Raff Trade, Heterogeneity, Intermediation 1 International Trade, Firm Heterogeneity, and Intermediation Horst Raff, University of Kiel Zhejiang University May 2011

Raff Trade, Heterogeneity, Intermediation 2  International Trade with Heterogeneous Firms i.Introduction ii.Trade Model with Monoplistic Competition (Krugman) iii.Monopolistic Competition with Heterogeneous Firms (Melitz, Ottaviano) iv.Reciprocal Dumping Model (Brander) v.Reciprocal Dumping Model with Heterogeneous Firms (Long, Raff, Stähler) vi.Trade and Innovation vii.Intra-Industry Adjustment to Import Competition  Intermediation in International Trade i.Introduction ii.Buyer Power in International Markets iii.Imports and the Structure of Retail Markets iv.Manufacturers and Retailers in the Global Economy Syllabus

Raff Trade, Heterogeneity, Intermediation 3 Intermediaries in International Trade 1. Role of retailers/wholesalers in intermediating international trade 2. Welfare effects of trade liberalization when there are big, powerful buyers who may capture rents from manufacturers and/or consumers 3. Effect of retail market structure and retail margins on pass-through of import prices into consumer prices 4. Effect of retail regulation on trade and pass-through 5. Structural shifts in employment from manufacturing into retailing 6. Retailers as gatekeepers to consumer markets Introduction

Raff Trade, Heterogeneity, Intermediation 4 Buyer Power in International Markets Horst Raff and Nicolas Schmitt Journal of International Economics 2009 Buyer Power

Raff Trade, Heterogeneity, Intermediation 5 Buyer power: Exercise of significant market power by retailers/wholesalers What is the impact of buyer power on international markets: the volume of international trade the terms of trade consumer prices domestic welfare/gains from trade? Buyer Power

Raff Trade, Heterogeneity, Intermediation 6 Stylized facts  In many countries, retailers and wholesalers have become significantly more powerful in recent years compared to manufacturers.  In EU food retailing, the concentration ratio rose by 20% between 1993 and  The aggregate concentration ratio is much higher than in manufacturing: the 20 largest retailing firms account for 43% of aggregate EU retail food turnover equivalent number for manufacturing: only 14.5%.  The same phenomenon has been observed in many other markets, such as apparel and clothing.  In these markets, the retailers impose contract terms on manufacturers, not the other way round. Buyer Power

Raff Trade, Heterogeneity, Intermediation 7 Wal-Mart which is today the world's biggest company by sales (US$312.4 billion). Procter & Gamble employs 200 people who work solely on the Wal-Mart account. The company, along with many others in the Fortune 500, set up offices in northwest Arkansas to be more accessible to Wal-Mart, its largest client. Buyer Power

Raff Trade, Heterogeneity, Intermediation 8 Source: Basker and Van (2005), p. 50

Raff Trade, Heterogeneity, Intermediation 9 Why is it important to look at buyer power from a trade perspective? 1.Retailers with buyer power participate extensively in international markets: Wal-Mart alone accounted for an incredible 10% of total US imports from China in 2004 (Basker and Hoang Van, 2005; Fishman, 2006). Wal-Mart imports more than half of its non-food products (Smith, 2004). In the apparel market, 12% of the apparel sold by US retailers in 1975 were imported against 48% in Buyer Power

Raff Trade, Heterogeneity, Intermediation 10 Without buyer power, imports from China and other developing countries would not have grown as quickly as they did over the last decade. -Pressure from big retailers (Wal-Mart) has forced domestic suppliers to relocate production abroad. -Major retailers also buy directly from low cost countries. Most major US retailers have overseas buying offices, especially in East Asia, with contacts with a large network of suppliers. -In 2002, Wal-Mart took over Pacific Resources Exports (PREL), its exclusive global buyer between 1989 and PREL lists over 6000 suppliers, 80% of which are located in China Buyer Power

Raff Trade, Heterogeneity, Intermediation 11 Source: Basker and Van (2005), p. 50

Raff Trade, Heterogeneity, Intermediation 12 Role of big buyers may be crucial in understanding why, despite formidable spatial and cultural distances, countries like Japan, South Korea, Taiwan, Hong Kong, Singapore, and now China have been so successful and for so long in exporting to Western countries. East Asian growth in trade may be better explained by the role of buyer-driven global commodity chains than by more traditional explanations, such as the role of export- oriented policies (Gereffi, 1999). But buyer power has also been blamed for limiting trade by making import penetration more difficult than it would otherwise have been, thanks in particular to the use of exclusive agreements. Buyer Power

Raff Trade, Heterogeneity, Intermediation 13 Why is it important to look at buyer power from a trade perspective? 2.Why does buyer power seem to be on the rise? Fundamental reason: greater prevalence of differentiated products in international markets. These goods require a lot of information and a good match between the characteristics of buyers and sellers (Rauch and Feenstra, 1999). Prices are not enough to convey the necessary information; hence some institutions must emerge to handle these issues. Buyer Power

Raff Trade, Heterogeneity, Intermediation 14 If buyers are in the driving seat, it must because they know consumers' characteristics better than segmented and/or distant suppliers. Buyer power may occur naturally in association with international markets. Buyer power can have far-reaching effects on international markets. But it is far from clear whether buyer power should increase or decrease trade and welfare. Hence, it seems important to start investigating the role of buyer power for international markets. Buyer Power

