FIRMS AND MARKETS : FROM LOCAL TO GLOBAL

1. FIRMS AND MARKETS:FROM LOCAL TO GLOBAL BA Festival of Science 2005, Trinity College Dublin Section F (Economics) Presidential Session 9.00 a.m. – 5.30 p.m., 7 September 2005 A one-day conference organised by the Geary Institute (UCD) and the Institute for International Integration Studies (TCD)

2. FROM LOCAL TO GLOBAL: FIRMS AND MARKETS IN INTERNATIONAL TRADE J. Peter Neary University College Dublin and CEPR BA Festival of Science 2005, Trinity College Dublin 7 September 2005

3. Introduction • Globalisation • General Equilibrium • Key: Interactions between goods and factor markets • Market Structure • Competition: Perfect or Monopolistic • Neary (JEL 2001, 2003a) • Oligopoly: Large Firms, entry barriers, strategic interaction • => “GOLE”: General Oligopolistic Equilibrium • Neary (JEEA 2003)

4. Plan • Market Structure: • Perfect Competition • Monopolistic Competition • Oligopoly • Extensions of GOLE: • Endogenous mode of competition • Heterogeneous firms and endogenous market structure • Implications for Policy: • Fostering entrepreneurship • Foreign direct investment (FDI) and trade costs

5. Plan • Market Structure: • Perfect Competition • Monopolistic Competition • Oligopoly • Extensions of GOLE: • Endogenous mode of competition • Heterogeneous firms and endogenous market structure • Implications for Policy: • Fostering entrepreneurship • Foreign direct investment (FDI) and trade costs

6. Perfect Competition • Traditional benchmark: • “Small” firms • Homogeneous goods • Production costs independent of firm scale • Pro: • Very adaptable • Con: • Unrealistic • No allowance for increasing returns, product differentiation, etc. • e.g., Implausible implications for international production patterns

7. O: No home or foreign production c F: Foreign production only • Equilibrium Production Patterns • in Perfect Competition a' H: Home production only c* a'

8. Monopolistic Competition • Chamberlin (1933) • “Small” firms • Differentiated goods • Declining average costs /Increasing returns to scale • No perceived interdependence • Pro: • Precise, tractable, versatile • Con: • Unrealistic • Dixit-Stiglitz (1977) preferences:

9. Monopolistic Competition (cont.) • Extensions: • Internal organisation of firms • Heterogeneous firms

10. Oligopoly • Perceived interdependence central • Firms large in their own market • Progress delayed by difficulties of modelling firms large relative to the economy • Resolution: Assume many sectors, all small • So: firms themselves are small in the economy • Demand: “Continuum-quadratic” preferences:

11. Oligopoly (cont.) • Simple model to illustrate effects of trade liberalisation • Heterogeneous sectors in 2 countries: • Integrated world market • Given numbers of firms at home & abroad: n, n* • Firms in each country have identical costs: c, c* • Cost configurations consistent with profitability:

12. O: No home or foreign production HF: Home and foreign production c F: Foreign production only • Equilibrium Production Patterns • for Arbitrary Home and Foreign Costs a' H: Home production only c* a'

13. Oligopoly (cont.) • To embed this in general equilibrium: • Costs depend on technology and wages • Wages (at home and abroad) determined in the labour markets

14. c F: Foreign production only O • Equilibrium Production Patterns • for a Given Cost Distribution H: Home production only HF: Home and foreign production c*

15. Oligopoly (cont.) • Specialisation patterns determined as shown • Wages and threshold sectors determined together in general equilibrium

16. Plan • Market Structure: • Perfect Competition • Monopolistic Competition • Oligopoly • Extensions of GOLE: • Endogenous mode of competition • Heterogeneous firms and endogenous market structure • Implications for Policy: • Fostering entrepreneurship • Foreign direct investment (FDI) and trade costs

17. Endogenous Mode of Competition • (joint work with Joe Tharakan, Natl. Univ. of Ireland, Maynooth) • “Cournot”/quantity-setting vs. “Bertrand”/price-setting • 2-stage capacity-price duopoly game: • [Kreps/Scheinkman (BJE 1983), Maggi (AER 1996)] • Investment in capacity commits a firm to charge higher prices • The credibility of the commitment depends on q, the cost premium of producing above capacity • If q is sufficiently high, then the outcome is “as if” competition was Cournot • Embed this in general equilibrium: • Assume a continuum of sectors z[0,1], with different values of q • Assume production (variable costs) uses unskilled labour and investment in capacity uses q(z) skilled labour; wages: w and r • Threshold sectors are then determined jointly with factor prices

