Managerial economics strategy by m perloff and brander chapter 17 global business

17.1 Reasons for International Trade• Comparative Advantage Reason – Comparative advantage: the ability to produce a good or service at lower opportunity cost than other countries – Supp

Chapter 17Global Business

• Managerial Problem

– Business is global Wheat and Rolls Royce cars are examples of it

– How does the price of wheat or a Rolls Royce change in response to a change in exchange rates? Does the change depend on the competitiveness of the

market?

• Solution Approach

– We need to examine why firms and countries participate in international trade, and how trade policies about taxes affects managerial decisions on investment and outsourcing

– Differentials in taxes, exchange rates, and outsourcing conditions affect

multinational enterprises’ investment decisions

17.1 Reasons for International Trade

• Comparative Advantage Reason

– Comparative advantage: the ability to produce a good or service at lower opportunity cost than other countries

– Suppose that the U.S and Japan do not trade and each country is in

competitive equilibrium (p = MC) The U.S produces and sells a bag of rice

for $1 and a silk scarf for $10 (10 rice bags = 1 scarf) Japan produces and sells a bag of rice for ¥200 and a scarf for ¥1,000 (5 rice bags= 1 scarf) The opportunity cost of scarves is lower in Japan, and the opportunity cost of rice

is lower in the U.S

• Comparative Advantage and Gains from Trade

– In the U.S and Japan example, the U.S has a comparative advantage in producing rice and Japan has a comparative advantage in producing scarves.– In the absence of transportation costs, both countries could gain if the U.S shipped rice to Japan and Japan shipped scarves to the U.S If the U.S could produce 1 scarf less and increase 10 rice bags, and Japan could produce 5 rice bags less and have 1 extra scarf, both countries could produce the same number of scarves and have 5 extra bags of rice

17.1 Reasons for International Trade

• Intra-firm Trade Reason

– Intra-firm trade: a single firm is on both sides of an international transaction

It exports the output from its operation in one country to an affiliated business unit in another country About one-third of world trade is intra-firm trade

– General Electric (GE), has production facilities in many countries, including Hungary and Romania To produce a refrigerator, GE must manufacture the basic parts and assemble those parts into a finished product So, GE may take advantage of intra-firm trade to reduce costs and maximize profits

• Gains from Intra-firm Trade

– Productivity information per day: A Hungarian worker can produce parts for 4 refrigerators or can assemble 4 refrigerators A Romanian worker can

produce parts for 2 refrigerators or can assemble 1 refrigerator

– Opportunity cost and comparative advantage: The Romanian plant has

comparative advantage in assembly (lower opportunity cost) and the Hungarian plant has comparative advantage in parts

– Intra-firm trade: The Romanian plant should assemble refrigerators and the Hungarian plant should manufacture parts

17.1 Reasons for International Trade

• Increasing Returns to Scale Reason

– Increasing returns to scale (IRS) production function: if all inputs are

doubled, the resulting output more than doubles Thus, all else the same,

having one IRS plant produce a given amount of output is less costly than spreading the production over two IRS plants

• Gains from IRS

– Production information: GE’s production function exhibits IRS, so that

doubling labor triples output GE has two plants in Hungary, each with 50 workers Operating independently, each plant can produce 200

refrigerators.

– Gains from IRS: Given IRS production function, GE may close one plant

and reallocate all 100 workers in only one facility Output will triple up to

600 units

– Gains from IRS and trade: If the Hungarian market size is small, only 400

refrigerators, GE can export the additional 200 units.

17.2 Exchange Rates

• The Price of a Currency

– An exchange rate is the price of one currency (such as the euro) in terms of another currency (such as the dollar)

– The euro (€) is the currency of 23 European countries that belong to the

Eurozone It can be traded for U.S dollars ($), Japanese yen (¥), British

pounds (₤), or many other currencies

• Determining the Exchange Rate

– Because currency is exchanged in a competitive market, we can use the

familiar supply and demand model to determine the exchange rate (dollar per euro)

– The demand curve slopes down because the quantity of euros demanded by Americans increases as the exchange rate falls: the euro costs fewer dollars

The supply curve of euros, S, slopes up because Europeans are willing to trade

more euros as the exchange rate increases

– The intersection of the supply and demand curves determines the equilibrium.– Many factors affect the supply and demand for a particular currency, including financial and macroeconomic conditions

17.2 Exchange Rates

• Exchange Rates and the Pattern of Trade

– If the exchange rate for the euro falls, U.S consumers and firms increase their demand for European goods (more goods for a given number of dollars)

Similarly, the demand of European consumers and firms for U.S goods falls – A change in exchange rates gives incentives to trade between countries

