Week 7-8 - Economies of scale and Firms in global economic PDF

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Week 7- Internaional Economics of Scale Economies of scale could mean either that larger irms or a larger industry would be more eicient. External economies of scale occur when cost per unit of output depends on the size of the industry. Internal economies of scale occur when the cost per unit of...

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Week 7- International Economics of Scale

 Economies of scale could mean either that larger firms or a larger industry would be more efficient.  External economies of scale occur when cost per unit of output depends on the size of the industry.  Internal economies of scale occur when the cost per unit of output depends on the size of a firm. (We covered this in Lecture 3 Monopolistic Competition)

Thinking like cluster – many businesses in the industry together = gain economies of scales = firms come together = semi conductor Ie, •

Many modern examples of industries seem to be powerful external economies:

– In the US, the semiconductor industry is concentrated in Silicon Valley, investment banking in New York, and the entertainment industry in Hollywood – In China, external economies are pervasive in manufacturing – Hangji: produce and supply more than 60% of the domestic toothbrush market by 2006 – Guzhen: largest production base of lighting fittings in China, made up 60% of the Chinese market with exports reaching $1 billion in 2001 – Yiwu: producing a third of the world's sock supply in 2012 •

India –

External economies plays a key role in India’s emergence as a major exporter of information services.

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Indian IT companies are clustered in Bangalore

Reasons for the External Economies of scale Specialised  If a car manufacturer had to produce all components (tires, airbags, brakes,…) in house, it would not be very efficient. equipment or services  Instead  Suppliers specialised in car components have an incentive to locate close to car manufacturers.  This circular causality brings about the geographical concentration of industries. gain efficiency Labour pooling

 Firms that need specialised workers want to locate where there is a large supply of these workers. Ie, technology companies in Boston adjacent to MIT, Harvard of Boston University  A specialised labour market: a large and concentrated industry may attract a pool of workers, reducing employee search and hiring costs for each firm. find the best person to work for = cheaper to find the human capital locally

Knowledge spillovers

 Workers from different firms may more easily share ideas that benefit each firm when a large and concentrated industry exists better communication, better R&D operations + whole network of industries (e.g. component suppliers, engineering and design firms) == better knowledge communications

External Economies - most important bits

Before Trade – (Linked to Ricardo and Hecksher-Ohlin model 2 countries, China and US 1 product – button = button production is subject to external economies of scale –

The larger the industry, the lower the industry’s costs.

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There is a forward-falling supply curve: the larger the industry’s output, the lower the price at which firms are willing to sell. = the larger the output = larger demand, the cheaper it gets

China is labour intensive = Price of button is lower in China than in the US = as the average cost is lower = US customers kept buying from China = higher demand

 The Chinese button industry will expand, while the US button industry will contract. –

In the end, all button production will be in China.

After Trade •

Before trade, China supplied only its domestic market. After trade, China supplies the world market, for both China and US consumers.

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Increased production leads to a price drop after trade. China’s buttons are cheaper. The Chinese button industry will expand, while the US button industry will contract.

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Trade leads to button prices to be lower than the prices in either country before trade.

NOTE 

In the previous trade models relative prices converge as a result of trade (Ricardian & H-O model) = PRICE RAISED IN THE HOME COUNTRY (China) AFTER TRADE AND DROPS IN THE FOREIGN COUNTRY (US)

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If cloth is relatively cheap in the home country and relatively expensive in the foreign country before trade opens, the effect of trade was to raise cloth prices in Home and reduce them in Foreign.

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With external economies, by contrast, the effect of trade is to reduce prices everywhere. What might cause one country to have an initial advantage from having a lower price? Summary (Swiss and Thai watch industry case) • Mutually beneficial trade can arise as a result of economies  Overall, it’s better for the world that each industry with external economies be concentrated somewhere. = of scale. country should not produce everything. • With trade,  In the watch case, it’d be better if they were produced in Thailand a country take  But due tocan a historical accident, they are produced in Switzerland = production may not always end up in the advantage ideal location as it is cheaper to produce watches in Thailand of economies of scale to produce - Cheaper to produce watches in Thailand than in more Switzerland as ACTHAI < ACSWISS efficiently - as Thailand start cost is C0 > current than if production it watch trade price at Point 1 ( because Swiss has tried to enough ofproduce a head start.) everything Even without trade, Thais would be better off by producingitself. watches at price P2 at Point 3.

