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

© van Marrewijk, 2005 Fig. 5.1 Monopolistic competition and the re-location of a firm Q Region 2

© van Marrewijk, 2005 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 assumptions 1.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).

© van Marrewijk, 2005 Q Q Fig. 5.3 National exporting firm

© van Marrewijk, 2005 Fig. 5.4 Horizontal multinational Q Q

© van Marrewijk, 2005 Fig. 5.5 Vertical multinational Q Q

© van Marrewijk, 2005 Fig. 5.6 Summary of the firm’s main decisions

Outsourcing 3 main advantages of sub-contracting 1.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 The effect of outsourcing in production and income distribution

© van Marrewijk, 2005 Figure 5.8 Decision Process and firm types