“Tell me and I forget. Teach me and I remember. Involve me and I learn.

”
Benjamin Franklin

ECON 4321

Module 5A: The firm in the world

economy

Corresponding Chapter in the Book: 6

 INTRODUCTION

What are the characteristics of firms that

engage in international trade?
What are the characteristics of firms
competing with imported goods from other
countries?
What are the activities of multinational
corporations?
What are the characteristics of multinational
corporations?

Econ 4321: International Trade 2

THE FIRM IN INTERNATIONAL TRADE
The firms engaged in international trade are
referred to as trade with heterogeneous firms
or firm heterogeneity.
In terms of international trade, only a minority
of firms export.

Econ 4321: International Trade 3

THE FIRM IN INTERNATIONAL TRADE 2

Table 6.1. Percentage of manufacturing firms that export

Country Percentage of exporting firms

United States 18.0

Norway 39.2

France 17.4

Japan 20.0

Chile 20.9

Colombia 18.2
4
Econ 4321: International Trade
THE FIRM IN INTERNATIONAL TRADE 3

Table 6.2 US manufacturing exports

Industry Exporting firms Exports/shipments

(%) (%)

Misc. manufacturing 2 15
Printing & publishing 5 14
Furniture 7 10
Apparel 8 14
Wood products 8 19
Nonmetallic mineral 9 12
Food 12 15
Textile products 12 12
Fabricated metals 14 12
Petroleum & coal 18 12
Beverages & tobacco 23 7

Econ 4321: International Trade 5

THE FIRM IN INTERNATIONAL TRADE 4

Table 6.2 US manufacturing exports, cont.

Industry Exporting firms Exports/shipments

(%) (%)

Leather 24 13
Paper 24 9
Textiles 25 13
Transportation equipment 28 13
Plastics & rubber products 28 10
Primary metals 30 10
Chemicals 36 14
Machinery manufacturing 33 16
Computers & related products 38 21
Electrical equipment, appliances 38 13
Average 18 14

Econ 4321: International Trade 6

THE FIRM IN INTERNATIONAL TRADE 5

Firms that export are:

o More productive
o More capital intensive
o More human capital intensive
o Better managed

Firms that export produce more output with any given

amount of capital and labor

Econ 4321: International Trade 7

THE FIRM IN INTERNATIONAL TRADE 6
Profits from
Profits + domestic sales
Profits from
export sales

D X

d Productivity

Profits -

Figure 6.1 Firm productivity and profitability

Econ 4321: International Trade 8

THE FIRM IN INTERNATIONAL TRADE 7

Any firm to the left of D will either not enter the

industry or exit if it is an existing firm.

Firms to the right of D but to the left of X will

service the domestic market.

Firms to the right of X will both serve the

domestic market and export.

Econ 4321: International Trade 9

THE FIRM IN INTERNATIONAL TRADE 8
“Every industry is populated by heterogeneous firms, which
differ in productivity levels. As a result, firms sort according
to productivity into different organizational forms. The
least productive firms leave the industry because, if they
stay, their operating profits will be negative no matter how
they organize. Other low-productivity firms choose to serve
only the domestic market. The remaining firms serve
domestic market as well as foreign markets. Their mode of
operation in foreign markets differs, however. The most
productive firms in this group choose to invest in foreign
markets while the less productive firms choose to export…”
Melitz, Marc, Elhanan Helpman, and Stephen Yeaple.
2004. “Export Versus FDI with Heterogeneous Firms.”
American Economic Review 94: 300-316.
Econ 4321: International Trade 10
 GLOBAL VALUE CHAINS
Table 6.3 The global value chain of German cars (percentage of final
output value)
Value added 1995 2008

German value added 79 66

High skilled labor 16 17
Medium skilled labor 34 25
Low skilled labor 7 4
Capital 21 20
Foreign value added 21 34
High skilled labor 3 6
Medium skilled labor 6 9
Low skilled labor 4 4
Capital 8 15

Econ 4321: International Trade 11

 THE MULTINATIONAL CORPORATION
A multinational corporation is a firm that conducts part
of its business across national boundaries (MNC)
Labor shortages in one country cause firms to recruit
from another or move workers to another.
They account for much of the international capital, labor,
and FDI movement.
They exist because they are efficient.
They internalize activities as opposed to contracting
them out.