Raff Trade, Heterogeneity, Intermediation 15 Buyer Power and Welfare – IO Perspective  Countervailing power hypothesis (Galbraith, 1952): buyer power counteracts seller power (second-best solution).  If sellers have little or no power, increased buyer power unambiguously leads to higher retail prices and lower welfare.  Recent IO literature looks at implications for prices and welfare of different contractual tools big buyers may employ w.r.t. to manufacturers: Marx and Shaffer (2004), Rey and al. (2005), Inderst and Wey (2004) General conclusion: retailers with market power have considerable scope for anti-competitive behavior. Buyer Power

Raff Trade, Heterogeneity, Intermediation 16 Our approach Start from recent IO literature by looking explicitly at the contractual arrangements between buyers and sellers. Extend the analysis to an international environment characterized by barriers to trade and asymmetries in the market shares of manufacturers. How does trade liberalization affect consumer prices and welfare in the presence of buyer power? How does this compares to a world in which producers have market power? Buyer Power

Raff Trade, Heterogeneity, Intermediation 17 Trade Literature on Intermediaries Rauch (2001) on the role of networks in international trade, Feenstra and Hanson (2004) on the role of Hong Kong intermediaries with respect to Chinese products, Raff and Schmitt (2005, 2006) on the role of exclusive territory and exclusive dealing in international markets Richardson (2004) on the comparison between exclusivity in the distribution of domestic products and trade policy to restrict the market access of foreign producers. Basker and Van (2005): only paper on buyer power in an international trade context. Focus is different from ours since they want to explain why, in the presence of economies of scale in retailing and in the import process, trade liberalization has led to an explosion of imports by large buyers. Buyer Power

Raff Trade, Heterogeneity, Intermediation 18 Model  Two differentiated retailers, R 1 and R 2, who distribute a homogeneous product in the domestic market.  The product can be obtained from a domestic manufacturer, h, and/or a foreign manufacturer, f.  Costs: Marginal production cost: c Marginal cost of distribution: zero  Preferences: where q‘s are quantities bought from the retailers. Buyer Power

Raff Trade, Heterogeneity, Intermediation 19 Demand faced by retailer i=1,2: Contracts: -Retailer i offers two-part tariffs to manuf. j, contingent on exclusivity E or no exclusivity N (j may sell to rival retailer) Timing of the game 1.Retailers make take-it-or-leave-it offers to manufacturers. 2.Manufacturers accept or reject contracts from one or both retailers. 3.Contracts are implemented and retailers compete in prices. Buyer Power

Raff Trade, Heterogeneity, Intermediation 20 Approach:  Derive equilibrium in autarky, where retailers can only by from manuf. h (Rey, Thal and Verge, 2005)  Then derive equilibrium in free trade, where both manufacturers are active.  Compare equilibrium prices and welfare in the two cases.  Extend results to the case of positive, non-prohibitive trade costs. Two equilibrium outcomes:  Exclusive contracts (E): manuf. sign exclusive contracts with one retailer, the other retailer does not sell  Non-exclusive contracts (N): both retailers are active (either non-exclusive contracts or each retailer has exclusive contract with a separate manuf.) Buyer Power

Raff Trade, Heterogeneity, Intermediation 21 Autarky – Exclusive contract equilibria Contracts: -conditional on exclusivity, offer the manufacturer a wholesale price equal to marginal cost and a fixed transfer equal to the entire monopoly profit, -for non-exclusivity, zero transfer. Manuf. h accepts one of the exclusive contracts. These equilibria always exist - trivially. Retailers compete to be the exclusive retailer, and are forced to give up the entire profit to the manuf. Equilibrium prices: -demand faced by the active retailer: q=1-p -wholesale price: c -retail price: -manuf. profit: Buyer Power

Raff Trade, Heterogeneity, Intermediation 22 Autarky - Non-exclusive equilibria Consider the one that is Pareto-undominated for the retailers. Two equilibrium conditions: 1.Manuf. must be indifferent between accepting one retailer's exclusive contract and accepting both retailers non-exclusive contracts. 2.Wholesale price offered by retailer i has to maximize the joint profit of retailer i and the manuf. given the wholesale price offered by the rival retailer -i. Equilibrium wholesale price: Equilibrium retail price: Buyer Power

Raff Trade, Heterogeneity, Intermediation 23 Equilibrium existence: -Necessary condition for existence of a non-exclusive equilibrium: joint profit of the manufacturer and both retailers in the non-exclusive equilibrium exceeds the joint profit of a single retailer-manufacturer pair under exclusive contracts. -This is satisfied if b≤ , i.e., when the retailers are sufficiently differentiated. -Only in this case are there enough rents to prevent retailers from deviating to offering an exclusive distribution arrangement to the manufacturer. Buyer Power

Raff Trade, Heterogeneity, Intermediation b 0,73205 Exclusive Non-exclusive Buyer Power

Raff Trade, Heterogeneity, Intermediation 25 Free Trade – Exclusive contract equilibria  harder to sustain than in autarky, since the active retailer now has to compensate two manuf. for not selling to his rival.  We show that such an equilibrium can only exist if there is sufficiently little differentiation between retailers (b≥ ).  Equilibrium prices are the same as in the foreclosure equilibrium in autarky.  Retailers compete to foreclose their rival and in the process transfer their entire profit to the two manuf. Buyer Power

