Tutorial 7 for Discussion on the Week of 1 June 2020

1. Suppose the two countries we considered in the numerical example on pages 206-210
were to integrate their automobile market with a third country, which has annual
market for 3.75 million automobiles. Find the number of firms, the output per firm,
and the price per automobile in the new integrated market after trade. (Chapter 8,
Problem 2)

Ans: First, find the equilibrium number of firms in the three-country integrated market
by setting average cost equal to price across all markets. The 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.

Set the average cost equal to price (Profit Maximization) yields the following
expression:

(nF/S) + c = c + (1/bn)
n² = (1/b) x S/F
n = [(1/b) x S/F] ½

The numerical problem in the chapter gives us the following values (208-212):
(fixed cost) F= 750,000,000
(Sales; total output for whole industry) SHome = 900,000; SForeign = 1,670,000, Scountry 3
= 3,750,000
(Marginal cost) c = 5,000
(constant) b = 1/30,000
Next, compute the total market size (industry sales) as the sum of the market sizes in
Home, Foreign, and Country 3:
S = SHome+ SForeign + SCountry 3 = 900,000 + 1,600,000 + 3,750,000 = 6,250,000

Plug in these values to solve for n:

n= [30,000 x 6,250,000/750,000,000] ½ = 15.8 (add 5 new firms; more firms more
intense the competition, and hence the lower the price each firm will charge.)

As we cannot have 0.8 firms enter into a market, there will only be 15 firms that enter this
market (the 16th firm knows that it cannot earn positive profits and will not enter). Once
we know n, we solve for Q (firm’s output) and P (price charge per unit).

Output per firms: Q = S/n = 6,250,000/15 = 416,667

Price P = c + (1/bn) = 5,000 + 30,000/15 = 7,000

This price is lower (dropped from 8,000 to 7,000) than that charged when there were only
two countries in the market (table above; increased number of firms n=10 to n= 15)
 Figure: Effects of Lager Market

2. Go back to the model with firm performance differences in a single integrated market
(pages 214-215). Now assume a new technology becomes available. Any firm can
adopt the new technology, but its use requires an additional fixed-cost investment.
The benefit of the new technology is that it reduces a firm's marginal cost of
production by a given amount. (Chapter 8, Problem 4)

a. Could it be profit maximizing for some firms to adopt the new technology but not
profit maximizing for other firm to adopt that same technology? Which firms
would choose to adopt the new technology? How would they be different from the
firms that choose not to adopt it?

Ans: We can model this decision by defining the technology in the following terms: If
a firm invests in the technology T, it will face a fixed cost F, but face a marginal cost
Ct, which is lower than its marginal cost c without the technology.

1. Thus, we define the firm’s total cost with and without the technology as:
Group 2 (c2) : Cost without Technology = TC= cQ + F
Group 1 (c1) : Cost with Technology = TC* = ctQ + F+T
 2. A firm will choose to adopt this technology whenever TC*(adopt)＜TC (don’t
adopt): ctQ + F+T ＜ cQ+ F
T＜(c-ct)Q
Q＞T/(c-ct)

3. As with most decisions involving fixed cost, the technology is more likely to
increase a firm’s profits when the scale of production (a) increases (exporting firm
becomes larger upon adopted technology to produce more efficiently; Year1 concept
of economies of scale and increasing returns to scale to see why a firm’s profit will
increase.)

Next, compare a firm with low marginal cost (ct) and one with high marginal cost (c).

The gap c-ct will be smaller for a low MC firm than for a high MC firm. Thus, a firm with
low MC will need a higher level of output to justify the technology than a firm with high MC.

So, it is possible that some firms (high-cost firms) will choose to adopt the technology (new
lower c2t line; to reduce costs holding the assumption given that the new technology can
reduce a firm’s MC) while others (low-cost firms) do not. (minimizes the catch-up gap
between c1- and c2- type of firms.)

Find the blue highlighted gap: Q > T/(c - cT) to determine if high cost firms will choose to
adopt technology.
b. Now assume there also trade costs. In the new equilibrium with both costs and
technology adoption, firms decide whether to export and also whether to adopt the
new technology. Would exporting firms be more or less likely to adopt the new
technology relative to non-exporters? Why?