Econ 4321: International Trade 12

THE MULTINATIONAL CORPORATION 2

The importance of MNCs

o They play a major role in the world economy
o MNCs are growing faster than the world GDP and
exports of goods and services.

Econ 4321: International Trade 13

 THE MULTINATIONAL CORPORATION 3
Table 6.4 Selected indicators of FDI and international production, 1982–2012

Value at current prices (billions of $) Annual growth rate(%)

Item 1982 1990 2005 2012 2002 2003 2004 2005 2012

Sales of foreign affiliates 2,620 6,045 22,171 32,532 11.2 30.4 11.4 5.6 10.6

Gross product of foreign affiliates 646 1,481 4,517 7,089 1.9 20.3 22.8 5.4 13.2

Total assets of foreign affiliates 2,108 5,956 51,564 89,568 36.7 27.9 3.5 6.4 6.9

Exports of foreign affiliates 647 1,366 4,214 7,321 4.9 16.5 21.0 12.9 0.9

Employment of foreign affiliates 19,537 24,551 62,059 67,155 10.0 –0.5 20.1 4.4 5.9
(thousands)

GDP (in current prices) 10,899 21,898 44,674 72,807 3.9 12.1 12.1 9.1 2.1

Exports of goods and services 2,247 4,261 12,641 22,593 4.9 16.5 21.0 12.9 0.9

Econ 4321: International Trade 14

 THE MULTINATIONAL CORPORATION 4
Reasons for the existence of MNCs
o Several choices for how they control assets
The firm can export its product to foreign firms
and let the foreign firm handle all aspects of
selling it in the foreign market.
The MNC can set up a wholly owned subsidiary
to serve the foreign market where the firm has
complete control from the production to the
ultimate customer.
The firm can establish joint ventures with a firm
in a foreign market, possibly to access raw
materials or reduce production costs.
Econ 4321: International Trade 15
 THE MULTINATIONAL CORPORATION –
OLI APPROACH
Are the U.S. affiliates in the U.K. or China more productive than
their U.K. or Chinese counterparts? If so, why?
Is it because of the U.S. advantage in the resources needed or
because of the relatively more efficient management of the
resources, which can be transferred across nations by U.S. firms?
The OLI approach (Dunning, 2000) is a framework that explains
why multinational companies engage in foreign direct investment.
O is ownership – ownership of a resource or tangible or intangible
asset (a firm-specific advantage regarding technology, know-how,
reputation, skills, and formulas…) that can be transferred across
borders and exploited.
A good or process a firm has developed that other firms find
difficult to replicate can be a source of competitive advantage.
Maintaining control of the asset makes setting up a subsidiary
in a foreign market necessary.
This explains why firms go abroad. Econ 4321: International Trade 16
 THE MULTINATIONAL CORPORATION –
OLI APPROACH 2
The L is for locational advantages.
It may be in the firm’s interests to locate outside the home
country
When firms decide to invest abroad, where should they go?
Country-specific factors will be at play.
Market potential, natural resources, labor, capital,
technology, or to take advantage of cheaper imports in a
vertically integrated process

Econ 4321: International Trade 17

 THE MULTINATIONAL CORPORATION –
OLI APPROACH 3
May use FDI to serve a foreign market more profitably
Horizontal FDI – produce in a foreign country and sell to the
consumers in that country (e.g., Tesla makes cars in Germany
and sells them to German consumers)
Japanese and German car makers produce their cars in the U.S.
and sell them directly to U.S. consumers
Horizontal FDI occurs mainly between advanced nations
Large market potential
Trade and transportation costs are lower compared to the
exporting option.

