Chapter 8

Firms in the Global Economy: Export

Decisions, Outsourcing, and
Multinational Enterprises

■ Chapter Organization

The Theory of Imperfect Competition.

Monopoly: A Brief Review.

Monopolistic Competition.

Monopolistic Competition and Trade.

The Effects of Increased Market Size.

Gains from an Integrated Market: A Numerical Example.

The Significance of Intra-Industry Trade.

Case Study: Intra-Industry Trade in Action: The North American Auto Pact of 1964 and the North
American Free Trade Agreement (NAFTA).

Firm Responses to Trade: Winners, Losers, and Industry Performance.

Performance Differences across Producers

The Effects of Increased Market Size

Trade Costs and Export Decisions.

Dumping.

Case Study: Antidumping as Protectionism

Multinationals and Outsourcing.

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44 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition, Global Edition

Case Study: Patterns of Foreign Direct Investment Flows Around the World.

The Firm’s Decision Regarding Foreign Direct Investment.

Outsourcing

Box: Whose Trade Is It?

Case Study: Shipping Jobs Overseas? Offshoring and Unemployment in the United States.

Consequences of Multinationals and Foreign Outsourcing.

Summary
APPENDIX TO CHAPTER 8: Determining Marginal Revenue

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Chapter 8 Firms in the Global Economy: Export Decisions, Outsourcing, and Multinational Enterprises 45

■ Chapter Overview

In previous chapters, trade among nations was motivated by their differences in factor productivity or
relative factor endowments. The type of trade that occurred, for example of food for manufactures, is
based on comparative advantage and is called interindustry trade. This chapter introduces trade based on
internal economies of scale in production. Such trade in similar productions is called intraindustry trade
and describes, for example, the trading of one type of manufactured good for another type of manufactured
good. It is shown that trade can occur when there are no technological or endowment differences but when
there are economies of scale or increasing returns in production.

Economies of scale can either take the form of (1) external economies, whereby the cost per unit depends
on the size of the industry but not necessarily on the size of the firm, or as (2) internal economies, whereby
the production cost per unit of output depends on the size of the individual firm but not necessarily on the
size of the industry. Chapter 7 looked at external economies of scale, whereas this chapter focuses on
internal economies of scale. Internal economies of scale give rise to imperfectly competitive markets,
unlike the perfectly competitive market structures that were assumed to exist in earlier chapters. This
motivates the review of models of imperfect competition, including monopoly and monopolistic
competition. The instructor should spend some time making certain that students understand the
equilibrium concepts of these models because they are important for the justification of intraindustry trade.

In markets described by monopolistic competition, there are a number of firms in an industry, each of
which produces a differentiated product. Demand for its good depends on the number of other similar
products available and their prices. This type of model is useful for illustrating that trade improves the
trade-off between scale and variety available to a country. In an industry described by monopolistic
competition, a larger market—such as that which arises through international trade—lowers average price
(by increasing production and lowering average costs) and makes a greater range of goods available for
consumption. Although an integrated market also supports the existence of a larger number of firms in an
industry, the model presented in the text does not make predictions about where these industries will be
located.

It is also interesting to compare the distributional effects of trade when motivated by comparative
advantage with those when trade is motivated by increasing returns to scale in production. When countries
are similar in their factor endowments, and when scale economies and product differentiation are
important, the income distributional effects of trade will be small. You should make clear to the students
the sharp contrast between the predictions of the models of monopolistic competition and the specific

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46 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition, Global Edition

factors and Heckscher-Ohlin theories of international trade. Without clarification, some students may find
the contrasting predictions of these models confusing. The chapter presents the case study of the 1964
North American Auto Pact, which lowered trade barriers in trade of automotive products between Canada
and the United States. Canadian auto plants declined in number, but the size of the remaining plants
increased significantly as they were producing for both the U.S. and Canadian markets. The net result was
an increase in exports of automotive products from Canada to the United States, rising from $16 million in
1962 to $2.4 billion in 1968. A similar example of trade with internal economies benefiting smaller
countries was seen with NAFTA, as Mexican firms gained from freer access to the much larger American
market, though there was also significant growth of exports by American auto parts manufacturers to
Mexico.

Another important issue related to imperfectly competitive markets is the practice of price discrimination,
namely charging different customers different prices. One particularly controversial form of price
discrimination is dumping, whereby a firm charges lower prices for exported goods than for goods sold
domestically. This can occur only when domestic and foreign markets are segmented. The economics of
dumping are illustrated in the text using the example of an industry that contains a single monopolistic
firm selling in the domestic and foreign markets. While there is no good economic justification for the
view that dumping is harmful, it is often viewed as an unfair trade practice.