Ans: The trade costs raise the MC of exporting. A firm that exports faces a higher
MC than one that does not export and will, therefore, be more likely to use this new
technology and still profitable (c1+t ＜c* threshold, diagram below); c1+1 added with
trade cost is still lower than c2 without trade cost and produce solely for domestic
market. Should the non-exporter c2 one day start exporting goods, it will face with
losses, is not profitable to operate in the export market and thus exit when c2+t＞c*
threshold).

Trade cost = t
 3. In the chapter we described a situation where dumping occurs between two symmetric
countries. Briefly describe how things would change if the two countries had different
sizes. (Chapter 8, Problem 5)

a. How would the number of firms competing in a particular market affect the
likelihood that an exporter to that market would be accused of dumping? (Assume
the likelihood of a dumping accusation is related to the firm’s price difference
between its domestic price and its export price: the higher the price difference, the
more likely the dumping accusation.)

n competing firms increases – see Figure 8.4 Effects of a Larger Market and Fig 8.6 that
increases probability of dumping practices.
 Ans: The number of firms competing in a market increases as the size of the market
rises. (S↑, n↑) At the same time, the price charged in a market falls as the number of
firms competing in that market rises. (n↑, P↓) Thus, as the number of firms increases
(n ↑, S ↑), the price charged by exporters (and domestic firms) will fall (P ↓). This
increases the probability that a dumping charge will be filed.

b. Would a firm from a small country be more or less likely to be accused of

dumping when it exports to a large country (relative to a firm from the large
country exporting to the small country)?

Firm exporting from a small country to a large country will be more likely to be accused
of dumping (effects of a larger market)
 Ans: A firm exporting from a small country to a large country will have a greater
difference between its higher domestic price and its lower export price, resulting in
more companies 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.

4. Which of the following are direct foreign investments? (Chapter 8, Problem 6)

FDI - Either by setting up a subsidiary, or by acquiring shares (at least 10%), or
through a merger or joint venture.

a. A Saudi businessman buys $10 million of IBM stock.

Ans: No, it’s a portfolio investment.

b. The same businessman buys a New York apartment building.

Ans: Yes, it’s FDI.

c. A French company merges with an American company; stockholders in the U.S.

company exchange their stock for shares in the French firm.
Ans: Yes, it’s FDI.
 d. An Italian firm builds a plant in Russia and manages the plant as a contractor to
the Russian government.
Ans: If the Italian firm retains ownership in Russia, it is FDI. If the Italian firm does
not retains the ownership, it would not be FDI.

5. FDI s, according to their typology, can be divided into (1) horizontal and vertical; (2)
inward and outward; (3) portfolio investments and Greenfield. Classify the following
cases according to the above parameters: (Chapter 8, Problem 7)

(1) Horizontal FDI (replicate all production processes to another new location; motivated
to avoid trade cost and to be nearer to large customer base location -- tariff-jumping), a firm
replicates its production process in multiple locations (eg. VW setup plant in Qingdao and
Tianjin China; Intel setup plant in Kulim Malaysia, Ho Chi Minh Vietnam and Chengdu
China; McDonald’s).

(2) Vertical FDI (replicate only certain element or selected part of production process to
another new location; partly motivated by lower trade costs or production cost savings), a
firm breaks up its production chain across multiple locations (eg. Intel process silicon wafer
production in Mexico and builds a chip assembly/testing plant in Malaysia; Apple design and
product development in US, assembly in South Korea, China & Taiwan by Foxconn/Hon Hai
equipment manufacturer, or IBM computers assembled in Japan and Taiwan). FDI by MNC
is driven by a proximity-concentration. Internal economies of scale give an advantage to
locating all production in one location.

a. Hua Wei (a Chinese corporation) opens up a factory in Indonesia.