Econ 4321: International Trade 18

 VERTICAL AND HORIZONTAL FDI
Vertical FDI – the value chain is sliced, and part of the production is
undertaken in a foreign country. For instance, some components of
cars manufactured by GM are produced by U.S. affiliates in Mexico.
Cars are shipped back to the U.S. and sold to U.S. consumers.
Usually, a firm from an advanced country (the U.S.) owns a plant
in a developing country (Mexico)
Vertical FDI occurs mainly because of significant production
cost differences (e.g., wages) across countries or because some
countries are more efficient in that part of the production
process.

In horizontal FDI, trade and transportation costs play a more critical

role than production cost differences across countries.
For instance, Japanese carmakers opened factories in the U.S.
starting in the 1980s to avoid import quotas imposed by the U.S.
and to better manage exchange rate fluctuations.

Econ 4321: International Trade 19

 THE MULTINATIONAL CORPORATION – OLI
APPROACH 4
The I is for internalization (how firms serve foreign markets)
What entry choices do firms make when they go abroad?
Exporting, licensing, franchising
FDI: greenfield investment, acquisition, joint ventures
Licensing – a foreign firm obtains the right to use the
technology or trademark of a U.S. firm
The foreign firm pays a fee

Franchising – a foreign firm gets the right to use a business

model of a U.S. firm (Starbucks in China)
The foreign firm pays a fee.
The U.S. firm has more control compared to the control it
would have with licensing.
The quality and the kind of coffee served at Starbucks stores
in China and the U.S. are the same. 20
Econ 4321: International Trade
THE MULTINATIONAL CORPORATION – OLI APPROACH 5
The I is for internalization (how firms serve foreign
markets)
Greenfield Investment
U.S. firms establish a new firm in a foreign country (e.g.,
Tesla opens a new factory in China) and fully own it (not
foreign partners)
More control and a lower risk of copying the technology
and knowledge
But, higher costs and more risk are associated with a new
market (liability of foreignness)
Acquisition
A U.S. firm purchases a fraction or all shares of a foreign
firm (e.g., Tesla purchases shares of BMW)
Fiat, an Italian firm, purchased Chrysler in 2009
21
Econ 4321: International Trade
The Joint Ventures
A U.S. firm (e.g., GM) and a foreign firm (e.g., a Chinese firm)
establish a new firm (a third firm) in a foreign country (China
or another country)
The Chinese firm is familiar with the home market.
Very common for each firm to hold a 50 percent ownership
stake, but it can vary
Firms combine their firm-specific capabilities, which can
translate into synergies.
Entry costs are shared
Partner’s familiarity with the local market
It can be risky as one firm may lose the knowledge and
technology
Having a higher equity stake can lower the risk of losing the
technology or knowledge
Differences in the management team and culture can make it
challenging (Mercedes and Chrysler)
22
Econ 4321: International Trade
THE MULTINATIONAL CORPORATION – OLI APPROACH 6
The I is for internalization (how firms serve foreign markets)
Firms prefer FDI over licensing to retain control over
know-how, manufacturing, marketing, and strategy or
because some firm capabilities are not amenable to
licensing
Licensing may result in a firm’s giving valuable
technological know-how to a potential foreign competitor
In the 1960s, RCA licensed its color television technology to
Japanese companies, including SONY
Matsushita and SONY adapted RCA’s technology and used it to
enter the U.S. market to compete with RCA

Econ 4321: International Trade 23

THE MULTINATIONAL CORPORATION – OLI APPROACH 6

The I is for internalization (how firms serve foreign markets)

Managers of multinational firms should consider the following
factors when serving foreign markets (Hill, Hwang, and Kim,
1990)
Degree of control (high in greenfield / full acquisition,
moderate in JV, and low in licensing/franchising)
Degree of Resource commitment (high in greenfield / full
acquisition, moderate in JV, and low in licensing/franchising)
Dissemination risk (Low for greenfield / full acquisition,
moderate in JV, and high in licensing/franchising)

Econ 4321: International Trade 24

 PUBLIC POLICY TOWARD MNCS

Public policy toward multinational corporations

o MNCs are generally managed from their home country
but operate in foreign countries.
o Public policy issues are how MNCs are regulated in
host countries.
o How do home and host countries tax MNCs?

