Marginal Analysis Presentation

In this module, you will have the opportunity to master the following competency:

• Understand economic terminology and economic definitions pertaining to decisions made by managers.

Further, the content in this module will help you achieve the following learning objectives:

• Evaluating opportunity cost and what is given up in order to gain the objective that is set.

• Evaluating comparative advantage and absolute advantage. • Analyze marginal analysis comparing the marginal benefit of each new

item to the marginal cost of obtaining each new item.

Absolute and Comparative Advantage

The concept of trade-offs in economics also applies to international trade. In the 1700s, Adam Smith formulated a theory for international trade. He determined that countries would be better off if they could produce and export goods/services that they had an absolute advantage in, while importing goods/services that they had an absolute disadvantage in. When a nation or individual concentrates its productive efforts on producing a limited variety of goods, while obtaining other goods through trade, this is called specialization. Absolute advantage is when one nation produces goods and services at a lower resource cost than other countries. A resource is any input that is required for the production of a good, such as labor, capital, natural resources, or entrepreneurship. Resources are sometimes referred to as inputs, or factors of production.

As an example of absolute advantage, let us say that Country A and Country B each produce beef and wheat. Country A can produce beef with fewer resources than Country B, while Country B can produce wheat with fewer resources than Country A. This means that Country A has comparative advantage in producing beef, while Country B has comparative advantage in producing wheat. Therefore, Country A should specialize in beef production, while Country B should specialize in wheat. Then, both countries are able to produce more goods with fewer resources, and it will be mutually beneficial for them to trade with one another.

In the 1800s, the theory was further developed when David Ricardo pointed out a flaw in the model. He noticed that countries with advanced economies oftentimes had absolute advantage in most products. However, it was still beneficial for them to specialize and engage in international trade due to comparative advantage. For example, let us say that two roommates, Adam and Benny, split up the chores of washing dishes and cleaning the floors. Adam can wash dishes in one hour and can sweep and mop all the floors in three hours. Benny is less efficient at both chores, and takes two hours to wash dishes and four hours to clean the floors. Adam has absolute advantage in both goods. Does this mean that Adam should do everything? Of course not, as there is not any incentive for Adam to do so without compensation, or trade. Rather, each should specialize in the chore they have comparative advantage in. To see how that benefits both, let us see what would happen if they each produced both goods, with Adam doing both chores one week, and Benny doing chores the next week. Adam would complete chores in four hours total, with Benny completing all chores in six hours. This gives us an average of five hours per week spent on chores.

Dishes Floors Total

Adam 1 hour 3 hours 4 hours

Benny 2 hours 4 hours 6 hours

We can use opportunity cost to figure out who has the comparative advantage. Whoever can produce at a lower opportunity cost, compared to their trading partner, has comparative advantage in the production of that good. When we analyze the trade-off each roommate makes, we see that Adam can clean a floor in three hours, but he could clean three loads of dishes in that timeframe. So, his opportunity cost of cleaning floors is three loads of dishes. Benny is able to clean floors in four hours, but gives up two loads of dishes by using his time for that activity. Therefore, his opportunity cost of cleaning floors is two loads of dishes.

Benny has a lower opportunity cost of cleaning the floors, since he only gives up two loads of dishes, while Adam gives up three loads of dishes. Benny has comparative advantage, so he should specialize in cleaning the floors.

Meanwhile, Adam has comparative advantage in washing dishes. In order to wash a load of dishes, he gives up one-third of a floor cleaning. On the other hand, Benny gives up one-half of a floor cleaning to wash dishes. Adam has the lower opportunity cost of washing dishes, so he has comparative

advantage and should specialize in washing dishes. Mathematically, you will always see that one country/individual will have comparative advantage in production of one good, while the other country/individual will have comparative advantage in the other good.

Opportunity Cost of Dishes

Opportunity Cost of Floors

Comparative Advantage

Adam 1 load of dishes = 1/3 floor

1 floor = 3 loads of dishes

Washes dishes

Benny 1 load of dishes = 1/2 floor

1 floor = 2 loads of dishes

Cleans floors

Marginal Benefit and Marginal Cost

Firms often face decisions where they will have to consider the costs of an undertaking in relation to the benefits derived from an action. This is when marginal cost-benefit analysis is very useful. In economics, marginal means additional. Marginal benefit is the additional benefit derived from producing one more unit of a good or service. Conversely, marginal cost refers to the cost to produce that additional unit.

Marginal benefits tend to decrease over time, due to the law of diminishing returns. As such, increased production will generally result in increased profits, but at a decreasing rate. Additional units of a good should be produced as long as marginal benefit exceeds marginal cost. Eventually, we will reach a point where marginal benefit equals marginal cost, or MB = MC. This is the point where your total benefit is maximized. If you continue producing past this point, you will end up in a situation where marginal cost exceeds marginal benefit, so you would be worse off by producing past this point.

