cost
• Each firm operates at decreasing average cost
– long-run average cost curve is downward
sloping at the point of operation.
– Increasing return to scale (Internal
economies of scale).

Effects of Larger Market
• An increase in the size of the market allows each firm, other things equal, to
produce more and thus have lower average cost.
– In short run, each firm’s demand curve shifts up, so as its marginal cost curve.
– Each firm makes economic profits with lower average cost.
• In long run, the number of firms increases due to economic profits in short run.
– Increase the variety of goods available for consumers
– Decrease the price of each brand with lower average cost.

Gains from Trade and Integrated Market
• Trade increases market size by integrating domestic and foreign markets.
– Each firm can access both domestic and foreign markets.
– Increased market size for firm decreases average cost in an industry.
– the number of firms in a new international industry increases relative to each
national market.
• Trade increases the welfare of consumers.
– The variety of goods that consumers can buy increases – both domestic
brands and foreign brands.
– Price of each brand decreases because average costs decrease.
• Integrating markets through international trade therefore has the same effects as
growth of a market within a single country.

Trade under Monopolistic Competition
• Product differentiation and internal economies of scale lead to
– trade between similar countries with no comparative advantage differences
between them (trade is not based on comparative advantage).
– trade similar products (with same factor intensity and technology) to each other.
• Two new channels for welfare benefits from trade:
– Benefit from a greater variety at a lower price.
– Firms consolidate their production and take advantage of economies of scale.
• A smaller country stands to gain more from integration than a larger country.
– By trading, a small country can enlarge market size much more than a large
country can.

Intra-Industry Trade
• Intra-industry trade refers to two-way exchanges of similar goods.
– About 25–50% of world trade is intra-industry.
• Intra-industry index (I): Measure a level of intra-industry trade within an industry.
I = min{exports, imports}/[(exports + imports)/2]
– Index value ranges from 0 to 1.
– When I = 0, no intra-industry trade: A country either only exports or imports
products in an industry.
– When I = 1, a complete intra-industry trade: A country exports products as
much as its imports of similar products with foreign countries.

Indexes of Intra-Industry Trade for U.S.
Industries, 2009
• For the United States,
industries that have the
most intra-industry trade
require relatively larger
amounts of skilled labor,
technology, and physical
capital.
• Examples:
– pharmaceuticals
– chemicals
– specialized machinery

Intra-Industry Trade in Action: The North
American Auto Pact of 1964 and NAFTA
• Before 1965, tariff protection by Canada and the United States produced a Canadian auto
industry that was largely self-sufficient, neither importing nor exporting much.
– The Canadian auto industry was about 1/10 the size of the United States and had a labor
productivity about 30 percent lower than that of the United States.
• The United States and Canada agreed in 1964 to establish free trade in automobiles,
which allowed the auto companies to reorganize their production.
– By the early 1970s, the Canadian industry was comparable to the U.S. industry in productivity.
• With the implementation of NAFTA (the North American Free Trade Agreement between
the United States, Canada, and Mexico), this transformation of the automotive industry
was extended to include Mexico.
– The manufacture of auto parts was also consolidated throughout the North American market.
– In the first decade following NAFTA, trade in automotive parts between the United States and
Mexico more than doubled in both directions, and then doubled again in the ensuing decade,
highlighting the increasing importance of intra-industry trade.

Difference in Performance of Monopolistically
Competitive Firms
• If monopolistically competitive firms are different in their marginal costs, then
those firms with lower marginal costs will produce more products and earn
higher profits.
– Large firms are more competitive with high profits.
• When markets are integrated, the market size increases and a number of firms
increases.
– Large firms will produce more and make even more profits, while small firms
will face less profits (possible losses) and exit from the market.

Trade and Industry Performance
• Trade and economic integration improve industry performance.
• International trade affects firms:
– Increased competition hurts 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.
• International trade leads to
– The industry will be dominated by few large firms in each country.
– The average cost in the industry will be lower as high average cost firms exit from
the market, increasing productivity in the industry.
– When the better-performing firms expand and the worse-performing ones
contract or exit, overall industry performance improves.