Raff Trade, Heterogeneity, Intermediation 26 Free Trade - Non-exclusive equilibria There are two possibilities: 1.each retailer deals exclusively with one manufacturer 2.at least one retailer buys from both manufacturers under a non-exclusive contract. Derive equilibria in four steps: -Prove that case (2) cannot occur in equilibrium, by showing that a deviation to dealing with a single manuf. is profitable. -Calculate equilibrium wholesale prices when each retailer buys from a single manufacturer. -Show that proposed contracts are best responses. -Verify necessary condition for existence. Buyer Power

Raff Trade, Heterogeneity, Intermediation b 0,73205 Exclusive Non-exclusive 0 b 0,67209 Non-exclusive Exclusive 1 Free Trade Autarky Buyer Power 0,61803

Raff Trade, Heterogeneity, Intermediation 28 Effects of Trade Liberalization – contracts and prices Buyer Power

Raff Trade, Heterogeneity, Intermediation 29 Buyer Power Effects of Trade Liberalization – social welfare

Raff Trade, Heterogeneity, Intermediation 30 Buyer versus seller power Buyer Power

Raff Trade, Heterogeneity, Intermediation 31 Buyer versus seller power Size of the rents accruing to the retailers and to the manufacturers differs depending on who has the power to make take-it-or-leave-it contract offers. More importantly, equilibrium prices and hence the competitive effects of free trade are different. Autarky Prices are at least as high under seller power than under buyer power. Reason: the domestic manufacturer is able to eliminate the competition between retailers by setting a wholesale price above marginal cost and extracting rents through the fixed fee. Under buyer power, retailers only internalize the effect of their wholesale price on the manufacturer, but not on the rival retailer. Hence competition is tougher under non-exclusive contracts. Buyer Power

Raff Trade, Heterogeneity, Intermediation 32 Free Trade Now compare retail prices in free trade: When there are non-exclusive contracts, retail price are the same under both buyer and seller power. But exclusivity, which occurs only under buyer power, leads to higher retail prices Buyer Power

Raff Trade, Heterogeneity, Intermediation 33 Buyer Power

Raff Trade, Heterogeneity, Intermediation 34 Conclusions Opening up markets to the forces of international trade has traditionally been seen as a means of inducing domestic industries to become competitive and more efficient. Monopoly rents are diluted, consumers gain from competition. Is this really true or can the rents that manufacturers may lose be captured by retailers, wholesalers and other intermediaries, especially once these become unavoidable agents in the process of reaching consumers? Buyer Power

Raff Trade, Heterogeneity, Intermediation 35 We obtain some surprising results: 1.Under some circumstances the rents can be completely captured by manufacturers once free trade is introduced, even if additional sources of supply are available in free trade and even if there is (imperfect) competition among retailers. 2.Hence buyer power does not necessarily mean that retailers capture the rents in free trade. 3.Price competition can be lower in free trade than in autarky because an equilibrium in which some retailers are foreclosed may be easier to sustain in free trade. 4.Hence economic integration may lead to a smaller increases in competition and smaller welfare gains than suggested by traditional models. Buyer Power

Raff Trade, Heterogeneity, Intermediation 36 What comes next? We do not yet have a theory of buyer power in an international context. -Buyer power in our model is exogenous: the retailers have all the bargaining power irrespective of the trade environment. -We only spell out the implications of the existence of buyer power – and find that it matters! -We have nothing to say about the idea that buyer power might be a by-product of freer trade. Need to endogenize market structure in retailing and in manufacturing to capture general equilibrium effects. Buyer Power

Raff Trade, Heterogeneity, Intermediation 37 International Trade and the Structure of Retail Markets Horst Raff (University of Kiel) Nicolas Schmitt (Simon Fraser University) Heterogeneous Retailers

Raff Trade, Heterogeneity, Intermediation 38 How does the retailing sector respond to globalization, especially the increased scope to import consumer products? 1. What are the effects of trade liberalization on the structure of retail markets and retail competition? 2. How does retail market structure affect the transmission of external shocks (fall in trade costs, exchange-rate changes) into consumer prices? 3. How does retail market regulation affect consumer prices, imports, pass-through of import prices? We address these questions in a model of trade with heterogeneous retailers. Heterogeneous Retailers

Raff Trade, Heterogeneity, Intermediation 39 Three stylized facts: 1. Retail market structure has changed dramatically Strong increase in market concentration due to growth of big national chains operating large stores. Retailing is often much more concentrated than manufacturing. 2. Big retailers handle a massive amount of trade Wal-Mart accounts for over 15% of US imports from China (Basker/Van). Big retailers are three times as likely to import from China as small retailers. Expansion of big retailers accounts for 19% of the growth in US consumer good imports from China. Heterogeneous Retailers

Raff Trade, Heterogeneity, Intermediation Distribution margins account for up to 50% of consumer prices Changes in the cost structure and competition in the retail sector will have strong effects on consumer prices and the demand for imports. Heterogeneous Retailers

Raff Trade, Heterogeneity, Intermediation 41 Policy Issues: 1. Pass-Through from Import to Consumer Prices Determines the gains from trade for consumers. Monetary policy and the choice of exchange rate regime depend on how external shocks are passed through into consumer prices. Pass-through from import into consumer prices appears to be very low (Exchange-rate disconnect puzzle). Retail sector plays a central role in explaining the seemingly low degree of pass-through since retail margins are such a big part of consumer prices. Which retail sector characteristics (trade costs, technology, productivity distribution,…) lead to the low pass-through rate? Heterogeneous Retailers