Let us look at an example of a firm that is considering investing in a mining operation. The project will cost $1,000,000 initially, with additional costs of $200,000 each year, and revenues of $500,000 each year. This would give a profit of $1,000,000 at the end of the six-year project.

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Total

Cost $1,000,0 00

$200,0 00

$200,0 00

$200,0 00

$200,0 00

$200,0 00

$2,000,0 00

Benef it

$500,000 $500,0 00

$500,0 00

$500,0 00

$500,0 00

$500,0 00

$3,000,0 00

This sounds great, but we also need to consider other investment opportunities. The easiest investment would be to simply do nothing and allow the money to work for itself. Consider if you had left the $1,000,000 initial investment in stocks earning 10% interest. After six years, you would have accrued a total interest of $771,561, which is lower than the total profit from the mining project. Thus, you should invest in the mining project.

Not all managers will be working for individual firms, however. A manager for a federal, state, or local government agency is a public servant and would also need to consider the needs of the people who may be impacted by this decision through externalities. Externalities are costs and benefits that are a side effect of commercial activity that affects other parties. Externalities are not reflected in an individual firm's costs or benefits. Rather, external costs and benefits are paid, or received, by others that are not privy to the decision being made.

As an example of externalities, let us say you have a neighbor who practices their violin incessantly. You are not involved in their decision, but you will be impacted by it. If they play beautifully, and you enjoy the violin, you may view this as a positive externality. You are receiving a benefit without having to pay for it. If, however, you have a new infant in your home who awakens every time your neighbor decides to practice, you would view this as a negative externality. You are paying part of the cost of this decision. The only decision- maker in this scenario is the violin player. Their cost/benefit analysis will look at the cost of the violin, opportunity costs of the time they spend playing, and many other variables, but they do not incorporate their neighbor's external costs and benefits into their analysis. Similarly, an individual firm will not incorporate external costs and benefits.

Let us go back to the example of a mining company. If a local government wishes to mine from publicly held land, they need to address these externalities. In addition to the expected profits, a positive externality would be increased employment, as the government project will need to hire workers. Negative externalities would include noise pollution as well as environmental concerns. Will the project affect the wildlife in the area, or any endangered or

rare species on the land? What about the local water supply? A government would include these externalities in their marginal cost-benefit analysis.

1 Introduction An Economist’s Theory of Reincarnation: If you’re good, you come back on a higher level. Cats come back as dogs, dogs come back as horses, and people—if they’ve been very good like George Washington—come back as money.

If all the food, clothing, entertainment, and other goods and services we wanted were freely available, no one would study economics, and we would not need managers. However, most of the good things in life are scarce. We cannot have everything we want. Consumers cannot consume everything but must make choices about what to purchase. Similarly, managers of firms cannot produce everything and must make careful choices about what to produce, how much to produce, and how to produce it. Studying such choices is the main subject matter of economics. Economicsis the study of decision making in the presence of scarcity.1 1 Many dictionaries define economics as the study of the production, distribution, and consumption of goods and services. However, professional economists think of economics as applying more broadly, including any decisions made subject to scarcity. Managerial economics is the application of economic analysis to managerial decision making. It focuses on how managers make economic decisions by allocating the scarce resources at their disposal. To make good decisions, a manager must understand the behavior of other decision makers, such as consumers, workers, other managers, and governments. In this book, we examine decision making by such participants in the economy, and we show how managers can use this understanding to be successful. Main Topics In this chapter, we examine two main topics

1. Managerial Decision Making: Economic analysis helps managers develop strategies to achieve a firm’s objective—such as maximizing profit—in the presence of scarcity.

2. Economic Models: Managers use models based on economic theories to help make predictions about consumer and firm behavior, and as an aid to managerial decision making.

1.1 Managerial Decision Making A firm’s managers allocate the limited resources available to them to achieve the firm’s objectives. The objectives vary for different managers within a firm. A production manager’s objective is normally to achieve a production target at the lowest possible cost. A marketing manager must allocate an advertising budget to promote the product most effectively. Human resource managers design compensation systems to encourage employees to work hard. The firm’s top manager must coordinate and direct all these activities.

Each of these tasks is constrained by resource scarcity. At any moment in time, a production manager has to use the existing factory and a marketing manager has a limited marketing budget. Such resource limitations can change over time but managers always face constraints.