Proportion of U.S. Firms Reporting Export
Sales by Industry, 2007
• Openness of industry varies greatly from
one industry to another.
• Most U.S. firms do not report any
exporting activity at all — sell only to U.S.
customers.
– In 2007, only 35% of U.S. manufacturing
firms reported any exports.
• Even in industries that export much of
what they produce, such as chemicals,
machinery, electronics, and transportation,
not every firms in the U.S. export.
Printing 15%
Furniture 16%
Wood Products 21%
Apparel 22%
Fabricated Metal 30%
Petroleum and Coal 34%
Transportation Equipment 57%
Machinery 61%
Chemicals 65%
Electrical Equipment and
Appliances
70%
Computer and Electronics 75%

Model with Trade Costs
• Assumptions:
– A firm must incur an additional cost t
for each unit of product that it sells to
customer across boarder.
– The same demand in domestic market
and foreign market.
• Due to the trade cost, firms will set
different prices in their export market
relative to their domestic market.
– MC for foreign market is higher by t
than domestic market.
– With higher cost, a firm sells less and
makes less profits in foreign market.

Trade Costs and Export Decisions
• In domestic market, both Firm 1 and Firm
2 operate.
– Firm 1 is bigger and more efficient with
lower marginal cost than Firm 2.
• In foreign market, only Firm 1 chooses to
export.
– Given the trade cost t, Firm 2’s MC
exceeds the maximum price that foreign
customers are willing to pay (c*).
– It is not profitable for Firm 2 to export,
so Firm 2 decides not to export at all.

Effects of Trade Costs
• High trade costs reduce the number of firms selling to customers across the border.
– Trade costs also reduce the volume of export sales of firms selling abroad.
– Trade costs include costs of shipping (transportation and insurance costs),
business costs to operate in foreign markets, and any regulation and bureaucratic
costs imposed by the government.
• Exporting firms are bigger and more productive than firms in the same industry
that do not export.
– In the United States, 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 non-exporters are even larger in many
European countries.

Dumping
• Dumping: the practice of charging a lower price for exported goods than for
goods sold domestically.
• Dumping is an example of price discrimination: the practice of charging different
customers different prices.
• Price discrimination and 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.

Dumping for Profit Maximization
• Dumping can be a profit-maximizing strategy:
• Firm may choose different profit margins (mark-ups) to be competitive in each market.
– A firm sets a lower markup over marginal cost if its marginal cost is high to
maintain prices across markets.
– An exporting firm will respond to the trade cost by lowering its markup for the
export market.
• Price of goods depends on supply and demand in each segmented market.
– Given same supply (marginal cost), a profit-maximizing firm may set lower price in
market with high-price elasticity of demand.
– If foreign customers are more responsible to price changes, an exporting firm can
increase its profits by lowering price in foreign market.

Anti-Dumping Process in the U.S.
• A U.S. firm may appeal to the Commerce Department to investigate if dumping by
foreign firms has injured the U.S. firm.
– The Commerce Department may impose an “anti-dumping duty” (tax) to protect the
U.S. 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.”
– Anti-dumping tax acts exactly like tariff. It increases a domestic price of imported
goods.
• Next, the International Trade Commission (ITC) determines if injury to the U.S. firm has
occurred or is likely to occur.
– If the ITC determines that injury has occurred or is likely to occur, the anti-dumping
duty remains in place.

Anti-Dumping Practice in the U.S.
• China has been subject to antidumping duties by the U.S. on:
– TVs, furniture, crepe paper, hand trucks, shrimp, ironing tables, plastic
shopping bags, iron pipe fittings, saccharin, solar panels, tires, and cold-rolled
steel.
• These duties are as high as 78% on color TVs, 266% for cold-rolled steel, and
330% on saccharin.
– Chinese firms benefitted from subsidized loans, rigged markets, and the
controlled yuan to lower marginal costs for their exports to the U.S.

Multinationals Corporations
• Multinational corporation (MNC): Organizations that are owned or
control productions of goods or services in one or more countries
other than the home country.
– In the U.S., a U.S. company is considered as foreign-MNC (foreign-controlled)
if 10% or more of its stock is held by a foreign company.
– A U.S.-based company is considered as MNC if it owns more than 10% of
foreign firm.