Raff Trade, Heterogeneity, Intermediation Retail-Market Regulation Some countries (France, Japan, Belgium, Italy,…) have a tradition of restricting the size of retail establishments. This affects retail market structure, imports and consumer prices. It limits the pass-through of import prices. France: consumers complain that their purchasing power is falling and that they don’t have access to cheap foreign goods. US: poor consumers benefit from the low-priced goods that Wal- Mart and other big retailers import from China (Broda and Romalis, 2008). Heterogeneous Retailers

Raff Trade, Heterogeneity, Intermediation 43 How does trade liberalization affect retail markets?  Retailers source goods through two channels: domestic sourcing – includes domestically produced goods and goods imported by third parties; imports.  Only the big retailers choose imports: low marginal cost (bypass additional layers of intermediaries, identify cheapest supplier,…) high fixed cost (operating buying offices, searching for suppliers, developing products, training suppliers, monitoring quality,…) Heterogeneous Retailers

Raff Trade, Heterogeneity, Intermediation 44  Hence trade liberalization favors big retailers: they tend to buy more imports, grow even bigger as a result, displace smaller competitors.  Evidence: Retail segments where the share of large retailers is high correspond to segments where the share of imports is high as well (Canada 2003: clothing, clothing accessories, footwear, audio, video, small electrical appliances, toys and games). US imports from China and other less-developed countries in rose especially quickly in retail sectors with the largest consolidation into chains (Basker and Van, 2008b). Heterogeneous Retailers

Raff Trade, Heterogeneity, Intermediation 45 Modelling issues 1. Significant size differences among retailers Few big, efficient firms and many small, inefficient firms. Pareto distribution of productivity provides a good fit (Campbell and Hopenhayn, 2005). 2. Fixed cost of direct imports Cost of maintaining buying offices, cooperating with foreign partners to bypass intermediaries, acquiring information, Endogenous mark-ups Important channel for pass-through. Melitz, Ottaviano, Market Size, Trade and Productivity, REStud Heterogeneous Retailers

Raff Trade, Heterogeneity, Intermediation 46 Model of firm heterogeneity in retailing  Continuum of retailers selling in the domestic market: retail services are non-tradable retailers are differentiated (products, retail location or services differ)  Consumers: L consumers each supplying 1 unit of labor Each consumer has quasi-linear preferences over goods sold by retailer i and the numeraire good y: Heterogeneous Retailers

Raff Trade, Heterogeneity, Intermediation 47  Market demand faced by retailer i, where N is the mass of consumed varieties, is the average retail price. Heterogeneous Retailers

Raff Trade, Heterogeneity, Intermediation 48  Technology Labor is the only factor of production (price of labor = 1) Labor requirements: Heterogeneous Retailers

Raff Trade, Heterogeneity, Intermediation 49  Pareto distribution of cost over support  Monopolistic competition in retailing: Retailers take the average industry price as given, earn zero profit in equilibrium Heterogeneous Retailers

Raff Trade, Heterogeneity, Intermediation 50  Profit maximization by retailer i: When sourcing domestically: When relying on direct imports:  Profit maximizing outputs: Heterogeneous Retailers

Raff Trade, Heterogeneity, Intermediation 51  Maximized profits:  Marginal cost at which a retailer is indifferent between domestic sourcing and direct imports:  Expected-zero-profit condition: Heterogeneous Retailers

Raff Trade, Heterogeneity, Intermediation 52 Equilibrium  Endogenous variables:  How does trade liberalization (marginal decrease in t) affect the equilibrium values of these variables? Examine the signs of and Then determine how the average retail price, number of active retailers, average output and the variance of output change with trade liberalization. Heterogeneous Retailers

Raff Trade, Heterogeneity, Intermediation 53 c Profits Imports Domestic Sourcing Inactive Profit functions (gross of sunk entry cost) Heterogeneous Retailers

Raff Trade, Heterogeneity, Intermediation 54 c Profits Imports Domestic Sourcing Trade Liberalization Inactive Heterogeneous Retailers

Raff Trade, Heterogeneity, Intermediation 55 Effects of Trade liberalization  More retailers source goods from abroad  Least efficient retailers become inactive This implies: Lower average retail price and, if the trade cost is sufficiently small, Higher average output, lower output variance Lower mass of active retailers Heterogeneous Retailers

Raff Trade, Heterogeneity, Intermediation Pass-through of import prices into  consumer prices of imported goods  consumer prices of domestic goods  average consumer prices Heterogeneous Retailers

Raff Trade, Heterogeneity, Intermediation 57 Heterogeneous Retailers

Raff Trade, Heterogeneity, Intermediation 58 Pass-through  First term: mark-up (share of cost savings passed on to consumers) times expected import share Import share depends on trade cost and k (high k = distribution skewed toward inefficient retailers)  Last three terms (from selection effect): fall in expected retail cost lower mark-up for domestically sourced goods Higher import share/prob. that a good is imported  Overall pass-through rate can be greater than unity. Heterogeneous Retailers

Raff Trade, Heterogeneity, Intermediation Retail Market Regulation  France: “Loi Raffarin”  Japan: Large-Scale-Retail-Store Law  Regulation acts like a constraint on the sales of the most efficient firms.  How does this affect retail market structure, consumer prices, imports, pass-through of import prices? Heterogeneous Retailers