Profit The main objective of most private sector firms is to maximize profit, which is the difference between revenue and cost. Senior managers of a firm might have other concerns as well, including social responsibility and personal career objectives. However, the primary responsibility of senior managers to the owners of the firm is to focus on the bottom line: maximizing profit. Managers have a variety of roles in the profit maximization process. The production manager seeks to minimize the cost of producing a particular good or service. The market research manager determines how many units of any particular product can be sold at a given price, which helps to determine how much output to produce and what price to charge. The R&D manager promotes the development of new products that will be attractive to consumers. The most senior manager, usually called the chief executive officer (CEO), must insure that all managerial functions are coordinated so that the firm makes as much profit as possible.

Trade-Offs People and firms face trade-offs because they can’t have everything. Managers must focus on the trade-offs that directly or indirectly affect profits. Evaluating trade-offs often involves marginal reasoning: considering the effect of a small change. Key trade-offs include: • How to produce. To produce a given level of output, a firm trades off inputs, deciding

whether to use more of one and less of another. Car manufacturers choose between metal and plastic for many parts, which affects the car’s weight, cost, and safety.

• What prices to charge. Some firms, such as farms, have little or no control over the prices at which their goods are sold and must sell at the price determined in the market. However, many other firms set their prices. When a manager of such a firm sets the price of a product, the manager must consider whether raising the price by a dollar increases the profit margin on each unit sold by enough to offset the loss from selling fewer units. Consumers, given their limited budgets, buy fewer units of a product when its price rises. Thus, ultimately, the manager’s pricing decision is constrained by the scarcity under which consumers make decisions.

• Whether to innovate. One of the major trade-offs facing managers is whether to maximize profit in the short run or in the long run. For example, a forward-looking firm may invest substantially in innovation—designing new products and better production methods—which lowers profit in the short run, but may raise profit in the long run.

Other Decision Makers

It is important for managers of a firm to understand how the decisions made by consumers, workers, managers of other firms, and governments constrain their firm. Consumers purchase products subject to their limited budgets. Workers decide on which jobs to take and how much to work given their scarce time and limits on their abilities. Rivals may introduce new, superior products or cut the prices of existing products. Governments around the world may tax, subsidize, or regulate products.

Thus, managers must understand how others make decisions. Most economic analysis is based on the assumption that decision makers are optimizers: they do the best they can with their limited resources. However, we also consider some contexts in which economic decision makers do not successfully optimize when we describe psychological biases and cognitive limits in decision making—a topic referred to as behavioral economics. Interactions between economic decision makers take place primarily in markets. A market is an exchange mechanism that allows buyers to trade with sellers. A market may be a town square where people go to trade food and clothing, or it may be an international telecommunications network over which people buy and sell financial securities. When we talk about a single market, we refer to trade in a single good or group of goods that are closely related, such as soft drinks, movies, novels, or automobiles. The primary participants in a market are firms that supply the product and consumers who buy it, but government policies such as taxes also play an important role in the operation of markets.

Strategy When competing with a small number of rival firms, senior managers consider how their firm’s products are positioned relative to those of its rivals. The firm uses a strategy—a battle plan that specifies the actions or moves that the firm will make to maximize profit. A strategy might involve choosing the level of output, the price, or the type of advertising now and possibly in the future. For example, in setting its production levels and prices, Pepsi’s managers must consider what choices Coca-Cola’s managers will make. One tool that is helpful in understanding and developing such strategies is game theory, which we use in several chapters.

1.2 Economic Models Economists use economic models to explain how managers and other decision makers make decisions and to interpret the resulting market outcomes. A model is a description of the relationship between two or more variables. Models are used in many fields. For example, astronomers use models to describe and predict the movement of comets and meteors, medical researchers use models to describe and predict the effect of medications on diseases, and meteorologists use models to predict weather. Business economists construct models dealing with economic variables and use such models to describe and predict how a change in one variable will affect another variable. Such models are useful to managers in predicting the effects of their decisions and in understanding the decisions of others. Models allow managers to consider

hypothetical situations—to use a what-if analysis—such as “What would happen if we raised our prices by 10%?” or “Would profit rise if we phased out one of our product lines?” Models help managers predict answers to what-if questions and to use those answers to make good decisions.

Mini-Case Using an Income Threshold Model in China According to an income threshold model, no one who has an income level below a particular threshold buys a particular consumer durable, such as a refrigerator or car. The theory also holds that almost everyone whose income is above that threshold buys the product. If this theory is correct, we predict that as most people’s incomes rise above the threshold in emergent economies, consumer durable purchases will increase from near zero to large numbers very quickly. This prediction is consistent with evidence from Malaysia, where the income threshold for buying a car is about $4,000.

