firms, trade and location chapter 5. distance in economics the relevance of transportation costs (...

Firms, Trade and Location

Chapter 5

Distance in economics The relevance of transportation costs (Box 5.1)

CIF (cost, insurance, freight) FOB (free on board)

Empirical evidence (Hummels, 1999) Shipping costs are higher in

countries located further away from major markets, and landlocked countries.

Transport costs have not declined uniformly over time (in post WWII, costs of air transport have declined but those of ocean travel have increased).

Also see Table 5.1.

The Gravity Model of International Trade

Link between distance and trade Introduces a spatial or geographical element. If the two countries are large and are close

to each other then bilateral trade (between them) will be large.

Is geography destiny?1. The role of infrastructure and technology.

2. No center of production remains a center forever.

Geographical Economics

Agglomerating vs. spreading Neoclassical explanation (consequences of

international factor mobility) Geographical economics (Paul Krugman and

others) Incorporates the role of geography. Increasing returns to scale at the firm level.

Fundamental question: What is the preferred location?

Centers of production (agglomeration) attract factors of production, inflow of labor increases demand and market

size, which raises profits and cause wages to increase

Thus, factor abundance leads to higher factor income (not lower, as predicted by the HO model!)

The analysis is made more complex due to the interaction of increasing returns to scale, transport cost and market size. Multiple equilibria

The Geographical Economics Approach

An example– Two regions North and South.– Two sectors (manufacturing producing a

differentiated product and farming sector producing a homogeneous product).

– Each firm produces a single variety of the product.

– Internal economies of scale.

Geography of sales and the location decision of each firm (Table 5.3)

5 important characteristics (Table 5.)

1. Cumulative causation

2. Existence of Multiple equilibria

3. An equilibrium could be stable or unstable

4. A stable equilibrium can be no-optimal

5. Interaction of agglomeration and trade flows

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Fig. 5.1 Monopolistic competition and the re-location of a firm

Q

Region 2

World GDP, FDI, and trade (1970 = 100)

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Data source: World Bank Development Indicators CD-ROM, 2004; GDP in constant 1995 US dollars; FDI, net inflows and trade as a percentage of GDP.

From Box 5.3

Multinational Behavior

Stylized facts (Markusen,2002):1. MNEs seem to be concentrated in industries

characterized by a high ratio of R&D relative to sales.

2. MNEs are often associated with new or technologically advanced and differentiated products.

3. MNEs tend to have high values of intangible assets.

4. MNEs are often large, relatively old, and more established firms within their sector.

Simplifying assumptions1. Firms can locate production in two (identical) countries.

2. Production uses only one input.

3. MCs in terms of labor are constant.

4. There are firm-specific fixed costs (F); related to knowledge capital. These costs are only imposed once.

5. Setting up a plant gives rise to plant-specific fixed costs (P).

6. Transportation costs (in terms of labor) are t per unit exported.

7. Markets are segmented (i.e., no risk of arbitrage).

8. Headquarters also use resources, which are covered by firm-specific fixed costs (F).

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Fig. 5.3 National exporting firm

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Fig. 5.4 Horizontal multinational

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Fig. 5.5 Vertical multinational

Q Q

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Vertical multinational? Export?

Production plant only in Foreign

• firm fixed costs Fh• plant fixed costs Pf• marginal cost mcf• transport costs t

Headquarter in Home

Multinational?

yes

yes no

no

Production plant in Home and Foreign

• firm fixed costs Fh• plant fixed costs Pf• marginal cost mcf• plant fixed costs Ph• marginal cost mch

Firm and production plant in Home

• firm fixed costs Fh• plant fixed costs Ph• marginal cost mch• transport costs t

Single plant MNC Multiple plant MNCprofit: areas C+D

National exporting firmprofit: areas A+B

yes

Vertical multinational? Export?

Production plant only in Foreign

• firm fixed costs Fh• plant fixed costs Pf• marginal cost mcf• transport costs t

Headquarter in Home

Multinational?

yes

yes no

no

Production plant in Home and Foreign

• firm fixed costs Fh• plant fixed costs Pf• marginal cost mcf• plant fixed costs Ph• marginal cost mch

Firm and production plant in Home

• firm fixed costs Fh• plant fixed costs Ph• marginal cost mch• transport costs t

Single plant MNCprofit: areas E+G

Multiple plant MNCprofit: areas C+D

National exporting firmprofit: areas A+B

yes

Vertical multinational? Export?

Production plant only in Foreign

• firm fixed costs Fh• plant fixed costs Pf• marginal cost mcf• transport costs t

Headquarter in Home

Multinational?

yes

yes no

no

Production plant in Home and Foreign

• firm fixed costs Fh• plant fixed costs Pf• marginal cost mcf• plant fixed costs Ph• marginal cost mch

Firm and production plant in Home

• firm fixed costs Fh• plant fixed costs Ph• marginal cost mch• transport costs t

Single plant MNC Multiple plant MNCprofit: areas C+D

National exporting firmprofit: areas A+B

yes

Vertical multinational? Export?

Production plant only in Foreign

• firm fixed costs Fh• plant fixed costs Pf• marginal cost mcf• transport costs t

Headquarter in Home

Multinational?

yes

yes no

no

Production plant in Home and Foreign

• firm fixed costs Fh• plant fixed costs Pf• marginal cost mcf• plant fixed costs Ph• marginal cost mch

Firm and production plant in Home

• firm fixed costs Fh• plant fixed costs Ph• marginal cost mch• transport costs t

Single plant MNCprofit: areas E+G

Multiple plant MNCprofit: areas C+D

National exporting firmprofit: areas A+B

yes

Fig. 5.6 Summary of the firm’s main decisions

Outsourcing

3 main advantages of sub-contracting1. Forgoing the plant specific fixed costs.2. Cutting storage costs.3. Access to experience and knowledge of the

foreign firm.Main disadvantage Increased economic uncertainty due to

dependence on the foreign partner and political and economic conditions in the partner’s country (see Box 5.5).

© van Marrewijk, 2005

I1

I2

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AB’

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F

F’

I1

I2

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The effect of outsourcing in production and income distribution

© van Marrewijk, 2005

Headquarters in Home Headquarters in Foreign

• firm fixed costs Fh• plant fixed costs Ph

• plant fixedcosts Pf

Nationalfirmheadquarterin Home

Multi-plant production?

yes no

Headquarter location

• firm fixed costs Ff• plant fixed costs Pf

Multi-plant production?

MNCheadquarterin Home

• plant fixedcosts Ph

yesno

Nationalfirm headquarter in Foreign

MNCheadquarterin Foreign

Headquarters in Home Headquarters in Foreign

• firm fixed costs Fh• plant fixed costs Ph

• plant fixedcosts Pf

Nationalfirmheadquarterin Home

Multi-plant production?

yes no

Headquarter location

• firm fixed costs Ff• plant fixed costs Pf

Multi-plant production?

MNCheadquarterin Home

• plant fixedcosts Ph

yesno

Nationalfirm headquarter in Foreign

MNCheadquarterin Foreign

Figure 5.8 Decision Process and firm types