18. Heterogeneous Firms and Endogenous Market Structure • Firm heterogeneity in monopolistic competition: • [Melitz (Em 2003), Helpman-Melitz-Yeaple (AER 2004)] • Firms pay a sunk cost to reveal their productivity • Draw c from a distribution g(c) • Given their productivity, they calculate their expected profits and choose to produce or exit • Exit if c < ce where p(ce) = 0 or r(ce) = f . • If exporting and/or FDI require an additional fixed cost, only high-productivity firms will engage in them • Predictions are consistent with micro-empirical evidence • Extend to a continuum of sectors: • Firms draw a productivity and a sector: {c, z} • Sectors differ in their fixed costs: f(z), f´>0 • In equilibrium, sectors have different expected firm numbers

19. E(ln2n) Monopolistic Competition 4 3 Oligopoly 2 1 Monopoly 0 1 Equilibrium Expected Market Structure

20. Plan • Market Structure: • Perfect Competition • Monopolistic Competition • Oligopoly • Extensions of GOLE: • Endogenous mode of competition • Heterogeneous firms and endogenous market structure • Implications for Policy: • Fostering entrepreneurship • Trade costs and foreign direct investment (FDI)

21. Fostering Entrepreneurship • How to encourage new (indigenous) firms? • Monopolistic Competition: • All entrants are de novo and identical • (Melitz: ex ante identical) • Spillovers from multinationals encourage indigenous entry • Theory: Markusen and Venables (EER 1999) • Empirical evidence: Görg and Strobl (EER 2002) • Oligopoly: Entry by diversification much more likely • Successful entrants are frequently incumbents in a related industry. • Theory: Gilbert and Newbery (AER 1982) • Empirical evidence: Geroski (IJIO 1995); Davies, Rondi and Sembenelli (IJIO 2001)

22. Trade Costs and FDI • Dominant view of FDI: • Theory has focused on “greenfield” case • Mostly horizontal (i.e., concerned with market access) • Relative to exporting, encouraged by trade costs • This view consistent with much evidence • But: counter-factual implication: falls in trade costs should reduce FDI • c.f. Ireland in 1990s: huge increase in FDI while trade costs in EU fell • Resolutions: • Export-platform FDI: Falls in internal EU trade costs • Cross-border mergers: brown not green-field • How to explain cross-border mergers? • M&A’s a huge % of all FDI • A high % of mergers are cross-border • Cross-border merger waves linked to market integration [EU Single Market; Mercosur]

23. Trade Costs and FDI (cont.) • How does trade liberalisation affect merger incentives? • No incentive if the 2 merging firms are identical • [Salant, Switzer, Reynolds (QJE 1983): “Cournot merger paradox”] • BUT: If firms differ in cost, a low-cost/high-cost takeover may be profitable

24. Incentives for foreign firms to take over home Incentives for home firms to take over foreign Home firms face similar incentives: c F O • Takeover Incentives H HF c*

25. Trade Costs and FDI (cont.) • Wage adjustment in general equilibrium: • Assume symmetric countries • Expanding and contracting firms in both • BUT: High-cost firms contract by more • So: Wages fall

26. c F O • Cross-Border Mergers Tend to Reduce Wages • (unlike greenfield FDI) H HF c*

27. Conclusion • Different approaches to modelling globalization • Here: Oligopoly in general equilibrium [GOLE] • Continuum of sectors avoids problems of firms being “too large” in the economy • Theoretical Applications: • Endogenous Mode of Competition [Bertrand vs. Cournot] • Heterogeneous Firms and Endogenous Market Structure • Level of fixed costs determines equilibrium expected number of firms • Policy Applications: • Fostering Entrepreneurship • Trade Costs and FDI • Standard model predicts that trade liberalisation will lower FDI • Oligopoly model avoids this • More work needed!

28. Further Reading • Neary, J.P. (2001): “Of hype and hyperbolas: Introducing the new economic geography," Journal of Economic Literature, 39:2, June, 536-561. • Neary, J.P. (2002): “"Foreign direct investment and the single market," The Manchester School, 70:3, June, 291-314. • Neary, J.P. (2003a): “Globalization and market structure,” Journal of the European Economic Association, 1:2-3, April-May, 245-271. • Neary, J.P. (2003b): “The road less travelled: Oligopoly and competition policy in general equilibrium,” in R. Arnott, B. Greenwald, R. Kanbur and B. Nalebuff (eds.): Economics for an Imperfect World: Essays in Honor of Joseph E. Stiglitz, Cambridge, Mass.: MIT Press, 485-500. • Neary, J.P. (2003c): “Monopolistic competition and international trade theory,” in S. Brakman and B.J. Heijdra (eds.): The Monopolistic Competition Revolution in Retrospect, Cambridge: Cambridge University Press, 159-184. • Neary, J.P. (2005): “Trade costs and foreign direct investment,” presented at CESifo Summer Institute Workshop on Recent Developments on International Trade: Globalization and the Multinational Enterprise, Venice, July 2005. • [All these papers available at www.ucd.ie/economic/staff/pneary/neary.htm]

29. European Trade Study Group (ETSG) 7th Annual Conference University College Dublin Thursday 8th – Saturday 10th September www.etsg.org