Foreign Direct Investment
• A U.S. firm may own a foreign company through foreign direct investment.
• Foreign direct investment: investment in which a firm in one country directly
controls or owns a subsidiary in another country.
– Greenfield FDI: a company builds a new production facility abroad.
 Example: BMW (German firm) built an assembly-line facility in South
Carolina.
– Brownfield FDI (or cross-border mergers and acquisitions): a domestic firm
buys a controlling stake in a foreign firm.
 Example: Lenovo (Chinese firm) purchased laptop-PC business units from
IBM.

Inflows of Foreign Direct Investment
• Worldwide flows of FDI have significantly
increased since the mid-1990s, though
the rates of increase have been very
uneven
• Historically, most of the inflows of FDI
have gone to the developed countries in
the OECD.
• However, the proportion of FDI inflows
going to developing and transition
economies has steadily increased over
time and accounted for roughly half of
worldwide FDI flows since 2009.

Outward Foreign Direct Investment for Top
25 Countries, Yearly Average 2013-2015
• Developed countries dominate the
list of the top countries whose firms
engage in outward FDI.
• More recently, firms from some big
developing countries such as China
and India have performed
significantly more FDI.

BRICS
• BRICS: Brazil, Russia, India, China, and South Africa - five major emerging national
economies.
– All developing or newly industrialized countries, but they are distinguished by
their large, fast-growing economies and significant influence on regional and
global affairs.
– The five BRICS countries represent almost 3 billion people which is 40% of the
world population, with a combined nominal GDP of US$16.039 trillion (20%
world GDP).
– FDI flows to the BRICS countries increased 20-hold in the past decade.

Two Types of Foreign Direct Investment
• 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.
 Example: Toyota builds the same facilities in Kentucky, Mississippi, Texas,
and Indiana to build Toyota Camry, Corolla, RAV4, and Sienna as in Japan.
– Vertical FDI when the production chain is broken up, and parts of the
production processes are transferred to the affiliate location.
 Example: Boeing 787 is assembled in Washington and South Carolina with
parts made in Japan (wing), Korea (wingtips), Italy (horizontal stabilizer),
Australia (trailing edge), and U.S. (engine, fuselage).

Horizontal FDI vs. Vertical FDI
• Horizontal FDI is used to locate production near a firm’s large customer bases.
– Trade and transport costs play a much more important role than production
cost differences for the horizontal FDI decisions.
– Horizontal FDI is dominated by flows between developed countries.
• Vertical FDI is mainly driven by production cost differences between countries.
– Vertical FDI is growing fast and is behind the large increase in FDI inflows to
developing countries.
– Vertical FDI is a part of worldwide supply chain.

Horizontal FDI and Trade Costs
• 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.
– The horizontal FDI decision involves a trade-off between the per-unit export
cost and the fixed cost of setting up an additional production facility.
• FDI activity concentrated in sectors with high trade costs.
– When increasing returns to scale are important and average plant sizes are
large, we observe higher export volumes relative to FDI.
– Multinationals tend to be much larger and more productive than other firms
(even exporters) in the same country.

Vertical FDI and Comparative Advantage
• The vertical FDI decision also involves a trade-off between cost savings and the
fixed cost of setting up an additional production facility.
– Cost savings related to comparative advantage make some stages of
production cheaper in other countries.
• Risks on vertical FDI
– Domestic political instability and economic breakdown can reduce production
of parts and cause substantial reduction of production of final products.
– Political and economic conflicts among countries restrict international trade
flows and disrupt the supply chain.

Outsourcing and Offshoring
• 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.
• Foreign outsourcing occurs when a firm contracts a service, such as product design
or manufacturing, to a third-party company in the foreign location.
– Example: Apple contracts with Chinese firms to build iPhone. Verizon contracts
with Indian firms to operate customer service center.
• Offshoring occurs when a company relocate a business process, such as
manufacturing and supporting processes (IT support, accounting), to the foreign
location.
– Example: GM builds and operate facilities to assembly cars in Mexico. Microsoft
operates own research lab in China.