Raff Trade, Heterogeneity, Intermediation 60  Critical value of the marginal cost at which a firm is just constrained (assuming that the firm for which the constraint is just binding is an importer):  What are the effects of a tightening of constraint ? Even less efficient importers will now be constrained. Constrained retailers raise their prices. Residual demand for unconstrained retailers rises. Heterogeneous Retailers

Raff Trade, Heterogeneity, Intermediation 61 c Profits Direct Imports Domestic Sourcing Profits of unconstrained firms Heterogeneous Retailers

Raff Trade, Heterogeneity, Intermediation 62 What happens to the average retail price?  Constrained firms raise their price, and the likelihood that a firm is constrained is higher.  Greater probability that inefficient retailers remain active.  But retailers are more likely to source (cheaper) goods from abroad. Heterogeneous Retailers

Raff Trade, Heterogeneity, Intermediation 63 Pass-through of import into consumer prices  Constrained firms do not change their retail price when import prices fall.  Only unconstrained firms lower their price in response to a fall in import prices. Heterogeneous Retailers

Raff Trade, Heterogeneity, Intermediation 64 Retail Competition and Welfare  Competition: Herfindahl Index  Welfare effect Heterogeneous Retailers

Raff Trade, Heterogeneity, Intermediation 65 Conclusions 1. Trade liberalization changes retail market structure and reduces average retail prices:  More direct imports  Small retailers are forced to shut down Heterogeneous Retailers

Raff Trade, Heterogeneity, Intermediation Pass-through of import into consumer prices:  Incomplete and increasing when trade is liberalized  Consistent with empirical evidence Pass-through has increased over time (Campa, Goldberg). Differences in pass-through rates in the Euro area are driven by differences in openness to non-Euro-area imports (Campa, Gonzales Minguez, 2006). Heterogeneous Retailers

Raff Trade, Heterogeneity, Intermediation Retail Market Regulation  Raises the likelihood that inefficient retailers survive  Induces more retailers to source from abroad  Tends to raise average consumer prices  Tends to reduce pass-through Heterogeneous Retailers

Raff Trade, Heterogeneity, Intermediation 68 Raff/Schmitt Manuf. and Retailers in the Global Economy 68 Manufacturers and Retailers in the Global Economy Horst Raff (University of Kiel) Nicolas Schmitt (Simon Fraser University)

Raff Trade, Heterogeneity, Intermediation 69 Raff/Schmitt Manuf. and Retailers in the Global Economy Increased importance of services in general and wholesale/retail trade in particular US employment fell in manufacturing between 1970 and 1990 but rose by 71% in wholesale/retail trade; US retail industry is second largest industry in terms of employment (10.5% share). In Canada, retailing accounted for 12% of employment in % of retailer expenditure on inputs is on labor. Retailing contributed 22% to productivity growth in the business sector between 1990 and Retailers are becoming bigger, retailing more concentrated More varieties, Greater average size, Higher ratio of square footage to sales. Stylized Facts

Raff Trade, Heterogeneity, Intermediation 70 Raff/Schmitt Manuf. and Retailers in the Global Economy 70 3.Retailers have become gatekeepers of consumer goods markets. Slotting allowances (lump-sum payments made by manufacturers to retailers to carry their products) have become an important feature of retailing. Slotting allowances started in US in the early 1980s. They exist now in groceries, tobacco, household supplies, health and beauty aid, textiles, footwear, automotive parts, etc; Typically explained by retailers choosing among many new products, many of them likely to fail; Slotting not used by all retailers in a given segment and they vary a lot across products. Stylized Facts

Raff Trade, Heterogeneity, Intermediation 71 Raff/Schmitt Manuf. and Retailers in the Global Economy What explains the reallocation of labor from manufacturing to retailing, market concentration in retailing, the rise of slotting allowances? Trade liberalization: increase in the number of imported varieties Technological change: new technology has made it cheaper to handle larger variety of goods Research Questions

Raff Trade, Heterogeneity, Intermediation 72 Raff/Schmitt Manuf. and Retailers in the Global Economy How does trade liberalization affect product variety, prices and welfare when retailers act as gatekeepers? We address these questions in a general equilibrium model of manufacturing and retailing. Research Questions

Raff Trade, Heterogeneity, Intermediation 73 Raff/Schmitt Manuf. and Retailers in the Global Economy Retailing (Feenstra and Ma, 2008) Multi-product retailers choosing assortment and retail prices Each retailer takes into account the impact of adding a variety on the demand for the other varieties it sells (cannibalization) 2. Manufacturing (Krugman, 1980) Monopolistic competition Single-product manufacturers 3. Wholesale market (Raff and Schmitt, 2009) Bargaining between manufacturers and retailers over the wholesale price Two-part tariff Model Components

Raff Trade, Heterogeneity, Intermediation 74 Raff/Schmitt Manuf. and Retailers in the Global Economy 74 I. Model Key elements: Dixit-Stiglitz preferences, only factor of production: labor with endowment L. Preferences: Demand for variety i: where is aggregate expenditure on differentiated products Model

Raff Trade, Heterogeneity, Intermediation 75 Raff/Schmitt Manuf. and Retailers in the Global Economy 75  R retailers, all carrying different varieties  Retailer 1 carries the first M 1 products, retailer 2 carries the following M 2 products….  Total mass of varieties consumed  The CES price index is: Model