In China, incomes have risen rapidly and now exceed the threshold levels for many types of durable goods. As a result, many experts correctly predicted that the greatest consumer durable goods sales boom in history would take place there. Anticipating this boom, many companies have greatly increased their investments in durable goods manufacturing plants in China. Annual foreign direct investments (FDI) have gone from $916 million a year in 1983 to $120 billion in 2014, overtaking the United States as the world’s largest recipient of FDI. In expectation of this growth potential, even traditional political opponents of the People’s Republic—Taiwan, South Korea, and Russia—are investing in China.

One of the most desirable durable goods is a car. Li Rifu, a 46-year-old Chinese farmer and watch repairman, thought that buying a car would improve the odds that his 22- and 24-year-old sons would find girlfriends, marry, and produce grandchildren. Soon after Mr. Li purchased his Geely King Kong for the equivalent of $9,000, both sons met girlfriends, and his older son got married.

Four-fifths of all new cars sold in China are bought by first-time customers. An influx of first- time buyers was responsible for Chinese car sales increasing by a factor of 15 between 2000 and 2015. By 2014, China was producing more than the United States and Japan combined.2 2 The sources for Mini-Cases are available at the back of the book.

Simplifying Assumptions Everything should be made as simple as possible, but not simpler.

—Albert Einstein

A model is a simplification of reality. The objective in building a model is to include the essential issues, while leaving aside the many complications that might distract us or disguise those essential elements. For example, the income threshold model focuses on only the

relationship between income and purchases of durable goods. Prices, multiple car purchases by a single consumer, and other factors that might affect durable goods purchases are left out of the model. Despite these simplifications, the model—if correct—gives managers a good general idea of how the automobile market is likely to evolve in countries such as China.

We have described the income threshold model in words, but we could have presented it using graphs or mathematics. Representing economic models using mathematical formulas in spreadsheets has become very important in managerial decision making. Regardless of how the model is described, an economic model is a simplification of reality that contains only its most important features. Without simplifications, it is difficult to make predictions because the real world is too complex to analyze fully.

Economists make many assumptions to simplify their models. When using the income threshold model to explain car purchasing behavior in China, we assume that factors other than income, such as the color of cars, do not have an important effect on the decision to buy cars. Therefore, we ignore the color of cars that are sold in China in describing the relationship between income and the number of cars consumers want. If this assumption is correct, by ignoring color, we make our analysis of the auto market simpler without losing important details. If we’re wrong and these ignored issues are important, our predictions may be inaccurate. Part of the skill in using economic models lies in selecting a model that is appropriate for the task at hand.

Testing Theories Blore’s Razor: When given a choice between two theories, take the one that is funnier.

Economic theory refers to the development and use of a model to formulate hypotheses, which are proposed explanations for some phenomenon. A useful theory or hypothesis is one that leads to clear, testable predictions. A theory that says “If the price of a product rises, the quantity demanded of that product falls” provides a clear prediction. A theory that says “Human behavior depends on tastes, and tastes change randomly at random intervals” is not very useful because it does not lead to testable predictions and provides little explanation of the choices people make.

Economists test theories by checking whether the theory’s predictions are correct. If a prediction does not come true, they might reject the theory—or at least reduce their confidence in the theory. Economists use a model until it is refuted by evidence or until a better model is developed for a particular use.

A good model makes sharp, clear predictions that are consistent with reality. Some very simple models make sharp or precise predictions that are incorrect. Some more realistic and therefore more complex models make ambiguous predictions, allowing for any possible outcome, so they are untestable. Neither incorrect models nor untestable models are helpful. The skill in model building lies in developing a model that is simple enough to make clear predictions but realistic enough to be accurate. Any model is only an approximation of reality. A good model is one that is a close enough approximation to be useful.

Although economists agree on the methods they use to develop and apply testable models, they often disagree on the specific content of those models. One model might present a logically consistent argument that prices will go up next quarter. Another, using a different but equally logical theory, may contend that prices will fall next quarter. If the economists are reasonable, they will agree that pure logic alone cannot resolve their dispute. Indeed, they will agree that they’ll have to use empirical evidence—facts about the real world—to find out which prediction is correct. One goal of this book is to teach managers how to think like economists so that they can build, apply, and test economic models to deal with important managerial problems.

Positive and Normative Statements

Economic analysis sometimes leads to predictions that seem undesirable or cynical. For instance, an economist doing market research for a producer of soft drinks might predict that “if we double the amount of sugar in this soft drink we will significantly increase sales to children.” An economist making such a statement is not seeking to undermine the health of children by inducing them to consume excessive amounts of sugar. The economist is only making a scientific prediction about the relationship between cause and effect: more sugar in soft drinks is appealing to children.

