The role of the firm

Chapter 4

Trade and Imperfect Competition

• Intra-industry trade

• Relevance to international business– MNEs and assumption of imperfect competition– The concept of competitive advantage

• Grubel-Lloyd index (Box 4.1)

Beugelsdijk, Brakman, Garretsen, and van Marrewijk International Economics and Business© Cambridge University Press, 2013 Chapter 4 – Modern trade theory: the role of the firmTable 4.1 Intra-industry trade per country in 2006, ranked from high to low

Country Share of world

trade (%) Share of 5-digit

sectors traded (%) Grubel-Lloyd

index

1 France 4.47 99.8 0.424 2 Austria 1.13 99.5 0.421 3 Canada 2.86 99.7 0.421 4 Germany 9.40 99.7 0.419 5 Czech Republic 0.77 99.2 0.412 6 Switzerland 1.55 99.6 0.396 7 Belgium 2.94 99.7 0.394 8 Hungary 0.57 98.2 0.365 9 United Kingdom 4.07 99.8 0.362 10 Italy 3.84 99.8 0.344 : : : : : 84 countries have a Grubel-Lloyd index of zero, including United Arab Emirates, Vietnam, Bangladesh, Nigeria, Tunisia, Kuwait, and Sri Lanka.

Source: based on data from Bruehlhart (2009); index per country is 5-digit weighted average.

Figure 4.1 Intra-industry trade: Grubel-Lloyd index for different income groups

Grubel-Lloyd index for different income groups across time

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0.35

0.40

lower income lower middle income upper middle income high income

1962

1975

1990

2006

Source: based on data from Bruehlhart (2009); countries are classified according to the World Bank’s income groups; index per country is 5-digit weighted average Grubel-Lloyd index; average per group

Characteristics of intra-industry trade (IIT)1. Horizontally-differentiated trade or vertically differentiated

trade? (problems of aggregation)

2. IIT tends to be high in sophisticated manufactured products.

3. IIT levels are high in more open economies.

4. IIT levels are high where inward FDI levels are high.

• Internal increasing returns to scale are the underlying main cause for most international trade models of imperfect competition (Fig. 4.2).

Monopoly Power Concentration ratios: Sum of the market shares of the top

4, 5 or 8 firms. Herfindahl index: sum of the squared market shares of all

firms in the market.

where si is the market share of firm i in the market, and N is the number of firms. Thus, in a market with two firms that each has 50 percent market share, the Herfindahl index is 0.502 + 0.502 = 0.5. A market with 10 firms (with equal shares) will have an index equal to 0.1.

(the possible value of the index is between 1/N and 1)

Figure 4.2 Increasing returns to scale and perfect and imperfect competition, demand and costs

Demand and costs

0

5

10

0 5 10quantity

pric

e, m

c, a

c, m

r

demand

average costs

marginal costs

marginal revenue

AD

CB

E

H G

FI

The Trading Equilibrium

Assumption: The foreign firm assumes the home firm will continue to produce the same quantity as in autarky.

The entry of the foreign firm causes the price to fall (increased competition)

Consumers in the home and foreign country gain.

(Fig. 4.3)

Figure 4.3 A trading equilibrium: monopoly versus duopoly, demand and costs

Demand and costs

0

5

10

0 5 10quantity

pric

e, m

c, a

c, m

r demand

average costs

marginal costs

initial marginal revenue

A

D C B

J

H

K

I

mr foreign

FE

GL1

4

32

Strategic interaction between firms: Airbus and Boeing.

Imperfect competition in international business: Fuji versus Kodak (Box 4.3)

Figure 4.4 Intra-industry trade as a result of transportation costs

national border

Home firm

Foreign firm

Home country

Foreign country

Home sales in Foreign

Foreign sales in Home

national border

Home firm

Foreign firm

Home country

Foreign country

Home sales in Foreign

Foreign sales in Home

Monopolistic competition

Three assumptions (for Fig. 4.6)

1. Number of sellers is sufficiently large so that firms take the price as given.

2. Products are heterogeneous.

3. Free entry and exit of firms.

Figure 4.5 The varieties approach of monopolistic competition

1 3 5

2 4 6

2n-3 2n-1

2n-2 2n

varieties in A

varieties in B

1 3 5

2 4 6

2n-3 2n-1

2n-2 2n

varieties in A

varieties in B

Figure 4.6 Monopolistic competition, demand and costs

Demand and costs

0

5

10

0 5 10quantity

pric

e, m

c, a

c, m

r

demand

average costs

marginal costs

marginal revenue

A

D

CB

I

C

F

D

Sequence of events (Fig. 4.7)1. Increased competition leads to higher demand elasticity.