Raff Trade, Heterogeneity, Intermediation 76 Raff/Schmitt Manuf. and Retailers in the Global Economy 76  Symmetry: each retailer sets the same retail price for all the products he sells:  CES price index  Price elasticity of demand where market share of retailer r is: Model

Raff Trade, Heterogeneity, Intermediation 77 Raff/Schmitt Manuf. and Retailers in the Global Economy 77 Technology  Retailing labor requirement:  Manufacturing labor requirement to produce variety i: Model

Raff Trade, Heterogeneity, Intermediation 78 Raff/Schmitt Manuf. and Retailers in the Global Economy 78 Wholesale Market  Two-part tariffs w – wholesale price T – transfer/fixed payment from the manufacturer to the retailer (slotting allowance if T is positive).  Bargaining: Simultaneous bargaining between retailer-manufacturer pairs Division of surplus of each pair through “efficient” bargaining Model

Raff Trade, Heterogeneity, Intermediation 79 Raff/Schmitt Manuf. and Retailers in the Global Economy 79 II. Equilibrium  Retailer maximizes:  First-order conditions: with respect to retail price leads to: with respect to retailer’s assortment, M: marginal benefit is reduced by the cannibalization effect Equilibrium

Raff Trade, Heterogeneity, Intermediation 80 Raff/Schmitt Manuf. and Retailers in the Global Economy 80  Total surplus for a manufacturer-retailer pair:  This surplus is maximized for a wholesale price>mc (due to cannibalization effect):  Externality since each retailer-manufacturer pair ignores the impact of its deal on other retailer-manufacturer pairs.  The zero-profit condition for manufacturer then determines T: Equilibrium

Raff Trade, Heterogeneity, Intermediation 81 Equilibrium  Zero-profit condition for retailers  Labor-market clearing condition  We can now solve for the equilibrium values of: Raff/Schmitt Manuf. and Retailers in the Global Economy 81

Raff Trade, Heterogeneity, Intermediation 82 Raff/Schmitt Manuf. and Retailers in the Global Economy 82 # of retailers: Retailer’s assortment: Retail price: Output per variety: Slotting allowance: Equilibrium

Raff Trade, Heterogeneity, Intermediation 83 Equilibrium Proposition 1: The equilibrium slotting allowance is i. increasing in the retailer fixed cost k o and cost per variety k 1 ii. decreasing in the manufacturer fixed cost iii. increasing in the elasticity of substitution Raff/Schmitt Manuf. and Retailers in the Global Economy 83

Raff Trade, Heterogeneity, Intermediation 84 Raff/Schmitt Manuf. and Retailers in the Global Economy 84 III. Second-best Allocation # of retailers: Retailer’s assortment: Output per variety: Retail price: Equilibrium

Raff Trade, Heterogeneity, Intermediation 85 Raff/Schmitt Manuf. and Retailers in the Global Economy 85 This implies: Excessive product variety implies that too much labor is devoted to distributing these varieties as opposed to producing output of each variety. Equilibrium

Raff Trade, Heterogeneity, Intermediation 86 Raff/Schmitt Manuf. and Retailers in the Global Economy 86 IV. Product market integration and technological change in retailing  What are the forces driving the structural changes in retailing and manufacturing? Shift in employment from manufacturing to retailing Retail market concentration Rise in slotting allowances.  Can we link these changes to market integration or technological change? Comparative Statics

Raff Trade, Heterogeneity, Intermediation 87 Raff/Schmitt Manuf. and Retailers in the Global Economy 87 Economic Integration A. Product market integration with C countries  Market size remains the same for retailers (retail services are non-tradeable).  Market increases for manufacturers: each can now sell to (and spread its fixed cost over) C markets.  Per-market fixed cost is equal to  Adjusted labor-market clearing condition:

Raff Trade, Heterogeneity, Intermediation 88 Raff/Schmitt Manuf. and Retailers in the Global Economy 88 Proposition 4: Product-market integration: i. leaves the number of retailers unchanged, ii. raises the product assortment carried by each retailer, iii. raises the total mass of varieties available to consumers, iv. raises slotting allowance per variety v. shifts labor from manufacturing to retailing. Economic Integration  Labor saved through decrease in domestic varieties is reallocated to retailing, enabling retailers to carry more imported varieties.  Slotting allowances increase as the quasi-rents earned by manufacturers fall by less than the fixed cost.

Raff Trade, Heterogeneity, Intermediation 89 Raff/Schmitt Manuf. and Retailers in the Global Economy 89 Technological Change in Retailing B. Technological Change in Retailing How is the equilibrium affected by a marginal reduction in k 1 at the expense of a marginal increase in k o ? Proposition 5: Technological change in retailing i. increases retail market concentration by reducing the number of retailers and increasing product assortment of each retailer, ii. has ambiguous effects on the allocation of labor between manufacturing and retailing and on the size of slotting allowances.