Such a scientific prediction is known as a positive statement: a testable hypothesis about matters of fact such as cause-and-effect relationships. Positive does not mean that we are certain about the truth of our statement; it indicates only that we can test the truth of the statement. An economist may test the hypothesis that the quantity of soft drinks demanded decreases as the price increases. Some may conclude from that study that “The government should tax soft drinks so that people will not consume so much sugar.” Such a statement is a value judgment. It may be based on the view that people should be protected from their own unwise choices, so the government should intervene. This judgment is not a scientific prediction. It is a normative statement: a belief about whether something is good or bad. A normative statement cannot be tested because a value judgment cannot be refuted by evidence. A normative statement concerns what somebody believes shouldhappen; a positive statement concerns what is or what will happen. Normative statements are sometimes called prescriptive statements because they prescribe a course of action, while positive statements are sometimes called descriptive statements because they describe reality. Although a normative conclusion can be drawn without first conducting a positive analysis, a policy debate will be better informed if a positive analysis is conducted first.3 3 Some argue that, as (social) scientists, we economists should present only positive analyses. Others argue that we shouldn’t give up our right to make value judgments just like the next person (who happens to be biased, prejudiced, and pigheaded, unlike us). Good economists and managers emphasize positive analysis. This emphasis has implications for what we study and even for our use of language. For example, many economists stress that they study people’s wants rather than their needs. Although people need certain minimum levels of food, shelter, and clothing to survive, most people in developed economies have enough money to buy goods well in excess of the minimum levels necessary to maintain life. Consequently, in wealthy countries, calling something a “need” is often a value judgment. You almost certainly have been told by someone that “you need a college education.” That person was probably making a value judgment—“you should go to college”—rather than a scientific prediction that you will suffer terrible economic deprivation if you do not go to college. We can’t test such value judgments, but we can test a (positive) hypothesis such as “Graduating from college or university increases lifetime income.”

Summary 1. Managerial Decision Making. Economic analysis helps managers develop

strategies to pursue their objectives effectively in the presence of scarcity. Various managers within a firm face different objectives and different constraints,

but the overriding objective in most private sector firms is to maximize profits. Making decisions subject to constraints implies making trade-offs. To make good managerial decisions, managers must understand how consumers, workers, other managers, and governments will act. Economic theories normally (but not always) assume that all decision makers attempt to maximize their well-being given the constraints they face.

2. Economic Models. Managers use models based on economic theories to help make predictions and decisions, which they use to run their firms. A good model is simple to use and makes clear, testable predictions that are supported by evidence. Economists use models to construct positive hypotheses such as causal statements linking changes in one variable, such as income, to its effects, such as purchases of automobiles. These positive propositions can be tested. In contrast, normative statements, which are value judgments, cannot be tested.

17 Global Business Traditionally, most imports come from other countries.

Learning Objectives 1. Use the concept of comparative advantage to explain why countries trade. 2. Characterize the effects of a change in the exchange rate on trade between

countries. 3. Describe the effects of tariffs, quotas, and subsidies on international markets. 4. Show how multinational enterprises take advantage of international tax rate

differences to raise profits. 5. Discuss why firms outsource production to foreign firms, and evaluate the criticisms

of outsourcing.

Managerial Problem Responding to Exchange Rates Business is now global. Virtually every country in the world exports and imports goods and services and invests in assets in other countries. Most major corporations actively trade and invest internationally.

The United States is the world’s largest exporter of wheat. In 2015, its exports were over 16% of world exports even though U.S. production was only about 8% of the world’s total. Wheat exporting is so important that Cargill, Inc., the U.S. agribusiness giant, and CHS, the largest U.S. farm co-op, have a major joint venture, Temco LLC, which built an export facility in the Pacific Northwest to ship wheat to Asia.

Rolls-Royce Motors, the maker of the world’s most famous luxury cars, sold 4,063 of its British- built cars worldwide in 2014, a small number compared to the millions sold by General Motors, Toyota, and other large producers. Nonetheless, Rolls-Royce’s sales revenue is large because it charges astronomical prices. The 2015 Rolls-Royce Phantom Drophead Coupé, sells for $500,000 in the United States and for £360,000 in Great Britain. Managers of these firms must make crucial pricing decisions when an exchange rate changes. An exchange rate is the number of units of one currency it takes to buy a unit of another currency. For example, in October 2015 the exchange rate between the U.S. dollar ($) and the Japanese yen (¥) was about 119, so that one dollar bought 119 yen. How do firms’ prices change around the world when exchange rates change? In particular, is the responsiveness of prices to exchange rates greater for highly competitive wheat or for Rolls- Royce automobiles, which are not sold in a competitive market?1 1Sources for the Managerial Problem, the Managerial Implication sections, and the Mini-Cases appear at the end of this chapter. Not long ago international business issues were of only modest significance in countries such as the United States, China, and India, each of which had large domestic markets and engaged in little trade. However, international trade has increased significantly in recent years. From 1990 to 2013, exports rose from 19% of the world’s total output as measured by gross domestic product (GDP) to 30%.1 The increase was particularly dramatic for India as exports more than tripled in