Goods flow from one country to the other, arbitrage, until no more profits can

be made

• Managing Exchange Rate Risk

– Exchange rates are determined in competitive markets, and not only

aggregate economic variables influence the equilibrium, but also political

factors So individual firms that operate in many countries bare the risk that exchange rates move in unexpected directions that may negatively affect

profits

– Reducing risk: a firm may transfer all risk to the other party by imposing the transaction in the firm’s own currency

– Hedging risk: a firm may buy a forward contract or a futures contract at a

fixed rate The Chicago Mercantile Exchange is the largest futures market in the U.S

17.3 International Trade Policies

• Trade Policies that Restrict Imports

– Historically, governments have concentrated on restricting imports rather than limiting or encouraging exports So, we focus on the effects of trade policies that restrict imports on prices, government revenue, and total surplus in a competitive domestic market

• Four Possible Import Trade Policies

– Allow free trade: Foreign firms may sell in the importing country without

restrictions

– Ban all imports: The government sets a quota of zero on imports

– Set a tariff: The government imposes a tariff on imported goods

– Set a positive quota: The government limits imports to a determined Q M level

• Application to the U.S Crude Oil Market

– To compare oil import trade policies, we assume that transportation costs are zero and that the U.S is small enough to be a price taker in world markets

– Consequently, the supply curve of oil is horizontal at the world price p*.

– The U.S can import as much crude oil as it wants at p* per unit.

17.3 International Trade Policies

• Free Trade Versus a Ban on Imports

– If p* is below the domestic price, preventing imports raises the price of

crude oil domestically, reduces consumer surplus, increases producer surplus, and creates deadweight loss.

– So the ban on imports does not help the U.S.

• Free Trade vs Ban on Imports: Graphical Analysis

– Free Trade: In Figure 17.2, the supply, S1,is horizontal at p* = $93 per barrel The equilibrium is at e1, the U.S daily consumption is 15 million barrels (7.7 imports).

– Ban: Limiting imports to zero, the crude oil supply is the U.S domestic

supply, S2 At the new equilibrium, e2, the new price is $218 per barrel for 10.2 million barrels per day.

– Deadweight loss: the ban increases PS in $1.09 billion per day but

reduces CS in $1.58 billion per day TS is reduced in $481 million per day.

17.3 International Trade Policies

17.3 International Trade Policies

• Free Trade Versus a Tariff

– Two common types of tariffs are specific tariffs (t dollars per unit) and ad valorem tariffs (α percent of the sales price).

– Tariffs are applied only to imported goods So tariffs do not raise as much tax revenue or affect equilibrium quantities as much as taxes applied to all goods.

• Free Trade vs Specific Tariff: Graphical Analysis

– Free Trade: In Figure 17.3, the supply, S1,is horizontal at p* = $93 per barrel The equilibrium is at e1, the U.S daily consumption is 15 million barrels (7.7 imports).

– t tariff of $40 per barrel: the new supply is horizontal at p = $133 and at the new equilibrium, e3, the daily consumption is 13.3 million barrels (5.2 imports).

– Deadweight loss: the specific tariff increases PS in $308 million per day, reduces CS in $566 million per day and government gets $208 million per day TS is reduced in $50 million per day, less than with a ban.

17.3 International Trade Policies

Figure 17.3

Effects of a

Tariff or a

Quota

17.3 International Trade Policies

• Free Trade Versus a Quota

– The effect of a positive quota is similar to that of a tariff

– Thus, a quota on imports of 5.2 million barrels per day leads to the same

equilibrium, e3 in Figure 17.3, as a tariff of $40 per barrel

• Positive Quota vs Specific Tariff: Deadweight Loss

– As it can be seen in Figure 17.3, the PS increases in $308 million per day and the CS reduces in $566 million per day either with a $40 tariff or a 5.2

million quota

– However, the government revenue of $208 million per day is only generated with a tariff This amount is not collected with a quota, so who gets it?

– If the government gives the right to sell the quota to foreign firms, they

benefit from buying at $93 internationally and selling it at $133 domestically

The TS is reduced in $258 million per day, instead of $50 million per day.

– If the government sells the right to sell the quota at $40 per barrel to any

firm, then the deadweight loss is exactly the same TS reduces by $50

million per day

17.3 International Trade Policies

• Why Trade Barriers? Rent Seeking

– If tariffs and quotas harm the importing country, why do governments impose trade barriers?

– It pays for producers to organize and lobby the government to enact

these trade policies because there are large individual potential gains On the other hand, consumers as a whole suffer large losses but the loss to any one consumer is usually small So firms engage in rent seeking

activities.