2. Price falls and the firm has a loss.

3. The loss drives some firms out of the market so demand increases for the remaining firms until zero profits are reached.

4. In the trade equilibrium, the remaining firms produce a larger quantity and lower average cost (internal economies of scale).

5. In the trade equilibrium, consumers benefit from lower prices and larger range of varieties.

6. In the trade equilibrium, the two countries engage in IIT.

Trade with monopolistic competition

Figure 4.7 Monopolistic competition and foreign trade pressure, demand and costs

Demand and costs

0.00

5.00

10.00

0 5 10quantity

pric

e, m

c, a

c, m

r

pre-trade demand

average costs

marginal costs

pre-trade mr

A'

B'

C'

FD'

A

B

C

D

post-trade demand

post-trade mr

What does the monopolistic competition model add?

1. Another explanation of IIT (with non-identical products – close substitutes ).

2. The number of suppliers is large but limited.

3. The model implies that after trade opens consumers will also buy varieties from foreign suppliers (leading to IIT)

4. More competition causes the demand curve for individual firms to become more elastic and shift downward. Each firm will produce more and charge a lower price.

IIT: Empirical Evidence IIT between two countries will be high if: per-capita incomes are high differences in levels of development are low the average of the countries’ GDP is high barriers to trade are low the two countries share a common language or border. if the countries are part of a preferential trade agreement

(PTA) the level of product differentiation within sectors is high transaction costs are low trade barriers for the industry are low scale economies are present.

Beugelsdijk, Brakman, Garretsen, and van Marrewijk International Economics and Business© Cambridge University Press, 2013 Chapter 4 – Modern trade theory: the role of the firmTable 4.2 Cross-country determinants of intra-industry trade, 2006

(dependent variable = log transformed Grubel-Lloyd index)

All sectors Primary Intermediate Final

Log mean per capita GDP 1.617*

(0.08) 1.534* (010)

1.918* (0.08)

1.513* (0.08)

Log difference per capita GDP

0.0444 (0.07)

-0.097 (0.09)

0.189* (0.07)

-0.0668 (0.07)

Log distance -0.700* (0.09)

-1.161* (0.11)

-0.622* (0.09)

-0.923* (0.09)

Contiguity 1.571* (0.41)

1.672* (0.53)

2.006* (0.45)

1.327* (0.44)

Observations 1375 1354 1374 1373

R2 0.33 0.28 0.34 0.31

Source: based on Bruehlhart (2009); * indicates statistical significance at the 1% level.

Beugelsdijk, Brakman, Garretsen, and van Marrewijk International Economics and Business© Cambridge University Press, 2013 Chapter 4 – Modern trade theory: the role of the firmTable 4.3 Exporter premia in US manufacturing, 2002

Exporter premia (%)

Employment 164 Shipments 194 Value-added per worker 12 TFP – total factor productivity 3 Wage 6 Capital per worker 13 Skill per worker 12 Additional covariates Industry fixed effects

Source: based on Bernard et al. (2007, Table 3); all results are significant at the 1 percent level.

Figure 4.8 Export orientation of US manufacturing firms, 2002

Export orientation of US manufacturing firms, 2002

0 5 10 15 20 25 30 35 40

Miscellaneous ManufacturingPrinting and Related Support

Furniture and Related ProductApparel Manufacturing

Wood Product ManufacturingNonmetallic Mineral Product

Food ManufacturingTextile Product Mills

Fabricated Metal ProductPetroleum and Coal Products

Beverage and Tobacco Product

Leather and Allied ProductPaper Manufacturing

Textile MillsPlastics and Rubber Products

Transportation EquipmentPrimary Metal Manufacturing

Machinery ManufacturingChemical Manufacturing

Computer and Electronic ProductElectrical Equipment Appliance

percent of firms that export

Average for US manufacturing

Source: van Marrewijk (2012), based on Bernard et al. (2007, Table 2).