Raff Trade, Heterogeneity, Intermediation 90 Raff/Schmitt Manuf. and Retailers in the Global Economy 90 V. Welfare and Policy Implications  Fundamental distortion in the relationship between multi-product retailers and manufacturers.  Product-market integration does not reduce this distortion, although welfare rises: consumers spread their income over a greater variety of goods. Retail Market Integration  Equivalent to full market integration: goods are simply traded by retailers instead of manufacturers.  Greater number of retailers in the C countries so that the market share of each retailer falls. Welfare

Raff Trade, Heterogeneity, Intermediation 91 Raff/Schmitt Manuf. and Retailers in the Global Economy 91 Welfare Proposition 6: Retail market integration i. moves the economy closer to the second best, ii. raises social welfare by more than product market integration.  Retail market integration implies that consumers buy from a larger number of retailers, each carrying a larger assortment.  As retailer market share falls, the cannibalization effect becomes smaller.  The wholesale price moves closer to marginal cost.

Raff Trade, Heterogeneity, Intermediation 92 Raff/Schmitt Manuf. and Retailers in the Global Economy Reallocation of labor from manufacturing to retailing and rise in slotting allowances are consistent with product- market integration. 2. Rise in retail market concentration is consistent with technological change in retailing. 3. Product-market integration raises social welfare but does not address the inefficiency created when big, multi-product retailers deal with small, single-product manufacturers. 4. Retail market integration moves the economy closer to the second best, hence yields bigger gains than product-market integration. Conclusions

Raff Trade, Heterogeneity, Intermediation 93 Raff/Schmitt Manuf. and Retailers in the Global Economy 93 Relation to the Literature  Effects of trade on retail market structure: Raff, Schmitt (2010): heterogeneous retailers face fixed cost of importing, trade liberalization raises market concentration in retailing as the big retailers get bigger and the small retailers are forced out Eckel (2010): increase in international product variety raises retailer fixed costs and leads to market concentration Basker/Van (2009): economies of scale in importing allow a chain store to take markets away from small, independent retailers.

Raff Trade, Heterogeneity, Intermediation 94 Raff/Schmitt Manuf. and Retailers in the Global Economy 94 Relation to the Literature  Retailer (buyer) market power may have negative effects on the gains from trade: Raff, Schmitt (2009): gains from trade are generally smaller in markets with buyer power compared to markets with seller power and may even be negative if trade leads to more exclusive dealing. Eckel (2010): possible losses from trade when greater market concentration allows retailers to raise their mark-up.

Raff Trade, Heterogeneity, Intermediation 95 Raff/Schmitt Manuf. and Retailers in the Global Economy 95 Relation to the Literature  Growing literature on intermediation in international trade. Raff, Schmitt (2005, 2006) Antras, Costinot (2010) Akerman (2010) Blum, Claro, Horstmann (2010) AER P&P (2010)

Raff Trade, Heterogeneity, Intermediation 96 Greasing the Wheels of International Commerce: How Services Facilitate Firms‘ International Sourcing Peter Debaere (Virginia) Holger Görg (Kiel) Horst Raff (Kiel)

Raff Trade, Heterogeneity, Intermediation 97 What role do services play in the international sourcing of material inputs? 1. Does better access to services induce more offshoring by manufacturing firms? 2. How crucial is access to local services? 1. Does this effect differ across firms? We examine these questions both theoretically and empirically using firm-level data from Ireland. Research Questions

Raff Trade, Heterogeneity, Intermediation Increased importance of global production networks Firms pursue complex offshoring strategies Imports of intermediates from many foreign suppliers 2. Global production requires “intermediation” services such as transportation, financing, insurance,…. Services grease the wheels of international commerce (Jones and Kierzkowski, 1990). 3. Large service sector geared to facilitating offshoring. Supply-chain management. Third-party logistics firms (UPS, DHL,…) coordinate and integrate a fragmented value chain. Observations

Raff Trade, Heterogeneity, Intermediation 99  Trade literature on offshoring (e.g. Antras/Helpman) has so far largely ignored the link between services and offshoring.  Exceptions: Jones and Kierzkowski (1990) Deardorff (2000) Long, Riezman, Soubeyran (2005)  Huge business literature on supply-chain management that explores how this link can be organized and optimized. Literature

Raff Trade, Heterogeneity, Intermediation 100  Model that explains the sourcing decision of individual firms as a function of: Availability of local services Firm characteristics – labor productivity, size,…  Empirical analysis: Plant-level data from Ireland on domestic and international sourcing of materials and services. How is the ratio of imported materials to total sales affected by firm characteristics and the availability of services (number of service firms in different regions in Ireland)? Structure of the Paper

Raff Trade, Heterogeneity, Intermediation Nearly all firms in Ireland source some materials from abroad. 2. How much do they import relative to total material input or total output?  How does this fraction depend on the productivity of the firm?  How does it depend on the availability of local services? Model:  Melitz, Ottaviano, Market Size, Trade and Productivity, REStud  Raff, Schmitt, Imports, Pass-Through, and the Structure of Retail Markets (2009). Modelling Issues

Raff Trade, Heterogeneity, Intermediation 102 International sourcing by heterogeneous firms Continuum of final-good producers selling in the local (Irish/European market): Differentiated final products, monopolistic competition in final goods, perfect competition in intermediates. Consumers: With quasi-linear preferences: Model

Raff Trade, Heterogeneity, Intermediation 103 Market demand faced by firm i is: where N is the mass of consumed varieties, is the average price. Model

Raff Trade, Heterogeneity, Intermediation 104 Technology Sunk cost of market entry: Production of a finished good requires c units of labor and one unit of a composite intermediate good x. Intermediate x combines a domestic input, z, and an imported input, m, according to: Labor productivity is Pareto distributed: Model