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• toInternationa But due a historical accident, they are produced l trade in Switzerland. allows each No guarantee countrythat to the right country will produce aspecialise good that is subject to external economies. without sacrificing variety in consumptio n. Infant industry argument • Trade need • = Temporary protection of industries enables them to gain experience: infant industry argument. not be the resultisofoften for a long time, and it is hard to identify when external economies of scale really exist. • But temporary comparative = These policies often fail because the local industry never becomes more efficient than the foreign advantage competition. (such Why?as the • PoliticiansRicardo do not have enough information to know whether the average cost curve of their country is really Model). It below that of the foreign competition (all countries like to think that they can have a Silicon Valley). can result • Protectionism fromdoes not incentivise local producers to improve productivity economies • Local producers will lobby their government to keep protectionist measures indefinitely of scale -

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External economies give an important role to history and accident in determining the pattern of international trade

Lecture 8: Firms in the Global Economy

FDI •

Foreign direct investment (FDI) refers to investment in which a firm in one country directly controls or owns a subsidiary in another country.

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Outflows of FDI are the flows of FDI out of a country

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Inflows of FDI are the flows of FDI into a country

The share value of FDI is okay in 2008 but worsen after the financial crisis Share outflow pf FDI in developed countries = decreased over time, general trend is decreasing overtime consistently Outflow FDI worldwide mostly come from the developed economies Top FDi outflows are US, Japan, China (only one who is developing country), UK

FDI forms Purchase of existing assets (Merger & Acquisition)

o Quick entry, local market knowhow, local financing may be possible, eliminate competitor, buying problems

New investment (Greenfield)

o No local entity exists or is available for sale, local financial incentives may encourage, no inherited problems, long lead time to generation of sales or other desired outcome.

Participation in an international jointventure

o Shared ownership with local and/or other non-local partner

 quicker to execute than greenfield investments  less risky for a firm to acquire desired assets than build them from the ground up  increase the efficiency of an acquired unit by transferring capital, technology, or management skills

The majority of cross-border investment involves mergers and acquisitions rather than greenfield investments

EXPORTING

LICENSING

The viability of an exporting strategy can be constrained by transportation costs and trade barriers – When transportation costs are high, exporting can be unprofitable – Foreign direct investment may be a response to actual or threatened trade barriers such as import tariffs or quotas = HIGH COST due to tariff and quotas charges + transportation cost and trade barriers -

Internalisation theory (also known as market imperfections) suggests that licensing has three major drawbacks: – It may result in a firm’s giving away valuable technological know-how to a potential foreign competitor – It does not give a firm the tight control over manufacturing, marketing, and strategy in a foreign country that may be required to maximise its profitability – It may be difficult if the firm’s competitive advantage is not amendable to licensing •

FDI over exporting o High transportation costs, trade barriers FDI over licensing or franchising o Need to retain strategic control o Need to protect technological knowhow o Capabilities not suitable for licensing/franchising

Eclectic Paradigm of FDI (Dunning) -

Ownership Advantage: For a firm to successfully compete in a foreign market, it must have some firm of firm specific advantage (technology, knowledge, management, product, resource base, cost base etc). Location Advantage: the FDI destination local market must offer factors (land, capital, know-how, cost/quality of labour, economies of scale) such that it is advantageous for the firm to locate its investment there Internalisation Advantage: transaction costs of an arms-length relationship --licensing, exports-- higher than managing the activity within the MNE’s boundaries

DECISION FRAMEWORK

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Horizontal FDI occurs when a firm from one country owns a company in another industrial country. Multiplant firms duplicate roughly the same activities in multiple countries WHY ???

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Allows the firm to avoid any tariffs or quotas from exporting to a foreign market since it produces locally.  Provides improved access to that economy because the local firms will have better facilities and information for marketing products.  An alliance between the production divisions of firms allows technical expertise to be shared.

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 Vertical FDI is growing fast and is behind the large increase in FDI inflows to developing countries.  IKEA buys forests in Romania and Bulgaria to ensure that manufacturing has access to raw materials

Benefits of FDI        

Direct employment Secondary employment New technology Reduction in imports Growth in exports Technology spillovers Training Competition? Drawback of FDI for the foreign country

 The possible adverse effects of FDI on competition within the host nation  Externalities e.g. workers welfare, pollution  The perceived loss of national sovereignty and autonomy

Vertical FDI Occurs when firms locate different stages of production in different countries It is mainly driven by production cost differences between countries WHY ???

Explains FDI • • • • • • •

Labour costs / local skilled labour Trade flows (open-ness) Local economic conditions Institutions – IPR protection, low corruption etc Geography Local technological capacity Local manufacturing capabilities...