The chapter concludes with a discussion of foreign direct investment (FDI). FDI may be horizontal or
vertical. With horizontal FDI, a firm replicates its production process in multiple locations. With vertical
FDI, a firm breaks up its production chain across multiple locations. The decision by a multinational to
engage in FDI is driven by a proximity-concentration trade-off. Internal economies of scale give an
advantage to locating all production in one location. However, trade costs increase the cost of exporting
from a single location. Thus, FDI is more likely when trade costs are high and internal economies of scale
are low. Finally, a multinational must decide whether to engage in direct foreign production through a
foreign affiliate or to engage in outsourcing. The former is more likely when the multinational has a
proprietary technology that it is concerned about losing control over or if foreign firms cannot produce as
efficiently as direct production through a foreign affiliate. One case study considers how offshoring (the
relocation of parts of the production chain abroad) have affected how we assess trade balances, using an
iPhone as an example. An iPhone 7 purchased in the United States represents a gross import value of $225
from China. However, only $5 of that cost reflects assembly and testing in China. The remainder is the
cost of components mostly produced outside of China. Evaluating trade balances on the basis of value
added at each production stage reduces by half the size of the U.S. trade deficit with China, but magnifies

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Chapter 8 Firms in the Global Economy: Export Decisions, Outsourcing, and Multinational Enterprises 47

the U.S. trade deficit with Germany, Japan, and Korea. This analysis underscores how important global
supply chains have become. Another case study examines the impact of offshoring on employment in the
United States. The study finds that offshoring has increased for U.S. firms, particularly of manufacturing
jobs. However, the productivity gains achieved by offshoring have actually led to an increase in the overall
level of U.S. employment. It is important to note, however, that the new jobs created by offshoring may
not be filled by those people who lost their jobs due to offshoring.

■ Answers to Textbook Problems

1. With internal economies of scale, there is imperfect competition, and firms set marginal revenue
equal to marginal cost. Unlike the case of perfectly competitive markets, under monopoly, marginal
revenue is not equal to price. Marginal revenue is always less than price under imperfectly
competitive markets because to sell an extra unit of output, the firm must lower the price of all units,
not just the marginal one. Furthermore, if internal economies of scale are driven by large fixed costs,
then setting price equal to marginal cost would actually lead to negative profit for a firm that needs
to set price above marginal cost to cover its fixed costs.

2. To solve this problem, we need first to find the equilibrium number of firms in the four countries
integrated market by setting average cost equal to price across all markets. We are doing this by
noting that average cost can be written as AC = (nF/S) + c and price can be written as
P = c + (1/bn), where n is the number of firms, F is the fixed cost, S is the market size, c is the
marginal cost and b is a constant. Setting the average cost equal to price yields the following
expression:

(nF/S) + c = c + (1/bn).

n2 = (1/b) × S/F.

n = [(1/b) × S/F] 1/2.

The numerical problem in the chapter gives us the following values:

F = 750,000,000.

S Home = 900,000, S Foreign = 1,600,000, S Country 3 = 2,000,000, S Country 4 = 1,000,000.

c = 5,000.

b = 1/30,000.

Now compute the total market size as the sum of the market sizes:

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48 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition, Global Edition

S = S Home + S Foreign + S Country 3 + S Country 4 = 5,500,000.

Now plug in these values to solve for n:

n = [30,000 × 5,500,000/750,000,000]1/2 = 14.83.

As we cannot have 0.83 firms enter to a market, we know that there will be only 14 firms that enter
the markets of country 3 and 4 (the 15th firm knows that it cannot earn positive profits and will not
enter). Once we know n, then solving for Q and P is straightforward:
Q = S/n = 5,500,000/14 = 392,857.

P = c + (1/bn) = 5,000 + 30,000/14 = 7,142.857.