Ans: Horizontal/Outward/Greenfield

b. Samsung (a Korean chaebol) acquires a minority stake in Japanese stylus maker

Wacom.
Ans: Horizontal/ Outward/ Portfolio

c. Geely (a Chinese multinational auto manufacturer) opens some new dealerships in

the UK, after having acquired the Swedish Volvo.
Ans: Vertical/ Outward/ Greenfield
 d. Unilever (an Anglo-Dutch corporation and one of the world's main producers of
healthcare and food products) builds a new production factory in Thailand to
produce for regional markets in ASEAN.
Ans: Horizontal/ Outward/ Greenfield

6. Most firms in the apparel and footwear industries choose to outsource production to
countries where labor is abundant (primarily, Southeast Asia and the Caribbean) but
those firms do not integrate with their suppliers there. On the other hand, firms in
many capital-intensive industries choose to integrate with their suppliers. What could
be some differences between the labor-intensive apparel and footwear industries on
the one hand and capital-intensive industries on the other hand that would explain
these choices? (Chapter 8, Problem 9)

Ans: This question relates to the decision by a multinational to (1) outsource production
or (2) 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.

Suggested Answer:

Two choices: Outsourcing - (1) Independent Supplier, or (2) Foreign Affiliate

(A) Firms at the labor-intensive industries:

1. Consider the integration with Supplier – own materials (weak integration) do not own
materials (strong integration)

(B) Firms at the capital-intensive industries:

2. Consider why MNCs decide to outsource production or to engage in direct production
through foreign affiliates (control over firms).
 A multinational (MNC) prefers to use a foreign affiliate if it has a proprietary
knowledge/technology that is concerned about losing through outsourcing (due to weak
property rights and weak enforcement of IP laws 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 process that make
foreign affiliate production a better choice for a multinational.

In additional, close integration with suppliers (foreign affiliate) can speed up the
development technological solutions for the different problems or chances to developing
product innovation on improvement in existing products.

Hence, capital-intensive industries are likely to have more vertical FDI** (cost savings
advantage; specialize in narrow part of the production process, local ownership in alignment
and ease the monitoring of production facility) and intra-firms trade will be higher in such
industries (advantage of internalization or offshoring and lessen the conflicts between firm
and supplier especially on critical inputs).

For Example, Apple R&D design in US, parts of labor assembly in Japan/China (in
factories owned by Taiwanese conglomerate firm - Foxconn) and India.
MCQ

1. Two countries engaged in trade in products with scale economies, produced under
conditions of monopolistic competition, are likely to be engaged in
A) intra-industry trade
B) inter-industry trade
C) price competition
D) Heckscher-Ohlinean trade

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2. Product differentiation and internal economies of scale yield gains from trade in the form
of
A) the proximity-concentration effect
B) a proliferation of competitive firms
C) higher profits and lower trade costs
D) lower production costs and a greater variety of goods

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3. Intra-industry trade will tend to dominate trade flows when which of the following exists?
A) homogeneous products that cannot be differentiated
B) large differences between relative country factor availabilities
C) small differences between relative country factor availabilities
D) uneven distribution of abundant resources between two countries

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4. In the model of monopolistic competition, if firms have ________ average cost curves,
then opening trade will ________ the total number of firms and ________ the average price.
A) downward sloping; decrease; increase
B) upward sloping; decrease; increase
C) downward sloping; decrease; decrease
D) upward sloping; increase; decrease

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5. In the model of monopolistic competition, trade costs between countries cause
A) all firms that can earn a profit on domestic sales to export their goods at higher prices.
B) marginal costs of goods sold domestically to exceed the marginal costs of exported goods.
C) marginal costs of exported goods to exceed the marginal costs of goods sold
domestically.
D) all firms that can earn a profit on domestic sales to export their goods at lower prices.

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6. Complaints are often made to the International Trade Commission concerning foreign
"dumping" practices. These complaints typically claim that
A) U.S. firms are harmed by the unfair pricing of foreign exporters.
B) U.S. consumers are harmed by the lack of quality control or health concerns in foreign
countries.
C) foreign companies are charging prices that are lower than prices they charge countries
other than the U.S.
D) foreign companies are charging exorbitant prices that are higher than the true value of the
products.

