firms, trade and location chapter 5. distance in economics the relevance of transportation costs (...
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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
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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
Q Q
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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’
B
F
F’
I1
I2
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AB’
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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