Figure 4.9 Distribution by number of products and export destinations; USA, 2000

1 2 3 4 5+

12

34

5+

11.9

40.4

0

20

40

60

80

100

Sh

are

of e

xpo

rtin

g fi

rms

# countries

# products

a. Share of exporting firms

1 2 3 4 5+

12

34

5+

92.2

0

20

40

60

80

100

Sh

are

of e

xpo

rt v

alu

e

# countries

# products

b. Share of export value

Source: van Marrewijk (2012), based on data from Bernard et al. (2007, Table 4).

Figure 4.10 Simultaneous exporting and importing; US manufacturing, 1997 US manufacturing; exporting and importing per sector

0

10

20

30

40

50

60

70

0 10 20 30 40 50 60 70

percent of firms that export

perc

ent

of f

irms

that

impo

rt

Aggregate Manufacturing average

diagonal

regression line

Computer and Electronic Product

Printing and Related Support

Leather and Allied Product

Source: van Marrewijk (2012, based on data from Bernard et al. (2007, Table 7).

q3 profit

demand

mr

c1

c2

c3

p1

p2

q2 q1 quantity

price, mc, mr mc

p3 (p3-c3)q3

(p2-c2)q2

(p1-c1)q1

(p1-c1)q1

(p2-c2)q2

E1

E2

E3

Figure 4.11 Firm heterogeneity, prices, and profits

profit

demand before trade

quantity

price mc

firms exit

firms make lower profits

firms make higher profits

demand after trade

c3

c4

c5

profit before trade

profit after trade

Figure 4.12 Firm heterogeneity and trade

Figure 4.13 Productivity and firm type in Latin America, 2006

National Domestic

Foreign Exporting

Foreign Domestic

National Exporting

density

normalized labor productivity0 1

Source: Chang and van Marrewijk (2013).

Beugelsdijk, Brakman, Garretsen, and van Marrewijk International Economics and Business© Cambridge University Press, 2013 Chapter 4 – Modern trade theory: the role of the firmTable 4.4 Productivity, exports, and foreign-ownership

Normalized productivity

Manufactures Services 1 2 3 4 5 6

National Exporter

0.046 0.039 0.043 0.020 0.013 0.013

(8.53)** (7.43)** (8.03)** (1.79) (1.13) (1.17) Foreign Domestic

0.081 0.070 0.070 0.103 0.087 0.087

(9.80)** (8.79)** (8.80)** (11.70)** (9.96)** (9.91)** Foreign Exporter

0.092 0.076 0.075 0.109 0.078 0.082

(10.12)** (8.53)** (8.39)** (5.63)** (4.15)** (4.32)**

Size Medium 0.042 0.038 0.036 0.024 0.018 0.019 (10.19)** (9.60)** (8.97)** (3.99)** (3.03)** (3.20)** Size Large 0.069 0.065 0.063 0.009 0.008 0.009 (12.83)** (12.36)** (11.91)** (1.23) (1.05) (1.22) Ln(GDP/cap) 0.115 0.126 0.080 0.067 0.049 0.032 (33.15)** (21.66)** (6.97)** (11.69)** (4.61)** (1.12)

Constant -0.670 -0.715 -0.174 -0.206 0.103 0.187 (21.56)** (13.74)** (1.35) (4.00)** (1.05) (0.71) Observations 6146 6146 6146 3075 3075 3075 R-squared 0.23 0.29 0.32 0.09 0.17 0.20

Test if coefficients are significantly different, F-test (Prob > F)

NE v FD 0.000** 0.001** 0.002** 0.000** 0.000** 0.000** NE v FE 0.000** 0.000** 0.001** 0.000** 0.002** 0.001** FD v FE 0.330 0.635 0.705 0.761 0.660 0.801 Source: Chang and van Marrewijk (2013). Dependent variable: normalized productivity; robust t statistics in parentheses; * significant at 5%; ** significant at 1%; the specification in columns 2, 3, 5 and 6 include sector and country fixed effects; the 3rd and 6th specification also include sector-country interaction fixed effects; NE = National Exporter; FD = Foreign Domestic; FE = Foreign Exporter.