Raff Trade, Heterogeneity, Intermediation 105 Two options for importing materials 1. Use local services to organize supply chain (mode D): Variable cost of imported materials (plus services) = This cost depends negatively on service availability. 2. Internalize the supply chain or import services (mode I): Variable cost of imported materials = 1 Fixed cost of internalization/imports: Model

Raff Trade, Heterogeneity, Intermediation 106  Conditional demands for imported intermediates:  Cost functions for composite intermediate input:  Profit maximization by firm i: Model

Raff Trade, Heterogeneity, Intermediation 107  Profit-maximizing outputs:  Profit-maximizing prices: Model

Raff Trade, Heterogeneity, Intermediation 108  Maximized profits:  Marginal cost at which a firm is indifferent between buying services on the market and internalizing services:  Expected-zero-profit condition: Model

Raff Trade, Heterogeneity, Intermediation 109 c Profits Mode I: Internalize services Mode D: use domestic services Equilibrium Inactive Profit functions (gross of sunk entry cost)

Raff Trade, Heterogeneity, Intermediation 110  Endogenous variables: Firm-level observations:  Spending on domestic materials, z  Spending on imported materials, m  Sales revenue: pq How does service availability affect m/(pq)? Equilibrium

Raff Trade, Heterogeneity, Intermediation 111 Effects of Service Availability  For mode-D firms a thicker service market implies a higher ratio of imported intermediates to sales: Substitution toward imported materials Lower output price Equilibrium

Raff Trade, Heterogeneity, Intermediation 112 Effects of Service Availability  Mode-I firms are only indirectly affected by service availability: no substitution effect, price of output falls. Equilibrium

Raff Trade, Heterogeneity, Intermediation 113 Empirical Implications  Ratio of imported materials to sales depends positively on availability of local services, is higher for more productive (lower c) firms.  Most productive firms internalize/import services, and therefore are not directly affected by local service market thickness.

Raff Trade, Heterogeneity, Intermediation 114 Empirical model  Plant i, industry j, region r, time t.  Thickness measure: thickness of services in industry j and region r in which firm i operates at time t.  Controls X Labor productivity of firm i (firm heterogeneity) Size, dummies for exporters, foreign and domestic multinationals (firm heterogeneity, internalization) Industry services intensity, industry intensity of use of local services  Dummies for three digit industry, region, time

Raff Trade, Heterogeneity, Intermediation 115 Data  Plant level data for Ireland: 2000 to 2004 Annual Business Survey of Economic Impact Survey of plants with at least 10 employees Plants in manufacturing as well as (internationally tradable) services Provides information on materials and services purchases, industry, nationality of ownership  In 2004, 1206 manufacturing plants, of which 343 foreign MNEs, 108 Irish MNEs, 557 domestic exporters, 198 purely domestic  In 2000 also information on domestic multinationals  3 regions: Dublin, South, Border/Midlands/West

Raff Trade, Heterogeneity, Intermediation 116 Data  Standard stylized facts: MNEs are bigger, more productive than local firms Exporters are bigger, more productive than non- exporters  Material imports/sales revenue: 20% on average max: 27 % Transport Equipment (NACE 34) min: 12 % Food (NACE 15)  Service thickness in each region: # of service firms # of service MNCs vs. domestic service firms “effective thickness”: # of service firms x service use in industry j

Raff Trade, Heterogeneity, Intermediation 117 Alternative service availability measure  variation across industries based on input-ouput linkages: Number of service firms in sector s: Inputs from service sector s used in manuf. sector j as as a percentage of output of industry j: Number of manufacturing firms in region r:

Raff Trade, Heterogeneity, Intermediation 118 Data

Raff Trade, Heterogeneity, Intermediation 119  All firms vs. subgroups (domestic and foreign MNEs, local firms, exporters)  Industry vs. firm-fixed effects  Different specifications to deal with endogeneity Estimation Results

Raff Trade, Heterogeneity, Intermediation 120 Table 5: All Plants Industry-Fixed Eff Time, Region Eff. LHS ln(imp/sales ) Estimation Results

Raff Trade, Heterogeneity, Intermediation 121 Table 5: OLS, all plants, industry, time, region dummies Dependent variable: ln(imported materials/sales)

Raff Trade, Heterogeneity, Intermediation 122 Dependent variable: ln(imported materials/sales) Table 5: OLS, subgroups, industry, time, region dummies.

Raff Trade, Heterogeneity, Intermediation 123 Table 7: exporters only, firm-fixed eff., time eff. Dependent variable: ln(imported materials/sales)

Raff Trade, Heterogeneity, Intermediation 124 Robustness checks  Endogeneity of service availability measure Dummies! Fixed effects. IV estimator using regional housing price index, first and second lags of availability measures as instruments. Valid instruments. Cannot reject exogeneity of variables (Durbin-Wu-Haussman test).  Include more time-varying variables at the region and industry level to alleviate concern that availability may pick up only regional time-varying characteristics.  Use alternative dependent variables: Imports relative to total inputs ln(exports*imports/sales)

Raff Trade, Heterogeneity, Intermediation 125 Conclusions  Availability of services is important for the decision to import material inputs.  This is especially so for local Irish firms.  Multinationals are not affected by the availability of local services (may internalize services provision or import services).  Evidence that services indeed grease the wheels of international commerce.

Raff Trade, Heterogeneity, Intermediation 126 Data

Raff Trade, Heterogeneity, Intermediation 127