importance, going from 7% of GDP in 1990 to 25% in 2013. For China, exports grew from 16% to 23% of GDP, and U.S exports grew from 9% to 14% of GDP. 1Data in this paragraph and the next are from the World Bank Development Indicators http://data.worldbank.org/products/wdiand the United States Census Bureau: http://www.census .gov/foreign-trade/balance/c5700.html. Simply quoting exports as a share of GDP fails to adequately portray the remarkable increase in trade that has occurred in much of the world, especially in countries where GDP has been growing rapidly. The real value of U.S. imports (measured in 2014 U.S. dollars) from China increased from $8.6 billion in 1985 to $467 billion in 2014. That is, for every freighter taking goods from China to the United States in 1985, 54 freighters made the trip in 2014!

Effectively, the world has grown smaller, with countries becoming more interconnected and more interdependent than ever. This increasing integration of the world economy is due in large part to improvements in communications technology, which have reduced the effect of distance, and to policy changes that have allowed for freer trade and investment flows between countries.

The increased integration of the world economy creates both opportunities and challenges for businesses. Gaining increased access to foreign markets is an important means of expanding demand for many firms. A more integrated global economy also provides managers with the opportunity to use an international supply chain, obtaining materials, components, and other inputs to production from many countries. For example, IBM uses inputs from about 20,000 suppliers in close to 100 different countries in producing its products and sells its output in almost all of the world’s more than 190 countries.2 However, increasing competition from foreign rivals is a potential problem for managers, as is the difficulty of dealing with a range of different legal and policy environments from country to country. 2See http://www.ibm.com/ibm/responsibility/2014/supply-chain/our-supply- chain.html (viewed August 26, 2015). In this chapter, we start by considering why countries and firms engage in international trade by exporting and importing goods and services, and then address the role of exchange rates in international trade. Next, we examine how international trade policy affects managerial decisions regarding trade flows. We then turn to trade and investment by multinational enterprises (MNEs), which are firms that control productive assets in more than one country. We show how managers of an MNE must take international differences in law and economic policy into account. For example, we show how an MNE reacts to differential corporate tax rates in the countries where it operates. Finally, we discuss a very contentious issue: international outsourcing. In many developed countries, labor unions and other groups have protested when a firm lays off domestic employees and shifts production to foreign countries where labor costs are lower.

Main Topics

In this chapter, we examine five main topics

1. Reasons for International Trade: Nations trade for many reasons, the most important of which is comparative advantage: A country exports goods it can produce at relatively low cost and imports goods that are relatively costly to produce domestically.

2. Exchange Rates: A change in the exchange rate affects trade in goods and services and leads to adjustments that bring prices in different countries closer together.

3. International Trade Policies: Governments have traditionally restricted imports by setting tariffs, which are taxes on imports, and quotas, which directly limit the quantity of imports, and often use subsidies to encourage exports.

4. Multinational Enterprises: Multinational enterprises are responsible for the majority of the world’s international trade and investment and are greatly affected by variations in tax rates across nations and changes in exchange rates.

5. Outsourcing: Firms shift from domestic production of needed inputs to buying them from foreign firms to lower their costs, but the resulting shifts in employment patterns have generated criticism by domestic workers who lose their jobs.

17.1 Reasons for International Trade Everyone consumes many imported products. A typical American breakfast might include bread made from Canadian wheat, jam imported from England, fruit from Mexico, and tea from India or coffee from Brazil—along with perhaps some corn flakes produced in the United States.

Why do we rely on other countries for the goods that we consume? Why doesn’t each country produce everything it needs domestically?

Trade between countries occurs for many reasons. The most important is that international trade allows countries to specialize in producing goods and services for which they have a comparative advantage: the ability to produce a good or service at lower opportunity cost than other countries.

Comparative Advantage According to the principle of comparative advantage, a country exports goods it can produce at relatively low cost and imports goods that are relatively costly to produce domestically. For example, Sweden and Spain benefit from such trade. Sweden has a climate and geography that enable it to produce forest products such as timber, pulp, and paper. Spain has a climate well suited to producing many types of fruit. Neither country is good at producing the other country’s product. Thus, it is not surprising that Sweden exports forest products to Spain while Spain exports fruit to Sweden and that both countries benefit from such trade.