Econ 4321: International Trade 25

 PUBLIC POLICY TOWARD MNCS 2
Host countries could ban the activities of MNCs.
Host countries could adopt a national treatment where
MNCs are treated as domestic firms.
Most likely, regulation falls between the two extremes
Activities could be restricted in a few key industries
Restrictions may include limiting the percentage of firms
that can be foreign-owned, a limit on exports, limits on
profits that can be repatriated

Econ 4321: International Trade 26

 PUBLIC POLICY TOWARD MNCS 3
Generally, MNCs must pay taxes on the profits
of local subsidiaries in foreign countries.
Home countries generally give tax credits
against the local tax liability for taxes paid
abroad.
If taxes differ significantly, there is an
incentive to transfer profit to a lower-taxed
country.
One way to do this is to adjust the price the
subsidiary pays for materials or services the
parent company provides.
Econ 4321: International Trade 27
PUBLIC POLICY TOWARD MNCS 4

Transfer pricing is the over or under-pricing

of goods in intra-firm trade of MNC
Allows firms to use intra-firm pricing to
maximize after-tax profit
It has been used to transfer profits out of
countries with exchange controls
Some transfer pricing will occur until income
taxes are uniform across countries
More details will be provided in the next
module
Econ 4321: International Trade 28
 SUMMARY
❖One of the most recent trends in international
trade is studying firms engaged in international
trade.
❖Firms in domestic industries are not alike. Some
firms do not export and only serve the domestic
market, while others export and serve the
domestic market.
❖Many firms both import and export components
for final assembly
❖These global value chains are becoming
increasingly important

Econ 4321: International Trade 29

 SUMMARY 2
❖With global value chains, countries are
importing and exporting value-added.
❖There are fixed costs for a firm entering an
industry. If a firm can successfully sell in the
domestic market, it may be able to export if it
can cover the additional fixed costs of
exporting.
❖Exporting firms tend to be larger than firms
that do not export

Econ 4321: International Trade 30

 SUMMARY 3
❖An MNC is a firm that conducts part of its
business across national boundaries.
❖MNCs become multinationals to maintain
ownership of an intangible asset, obtain
locational advantages, or internalize aspects of
the business.
❖With global value chains, an MNC may move part
of the production process to another country.
❖There are major public policy issues relating to
MNCs involving regulation and taxes.

Econ 4321: International Trade 31

 SOURCES
Sources
W. Charles Sawyer and Richard L. Sprinkle, International Economics, 2nd
edition, 2006.
P. R. Krugman and M. Obstfeld, International Economics: Theory &Policy, 7th
edition, 2006.
Robert C. Feenstra and Alan M. Taylor, International Economics, 1stedition,
2008, New York: Worth Publishers.
T. Pugel. International Economics, 13th edition, 2007, New York: McGraw Hill.
Paul R. Krugman and Maurice Obstfeld, International Economics: Theory and
Policy, 8th edition, 2009, New York: Pearson/Addison-Wesley.
Husted, S. And M. Melvin, International Economics, 9th edition, 2013, Pearson.
Sjoerd Beugelsdijk, Steven Brakman, Harry Garretsen, Charles Van Marrewijk,
Arjen van Witteloostuijn, International Economics and Business Nations and
Firms in the Global Economy, 2013, 2nd Edition, Cambridge University Press.
Melitz, Marc, Elhanan Helpman, and Stephen Yeaple. 2004. “Export Versus FDI
with Heterogeneous Firms.” American Economic Review 94: 300-316.

Econ 4321: International Trade 32