ECO2008 International Economics Week 9a PDF

ECO2008 International Economics Firms in the Global Economy: Export and Foreign Sourcing Decisions and Multinational Enterprises Week 9a Brian Varian Introduction (1 of 3) Internal economies of scale result when large firms have a cost advantage ove...

ECO2008 International Economics Firms in the Global Economy: Export and Foreign Sourcing Decisions and Multinational Enterprises Week 9a Brian Varian Introduction (1 of 3) Internal economies of scale result when large firms have a cost advantage over small firms, causing the industry to become uncompetitive. Internal economies of scale imply that a firm’s average cost of production decreases the more output it produces. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Introduction (2 of 3) Perfect competition that drives the price of a good down to marginal cost would imply losses for those firms because they would not be able to recover the higher costs incurred from producing the initial units of output. As a result, perfect competition would force those firms out of the market. In most sectors, goods are differentiated from each other and there are other differences across firms. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Introduction (3 of 3) Integration causes the better-performing firms to thrive and expand, while the worse-performing firms contract. Additional source of gain from trade: As production is concentrated toward better-performing firms, the overall efficiency of the industry improves. Better-performing firms have a greater incentive to engage in the global economy. Copyright © 2018 Pearson Education, Ltd. All rights reserved. The Theory of 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 or when each firm produces a good that is differentiated from that of rival firms. Each firm views itself as a price setter, choosing the price of its product. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Monopoly: A Brief Review (1 of 4) A monopoly is an industry with only one firm. An oligopoly is an industry with only a few firms. In these industries, the marginal revenue generated from selling more products is less than the uniform price charged for each product. – To sell more, a firm must lower the price of all units, not just the additional ones. – The marginal revenue function therefore lies below the demand function (which determines the price that customers are willing to pay). Copyright © 2018 Pearson Education, Ltd. All rights reserved. Monopoly: A Brief Review (2 of 4) Assume that the demand curve the firm faces is a straight line Q = A – B(P), where Q is the number of units the firm sells, P the price per unit, and A and B are constants. Q Marginal revenue equals MR = P -. B Suppose that total costs are C = F + c(Q), where F is fixed costs, those independent of the level of output, and c is the constant marginal cost. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Monopoly: A Brief Review (3 of 4) Average cost is the cost of production (C) divided by the total quantity of production (Q). C F AC = = +C c Q Q Marginal cost is the cost of producing an additional unit of output. A larger firm is more efficient because average cost decreases as output Q increases: internal economies of scale. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 8.2 Average Versus Marginal Cost This figure illustrates the average and marginal costs corresponding to the total cost function C = 5 + x. Marginal cost is always 1; average cost declines as output rises. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 8.1 Monopolistic Pricing and Production Decisions A monopolistic firm chooses an output at which marginal revenue, the increase in revenue from selling an additional unit, equals marginal cost, the cost of producing an additional unit. This profit-maximizing output is shown as QM; the price at which this output is demanded is PM. The marginal revenue curve MR lies below the demand curve D because, for a monopoly, marginal revenue is always less than the price. The monopoly’s profits are equal to the area of the shaded rectangle, the difference between price and average cost times the amount of output sold. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Monopoly: A Brief Review (4 of 4) The profit-maximizing output occurs where marginal revenue equals marginal cost. – At the intersection of the MC and MR curves, the revenue gained from selling an extra unit equals the cost of producing that unit. The monopolist earns some monopoly profits, as indicated by the shaded box, when P > AC. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Monopolistic Competition (1 of 7) Monopolistic competition is a simple model of an imperfectly competitive industry that assumes that each firm 1. can differentiate its product from the product of competitors, and 2. takes the prices charged by its rivals as given. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Monopolistic Competition (2 of 7) A firm in a monopolistically competitive industry is expected to sell – more as total sales in the industry increase and as prices charged by rivals increase. – less as the number of firms in the industry increases and as the firm’s price increases. These concepts are represented by the function: Copyright © 2018 Pearson Education, Ltd. All rights reserved. Monopolistic Competition (3 of 7) é1 ù Q = S ê - b ( P - P )ú ën û – Q is an individual firm’s sales – S is the total sales of the industry – n is the number of firms in the industry – b is a constant term representing the responsiveness of a firm’s sales to its price – P is the price charged by the firm itself – P is the average price charged by its competitors Copyright © 2018 Pearson Education, Ltd. All rights reserved. Monopolistic Competition (4 of 7) Assume that firms are symmetric: all firms face the same demand function and have the same cost function. – Thus all firms should charge the same price and have s equal share of the market Q = n – Average costs should depend on the size of the market and the number of firms: C F F AC = = +C c = n +C c Q Q S Copyright © 2018 Pearson Education, Ltd. All rights reserved. Monopolistic Competition (5 of 7) æF ö AC = n ç ÷ + Cc èS ø As the number of firms n in the industry increases, the average cost increases for each firm because each produces less. As total sales S of the industry increase, the average cost decreases for each firm because each produces more. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 8.3 Equilibrium in a Monopolistically Competitive Market The number of firms in a monopolistically competitive market, and the prices they charge, are determined by two relationships. On one side, the more firms there are, the more intensely they compete, and hence the lower is the industry price. This relationship is represented by PP. On the other side, the more firms there are, the less each firm sells and therefore the higher is the industry’s average cost. This relationship is represented by CC. If price exceeds average cost (that is, if the PP curve is above the CC curve), the industry will be making profits and additional firms will enter the industry; if price is less than average cost, the industry will be incurring losses and firms will leave the industry. The equilibrium price and number of firms occurs when price equals average cost, at the intersection of PP and CC. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Monopolistic Competition (6 of 7) At some number of firms, the price that firms charge (which decreases in n) matches the average cost that firms pay (which increases in n). – At this long-run equilibrium number of firms in the industry, firms have no incentive to enter or exit the industry. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Monopolistic Competition (7 of 7) If the number of firms is greater than or less than the equilibrium number, then firms have an incentive to exit or enter the industry. – Firms have an incentive to exit the industry when price < average cost. – Firms have an incentive to enter the industry when price > average cost. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Monopolistic Competition and Trade (1 of 2) Because trade increases market size, trade is predicted to decrease average cost in an industry described by monopolistic competition. – Industry sales increase with trade leading to decreased average costs: AC = n æç ö÷ + C F c èS ø Because trade increases the variety of goods that consumers can buy under monopolistic competition, it increases the welfare of consumers. – And because average costs decrease, consumers can also benefit from a decreased price. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 8.4 Effects of a 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. This is represented by a downward shift from CC1 to CC2. The result is a simultaneous increase in the number of firms (and hence in the variety of goods available) and a fall in the price of each. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Gains from an Integrated Market: A Numerical Example (1 of 2) Suppose there are two countries, Home and Foreign. Home has annual sales of 900,000 automobiles; Foreign has annual sales of 1.6 million. The two countries are assumed (for now) to have the same costs of production. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 8.5 Equilibrium in the Automobile Market (1 of 2) (a) The Home market: With a market size of 900,000 automobiles, Home’s equilibrium, determined by the intersection of the PP and CC curves, occurs with six firms and an industry price of $10,000 per auto. (b) The Foreign market: With a market size of 1.6 million automobiles, Foreign’s equilibrium occurs with eight firms and an industry price of $8,750 per auto. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 8.5 Equilibrium in the Automobile Market (2 of 2) (c) The combined market: Integrating the two markets creates a market for 2.5 million autos. This market supports 10 firms, and the price of an auto is only $8,000. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Table 8.1 Hypothetical Example of Gains from Market Integration Home Market Foreign Market, Integrated Market, Blank before Trade before Trade after Trade Industry output 900,000 1,600,000 2,500,000 (# of autos) Number of firms 6 8 10 Output per firm 150,000 200,000 250,000 (# of autos) Average cost $10,000 $8,750 $8,000 Price $10,000 $8,750 $8,000 Copyright © 2018 Pearson Education, Ltd. All rights reserved. Gains from an Integrated Market: A Numerical Example (2 of 2) The integrated market supports more firms, each producing at a larger scale and selling at a lower price than either national market does on its own. Everyone is better off as a result of the larger market with integration: – Consumers have a wider range of choices, and – Each firm produces more and is therefore able to offer its product at a lower price. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Monopolistic Competition and Trade Product differentiation and internal economies of scale lead to trade between similar countries with no comparative advantage differences between them. – This is a very different kind of trade than the one based on comparative advantage, where each country exports its comparative advantage good. Copyright © 2018 Pearson Education, Ltd. All rights reserved. The Significance of Intra-Industry Trade (1 of 2) Intra-industry trade refers to two-way exchanges of similar goods. 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. Copyright © 2018 Pearson Education, Ltd. All rights reserved. The Significance of Intra-Industry Trade (2 of 2) About 25–50% of world trade is intra-industry. Most prominent is the trade of manufactured goods among advanced industrial nations, which accounts for the majority of world trade. – For the United States, industries that have the most intra-industry trade—such as pharmaceuticals, chemicals, and specialized machinery—require relatively larger amounts of skilled labor, technology, and physical capital. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Table 8.2 Indexes of Intra-Industry Trade for U.S. Industries, 2009 Metalworking Machinery 0.97 Inorganic Chemicals 0.97 Power-Generating Machines 0.86 Medical and Pharmaceutical Products 0.85 Scientific Equipment 0.84 Organic Chemicals 0.79 Iron and Steel 0.76 Road Vehicles 0.70 Office Machines 0.58 Telecommunication Equipment 0.46 Furniture 0.30 Clothing and Apparel 0.11 Footwear 0.10 Copyright © 2018 Pearson Education, Ltd. All rights reserved. Firm Responses to Trade Increased competition 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. When the better-performing firms expand and the worse- performing ones contract or exit, overall industry performance improves. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 8.6 Performance Differences Across Firms (a) Demand and cost curves for firms 1 and 2. Firm 1 has a lower marginal cost than firm 2: c1 < c2. Both firms face the same demand curve and marginal revenue curve. Relative to firm 2, firm 1 sets a lower price and produces more output. The shaded areas represent operating profits for both firms (before the fixed cost is deducted). Firm 1 earns higher operating profits than firm 2. (b) Operating profits as a function of a firm’s marginal cost ci. Operating profits decrease as the marginal cost increases. Any firm with marginal cost above c* cannot operate profitably and shuts down. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Trade Costs and Export Decisions Trade costs added 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). Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 8.8 Export Decisions with Trade Costs (a) Firms 1 and 2 both operate in their domestic (Home) market. (b) Only firm 1 chooses to export to the Foreign market. It is not profitable for firm 2 to export given the trade cost t. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Summary (1 of 2) 1. Internal economies of scale imply that more production at the firm level causes average costs to fall. 2. With monopolistic competition, each firm can raise prices somewhat above those on competing products due to product differentiation but must compete with other firms whose prices are believed to be unaffected by each firm’s actions. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Summary (2 of 2) 3. Monopolistic competition allows for gains from trade through lower costs and prices, as well as through wider consumer choice. 4. Monopolistic competition predicts intra-industry trade, and does not predict changes in income distribution within a country. Copyright © 2018 Pearson Education, Ltd. All rights reserved.