Gains from Trade Between Countries. We use an example to illustrate why participants gain from trade. Suppose that the United States and Japan initially do not trade and each country is in competitive equilibrium, in which the prices of goods equal their marginal costs of production. The United States produces and sells a bag of rice for $1 and a silk scarf for $10. Japan produces and sells a bag of rice for ¥200 and a scarf for ¥1,000. If the United States were to reduce the number of silk scarves it produces by one, it could afford to produce 10 extra bags of rice. In contrast, Japan could produce one more scarf at the cost of only five bags of rice. Therefore, the two countries could produce the same number of scarves and have five extra bags of rice if they reallocated their resources. In the absence of transportation costs, both countries could gain if the United States shipped rice to Japan and Japan shipped scarves to the United States.

The reason for this gain is that the United States has a comparative advantage in producing rice and Japan has a comparative advantage in producing scarves. The cost of producing a scarf is 10 bags of rice in the United States and only 5 in Japan, so it is relatively inexpensive to produce a scarf in Japan. Similarly, the cost of producing a bag of rice is one-tenth of a scarf in the United States and one-fifth of a scarf in Japan, so it is relatively inexpensive to produce a bag of rice in the United States.

Gains from Intra-Firm Trade. This basic idea of comparative advantage also works for intra-firm trade—where a single firm is on both sides of an international transaction—exporting the output from its operation in one country to an affiliated business unit in another country. Lanz and Miroudot (2011) show that intra-firm trade is an important part of overall trade flows—about one-third of total trade for OECD countries. We illustrate the gains from intra-firm trade with an example concerning General Electric (GE), a major producer of kitchen appliances and many other products, which has production facilities in many countries, including Hungary and Romania. Suppose that GE is considering how to organize its production of refrigerators in Eastern Europe. To produce a refrigerator, GE must manufacture the basic parts or components and assemble those components into a finished product. A production employee might work in either component production or assembly.

We assume that Hungarian workers are more productive at both component production and assembly than workers in Romania. (This difference in productivity might reflect factors such as the quality of equipment and training.) That is, a Hungarian worker has absolute advantage over a Romanian worker: With the same amount of effort, the Hungarian worker can produce more of both outputs than can the Romanian. As Table 17.1 shows, a Hungarian worker can produce enough components (parts) for four refrigerators per day or can assemble four refrigerators in a day. A Romanian worker can produce enough parts for two refrigerators per day or can assemble one refrigerator per day. Table 17.1 Output per Worker per DayMyEconLab Video

Components

Hungary 4

Romania 2

However, both plants have a comparative advantage. If a Romanian worker assembles one refrigerator, that worker does not have the time to produce two sets of parts, so the opportunity cost of assembling a refrigerator is the value of the labor it takes to produce two sets of parts. In contrast, if a Hungarian assembles one refrigerator, the opportunity cost is that the worker does not produce one set of parts. Thus, the cost to GE of having a Romanian working in assembly is twice that of a Hungarian. Therefore, the Hungarian plant should specialize in assembling refrigerators. Similarly, it is more efficient to have the Romanian plant produce parts, because producing a set of parts has an opportunity cost of assembling one refrigerator in Hungary, but only half a refrigerator in Romania.

Suppose that GE has 120 workers in its Hungarian plant and 240 in its Romanian plant. If GE cannot lay off any workers in the short run, how should GE allocate activities in Hungary and Romania to maximize total output?

One approach is for each plant to act independently, producing complete refrigerators by manufacturing the parts and then assembling them. Under this plan, the Hungarian plant allocates 60 workers to parts and 60 to assembly. Because a component worker produces 4 sets of parts per day, these workers produce 4×60=2404×60=240 sets of parts. The 60 Hungarian assembly workers can assemble all 240 sets of parts because each worker can assemble 4 refrigerators per day. This allocation of workers to tasks yields 240 refrigerators per day in Hungary. Any other allocation would yield less output. In Romania, 80 workers work on parts and 160 on assembly, yielding an output of 160 refrigerators per day. Thus, the two plants working independently can produce 400 refrigerators per day—240 in Hungary and 160 in Romania—as the first row of Table 17.2 shows. Table 17.2 Total Production of RefrigeratorsMyEconLab Video

No trade: Plants work independently

Trade: Plants specialize

Romania specializes in components, Hungary in assembly

Romania specializes in assembly, Hungary in components

A better alternative is to have Romania specialize in producing parts and Hungary specialize in production. If all 240 workers in Romania produced parts, they could manufacture enough for 480 refrigerators each day. If these parts were then sent to Hungary, the 120 Hungarian workers could assemble all 480 refrigerators in a day, as the second line of Table 17.2 shows.3 This allocation of labor, involving specialization and trade, maximizes output. The gain from trade is 80 refrigerators. 3We assume the cost of transporting components or assembled products is small enough so that we do not need to consider it explicitly. If instead GE has its Romanian plant specialize in assembly, only 360 refrigerators would be produced (third row of Table 17.2), as Q&A 17.1explains. Such an outcome is worse than no trade as 40 fewer refrigerators are produced. As summarized in Table 17.2, the best outcome is for the Romanian plant to produce parts and for the Hungarian plant to assemble these parts into refrigerators. This allocation of resources produces the most output because each plant specializes in the activity in which it has a comparative advantage. Q&A 17.1 In our GE example, if the Romanian plant specializes in assembly and the Hungarian plant in producing components, what is the largest number of refrigerators that GE can produce per day?