This price is lower than that charged when there were only two countries in the market.
3. We are given the following information (with all dollar amounts in thousands):
F = 7,500,000,000.
c = 20,000.
S US = 400,000,000 S EU = 650,000,000.
P = c + (1/bn) = 20,000 + (200/n).
The condition we derived in Problem 2 was n = [(1/b) × S/F]1/2. Looking at the price equation above,
we see that 1/b = 200. Plug in the relevant parameters to solve for the equilibrium number of firms in
the United States and the European Union:

n US = [200 × 400,000,000/7,500,000,000]1/2 = [10,66]1/2 = 3,27

n EU = [200 × 650,000,000/7,500,000,000]1/2 = [17,33]1/2 = 4,17

a. Without trade, there will be different prices in the United States and the European Union:

P US = 20,000 + (200/3) = 20,066.66

P EU = 20,000 + (200/4) = 20,050

b. After trade, the new market size is

S = 400,000,000 + 650,000,000 = 1,050,000,000

Simply plug this new market size into the equilibrium number of firms’ expression obtained
above:

n = [200 × 1,050,000,000/7,500,000,000]1/2 = [28]1/2 = 5.29

P = 20,000 + (200/5) = 20,040

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Chapter 8 Firms in the Global Economy: Export Decisions, Outsourcing, and Multinational Enterprises 49

4. a. We can model this decision by defining the technology in the following terms: If a firm invests in
the technology, it will face a fixed cost T, but face a marginal cost c T which is lower than its
marginal cost c without the technology. Thus, we define the firm’s total cost with and without
the technology as:
Cost without Technology = TC = cQ + F
Cost with Technology = TC* = c T Q + F + T
A firm will choose to adopt this technology whenever TC* < TC:
c T Q + F + T < cQ + F
T < (c − c T )Q
Q > T/(c − c T )

As with most decisions involving fixed costs, the technology is more likely to increase a firm’s
profits when the scale of production increases.

Now compare a firm with low marginal costs and one with high marginal costs. The gap c − c T
will be smaller for a low marginal cost firm than for a high marginal cost firm. Thus, a firm with
low marginal cost will need a higher level of output to justify the technology than a firm with
high marginal costs. So, it is possible that some firms (high-cost firms) will choose to adopt the
technology while others (low-cost firms) do not.

b. Trade costs raise the marginal cost of exporting. A firm that exports faces a higher marginal cost
than one that does not export and will, therefore, be more likely to use this new technology.
5. a. We know that the number of firms competing in a market increases as the size of the market
rises. At the same time, the price charged in a market falls as the number of firms competing in
that market rises. Thus, as the number of firms increases, the price charged by exporters (and
domestic firms) will fall. This increases the probability that a dumping charge will be filed.
b. A firm exporting from a small country to a large country will experience a larger difference
between its domestic price (higher) and its export price (lower) because there will be more firms
competing in the larger country. Thus, a firm exporting from a small country to a large country
will be more likely to be accused of dumping than a firm exporting from a large country to a
small country.

6. a. The investment is for a stake of 25%, so it is a Foreign Direct Investment.

b. This is not a foreign direct investment, it is a portfolio investment.
c. This acquisition would represent more than 10% ownership of the company and is therefore
Foreign Direct Investment.

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50 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition, Global Edition

d. If the Turkish company retains ownership of the factory in Turkey, then it is a Foreign Direct
Investment. If, however, the Turkish company simply built and managed the factory, but it is
owned by the Turkish government, this would not be Foreign Direct Investment.
7. a. This would be a horizontal FDI outflow from the United Kingdom and inflow into Romania.
b. This would be a horizontal FDI, but not outflow or inflow, as the acquisition happens in the
United States.
c. This would be a vertical FDI outflow from the United States and inflow into Belgium.
d. This would be a vertical FDI outflow from China and inflow into Australia.
8. Even with internal economies of scale, there may still be an advantage to producing the same good in
multiple production facilities. This is an example of the proximity-concentration trade-off. The
advantage of producing in only one location is that economies of scale are maximized. However,
producing in only one location exposes this firm to trade costs when it exports from that location. If
these trade costs are high enough, it may be more efficient to locate production in multiple locations.
The number of locations is limited by the losses from splitting production and losing out on
economies of scale.
9. This question relates to the decision by a multinational to outsource production or to engage in direct
production through foreign affiliates. A multinational may prefer to use a foreign affiliate if it has a
proprietary technology that it is concerned about losing through outsourcing (perhaps due to weak
property rights in foreign countries) or if it doubts the ability of other firms to produce as efficiently
as it could. Capital-intensive industries are more likely to have proprietary technologies or complex
production processes that make foreign affiliate production a better choice for a multinational.
10. Intrafirm trade will be higher in industries with a high degree of vertical FDI. As capital-intensive
industries are likely to have more vertical FDI for the reasons outlined above, we should expect more
intrafirm trade in these industries. This is supported by the higher degree of intraindustry trade in
capital-intensive industries in Table 8-3.

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