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7. Consider the following two cases. In the first, a U.S. firm purchases 18% of a foreign firm.
In the second, a U.S. firm builds a new production facility in a foreign country. Both are
________, with the first referred to as ________ and the second as ________.
A) foreign direct investment (FDI) inflows; brownfield; greenfield
B) foreign direct investment (FDI) outflows; brownfield; greenfield
C) foreign direct investment (FDI) outflows; greenfield; brownfield
D) foreign direct investment (FDI) inflows; greenfield; brownfield

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8. When a multinational affiliate replicates elements of a production process in a foreign
country it is called ________ foreign direct investment.
A) horizontal
B) vertical
C) transitional
D) direct

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9. A firm is more likely to engage in horizontal foreign direct investment if
A) trade costs are low and there are internal economies of scale.
B) trade costs are high and there are internal economies of scale.
C) trade costs are high and there are external economies of scale.
D) trade costs are low and there are external economies of scale.

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10. If an industry is imperfectly competitive, and markets are segmented then
A) a firm may find that it should promote scale economies.
B) a firm may find that it is profitable to engage in dumping.
C) a firm may find that it should become more specialized.
D) a firm may find that international trade is unprofitable.

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11. Which of the following is an example of vertical FDI?
A) Zotye Automobile (a Chinese automaker) opens some new dealerships to sell electric
SUV in the United States.
B) Toyota—a Japanese automaker—constructs a truck manufacturing plant in Texas.
C) Chevron—an American petroleum firm—acquires a British petroleum firm.
D) General Motors—an American auto manufacturer—builds a plant in China to supply
Buicks to the Chinese market.

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12. With increasing returns (falling average costs), international trade will cause the demand
curves of monopolistically competitive firms to become _______________ because of
foreign competition and firms must _______________to meet foreign competition.
A) steeper; raise prices
B) flatter; lower prices
C) flatter; raise prices
D) steeper; lower prices

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13. Suppose that industry X and industry Y have intra-industry trade indexes equal to 0.80
and 0.20, respectively. Which of the following is then CORRECT?
A) There is a greater share of intra-industry trade in industry X than in industry Y.
B) There is a greater share of intra-industry trade in industry Y than in industry X.
C) Industry X and industry Y have equal shares of intra-industry trade.
D) There is no intra-industry trade in either industry X or industry Y.

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14. Intel produces microchips in China and Costa Rica using subsidiaries that it owns. Mattel,
in contrast, contracts with firms in several different countries to produce the Barbie doll,
which it then imports to the United States. Which of the following statements about the two
companies is correct?
A) Intel and Mattel are both involved in foreign outsourcing.
B) Intel and Mattel are both involved in foreign offshoring.
C) Intel is involved in foreign outsourcing, and Mattel is involved in foreign offshoring.
D) Intel is involved in foreign offshoring and Mattel is involved in foreign outsourcing.

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15. The table below gives U.S. and Indian labor requirements (hours per unit of output)
needed in each of four activities to produce the final product. Suppose that wages of unskilled
and skilled workers are $10 and $20 in the United States and $1 and $5 in India. If trade costs
are zero, where is the value chain sliced? Which operations will the United States offshore to
India?

A) assembly operations only

B) assembly operations and component production
C) assembly operations, component production, and office services
D) assembly operations, component production, office services, and R&D

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16. If two countries begin trade and both produce a product subject to internal economies of
scale, then the country with the __________ price will ________ production until it controls
________ of the market.
A) lower; increase; 50%
B) lower; increase; 100%
C) higher; increase; 50%
D) higher; increase; 100%

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17. Which of the following is NOT an example of intra-industry trade?
A) Trading Jeeps for Toyotas
B) Trading Boeing airplanes for Airbus airplanes
C) Trading Bush beer for Heineken beer
D) Trading oil for trucks

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18. A firm’s foreign direct investment decisions are, in the case of horizontal FDI, strongly
influenced by ______ and, in the case of vertical FDI, strongly influenced by _________.
A) material costs; labor costs
B) trade costs; production costs
C) labor costs; trade costs
D) production costs; trade costs

True or False

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19. In the model of monopolistic competition, trade costs between countries will cause
domestic and foreign markets to have different prices, different quantities sold, and different
profit levels. True

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20. With a market failure, marginal social benefit is not accurately measured by the producer
surplus of private firms, so that economic efficiency loss calculations are misleading. False

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21. Trading French wine for California wine is an example of intra-industry trade. True