U.S. International Trade in Business Services
• Service offshoring: a firm that provides
services moves its operations to a foreign
location
• Although service offshoring has
dramatically increased over the past
decade, U.S. in-shoring (exports of
business services) has grown even faster.
• The net balance is positive and has also
substantially increased over the past
decade.

Foreign Outsourcing vs. Offshoring
• Internalization occurs when it is more profitable to conduct transactions and
production within a single organization. Reasons for this include:
1. Technology transfers: transfer of knowledge or another form of technology may be
easier within a single organization than through a market transaction between
separate organizations.
– Patent or property rights may be weak or nonexistent.
– Knowledge may not be easily packaged and sold.
2. Vertical integration involves consolidation of different stages of a production process.
– Consolidating an input within the firm using it can avoid holdup problems and
hassles in writing complete contracts.
– But an independent supplier could benefit from economies of scale if it performs
the process for many parent firms.

Types of Facility Locations
• Multinational Corporations may have offshore facilities. Facility location decision
may be based on availability of resources, costs of production, and trade costs of
final products, raw materials, and intermediate goods.
• Resource-oriented industries: Locate near the source of the raw materials used
by the industries.
• Market-oriented industries: locate near the markets for the products of the
industries.
• Footloose industries: neither substantial weight gains or losses during the
production process.

Firm’s Decision on Facility Locations
• Resource-oriented industries: Costs of transporting the raw materials used by the
industry is substantially higher than for shipping the finished product to markets.
– Example: Steel, basic chemical
• Market-oriented industries: Goods become heavier or more difficult to transport
during the production process.
– Example: Soft drink
• Footloose industries: Goods with high value-to-weight ratios and highly mobile.
– Availability of other inputs leads to the lowest overall manufacturing cost.
– Example: Assembling of PC components

Benefits from Foreign Direct Investment
• Foreign direct investment should benefit the countries involved for reasons
similar to why international trade generates gains.
– Multinationals and firms that outsource take advantage of cost differentials
that favor moving production (or parts thereof) to particular locations.
– FDI is very similar to the relocation of production that occurred across
sectors when opening to trade.
– There are similar welfare consequences for the case of multinationals and
outsourcing: Relocating production to take advantage of cost differences
leads to overall gains from trade.

FDI and Bilateral Trade Deficit
• With vertical FDI and worldwide supply chain, a bilateral trade statistic becomes
misleading.
• Large bilateral trade deficit between the United States and China.
– $305 billion in 2015
– accounts for 60 percent of the overall U.S. trade deficit (in goods and services)
with the rest of the world,
• However, not all the products imported from China are made in China.
– For example, an iPhone 7 (32 GB) is recorded as a $225 import from China
(where the iPhone is assembled and tested).
– Only $5 of $225 stems from assembly and testing (performed in China).
– The remaining $220 represents the iPhone’s component costs, which are
overwhelmingly produced outside of China.

Bilateral Trade Deficit and Production in U.S.
• iPnone Parts manufactures are spread throughout Asia (Korea, Japan, and Taiwan
are the largest suppliers), Europe, and the Americas
• 75 sites in the United States contribute to the production of iPhone components
and employ 257,000 U.S. workers.
• Many of the component producers outside the United States employ U.S.
researchers and engineers.
– For example, the Korean company Samsung—one of the largest suppliers of
iPhone components (by value)—operates research facilities in Texas and
California that employ several thousand workers.

Facts on Bilateral Trade Deficit
• The true bilateral deficit between the United States and China (at
value added) is estimated to be roughly half of the reported bilateral
trade deficit based on gross value.
• The trade deficits with Germany, Japan, and Korea are magnified
when measured as value added, because those countries
manufacture many of the components that are assembled in China
and then imported as final goods into the United States.
• Leaves the overall U.S. trade deficit (with the rest of the world)
unchanged.

Disclaimer
Please do not copy, modify, or distribute
this presentation
without author’s consent.
This presentation was created and owned
by
Dr. Ryoichi Sakano
North Carolina A&T State University
Disclaimer
Please do not copy, modify, or distribute
this presentation
without author’s consent.
This presentation was created and owned
by
Dr. Ryoichi Sakano
North Carolina A&T State University

Econ452 Learning Unit 11 - Part 2 - 2020 fall

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