• Rent Seeking in Food and Tobacco Industries

– Lopez and Pagoulatos (1994) estimated the deadweight loss and the

additional losses due to rent-seeking activities in the U.S in food and tobacco products was $17.8 billion (in 2013 dollars), or 2.6% of the domestic consumption expenditure on these products.

– In dairy products and sugar manufacturing, the loss to consumers was

$84.8 billion, producers gained $64.4 billion and the government collected

$2.2 billion The deadweight loss was $17.8 billion.

17.3 International Trade Policies

• Other Reasons for Trade Policies: Creating Market Power

– A government can drive the price to a monopoly level by using tariffs or quotas, even if the underlying industry is highly competitive

– The Philippines used this policy to drive the price of coconut oil up.

• Other Reasons for Trade Policies: Strategic Trade Policy

– A government’s trade policy can increase the share of the profits in

imperfectly competitive industries that goes to its domestic industry.

• Other Reasons for Trade Policies: Contingent Protection

– Contingent protection is a trade policy that protects domestic producers

from certain actions by foreign firms or governments.

– Many countries have contingent protection laws against dumping (a

foreign producer sells a product at a price that is lower than its cost of production).

17.3 International Trade Policies

• Trade Liberalization and the World Trade System

– The General Agreement of Tariffs and Trade (GATT-1947) was replaced by the World Trade Organization (WTO-1995) to promote trade liberalization and limit trade policies that create distortions (tariffs and quotas to gain market power)

– Only 23 nations signed the first GATT agreement in 1947 At present, over

150 countries are members of the WTO and signatories to the GATT These countries are responsible for almost all of the world’s trade

– WTO allows members to establish preferential trading arrangements,

including multilateral or bilateral free trade agreements, like NAFTA or CAFTA

• Trade Liberalization Problems

– Critics of freer trade raise concerns about environmental standards and

wages and labor standards They predict developing countries may become pollution havens and manufacturing infernos

– However, the Mexican experience after entering NAFTA indicates neither a

notable increase in environmental problems, nor a notable decrease And

17.4 Multinational Enterprises

• Multinational Ownership Structure

– Multinational enterprises (MNE) normally have a parent company and a number of foreign affiliates with their own CEOs

– An affiliate is a company in which the parent has at least 10% ownership

If the ownership share is 50% or more, then the affiliate is called a subsidiary

– Each subsidiary normally has discretion over business decisions such as how much to produce, what prices to charge, and how much and where to advertise.

– Typically, a MNE is an interlocking network of corporations connected

through ownership.

• Becoming a Multinational

– A firm becomes a MNE through foreign direct investment (FDI)

– The two types of FDI are greenfield investments and the purchase of

foreign assets.

17.4 Multinational Enterprises

• International Transfer Pricing

– A MNE can gain tax and other advantages by trading goods among its subsidiaries located in different countries The key element is the transfer price: the price used for an intra-firm transfer of goods or services.

– Toyota Motor Corporation (parent firm) has two subsidiaries in the U.S., Toyota Motor Engineering & Manufacturing North America (TEMA) and Toyota Motor Sales, U.S.A., Inc (TMS) Toyota also has a subsidiary in Canada, Toyota Motor Manufacturing Canada Inc (TMMC)

– TEMA and TMMC sell cars to TMS, which in turn sells and distributes them

to Toyota dealerships The price at which TEMA sells cars to TMS is a domestic transfer price and the price at which TMMC sells cars to TMS is

an international transfer price.

• Transfer Pricing Using Toyota Motor Corporation

– We will examine how TMMC sets its transfer price to TMS for a Toyota RAV4 Electric crossover SUV, which was jointly developed with Tesla Motors and is produced by only TMMC as of 2012.

– We assume, for simplicity, that the RAV4 is a monopoly product.

17.4 Multinational Enterprises

• Profit Maximizing Transfer Pricing: Vertical Integrated Case

– If TMS were vertically integrated with TMMC (produce and sell cars) it would apply a

monopoly markup M to its marginal cost of producing a RAV4 car, m, to obtain its

– M > 1 because a profit-maximizing monopoly sets its price above its marginal cost.

• Profit Maximizing Transfer Pricing: Non-vertical Integrated Case

– In reality the two Toyota subsidiaries are independent TMMC is the monopoly

supplier of the electric RAV4 to TMS, and TMS sells RAV4’s to consumers

– TMMC sells to TMS at a monopoly transfer price, p* = M* × m, where M* is TMMC’s markup and m is its marginal cost

– TMS, in turn, sets a markup M to p* (its real marginal cost) and sells a RAV4 in the

parent company’s total profit So, Toyota parent should coordinate transfer pricing