Answer 1. Determine how many Hungarian workers must produce components to keep the 240

Romanian workers fully occupied assembling refrigerators and how many refrigerators are produced. The Romanian workers can assemble 240 refrigerators a day. To keep all the Romanian workers busy, only 60 Hungarian workers are needed to make 240 sets of parts each day.

2. Explain how the remaining 60 Hungarian workers must be allocated to produce the most additional refrigerators and determine how many refrigerators they make. The remaining 60 Hungarian workers can produce the largest number of refrigerators by having 30 workers each producing 4 sets of components a day and 30 assembling 4 refrigerators per day, thereby producing an additional 120 refrigerators.

3. Determine GE’s total production with this allocation of workers and compare it to GE’s other two options. Because 240 refrigerators are assembled in the Romanian plant and 120 more refrigerators are completely produced in the Hungarian plant, this approach yields a total of only 360 refrigerators. This quantity is less than the 400 GE produces if the plants do not trade or the 480 they produce if they trade and the Romanian plant specializes in components and the Hungarian plant in assembly.

Managerial Implication Brian May’s Comparative Advantage

The principle of comparative advantage is important in making decisions, even in the rock music business. Brian May had completed most of his PhD in astrophysics at Imperial College in London by 1974. In that year, his band, Queen, launched its second album, “Queen II,” which became internationally successful. Discovering that his comparative advantage was in rock music, he stopped working on his PhD and toured the world with Queen. After the death of its lead singer, Freddie Mercury, in 1991, the band became less active. Its last major world tour as Queen+PaulQueen+Paul Rodgers ended in 2006, though the band remains sporadically active. In 2007, as the opportunity cost of spending his time in studying dropped, May returned to complete his PhD, as implied by the principle of comparative advantage. Since then, he’s worked at least part time as an astrophysicist, including collaborating on NASA’s New Horizons space probe in 2015.

Increasing Returns to Scale Trade occurs for many reasons in addition to comparative advantage. One of the other major motives for trade is to take advantage of increasing returns to scale (Chapter 5). With an increasing returns to scale (IRS) production function, doubling all the inputs more than doubles output. 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. In our GE refrigerator example, the production process exhibits constant returns to scale. Production involves only one input, labor. Doubling the number of workers doubles the output. We showed that with constant returns to scale, GE benefits from trade due to comparative advantage.

Suppose instead that GE’s production function exhibits increasing returns to scale, so that doubling labor triples output. Initially, GE has two plants in Hungary, each with 50 workers. The workers in both plants are equally productive in all activities. Operating independently, each plant can produce 200 refrigerators, so total production is 400 refrigerators. GE could increase its

output by closing one plant and shifting all its workers to the remaining plant, where the 100 workers could produce 600 refrigerators due to increasing returns to scale.

Indeed, if GE increases its labor force at this one plant even more, its production will grow more than in proportion, so that its cost per refrigerator would drop further. If GE can only sell its refrigerators in Hungary, the limited demand for refrigerators there would cap the number of refrigerators GE wants to produce at this plant. However, if GE can export refrigerators to other countries, it can increase production at this one plant and lower its cost of production. Thus, increasing returns to scale provides an incentive to trade by selling in other countries.

Country Size. Relatively small countries in particular may benefit from taking advantage of returns to scale. Consider Canada, whose population and gross domestic product (GDP) are about one-tenth that of the United States. If Canada were unable to trade with other countries, its relatively small market would prevent it from cost-effectively producing and consuming commercial jet aircraft, which are produced with substantial increasing returns to scale.

However, if a Canadian producer can export its products all over the world, it can take advantage of increasing returns to scale by producing a large quantity of jet aircraft. For example, by taking advantage of international trade, Bombardier Aerospace, a Canadian firm, has become the world’s third-largest commercial jet producer, specializing in light jets, including the business jets favored by senior executives and rock stars. Canada exports these light commercial jets and imports large commercial jets manufactured by the two major producers, the United States’ Boeing Company and Europe’s Airbus S.A.S. All the countries involved gain from trade due to increasing returns to scale.

Product Variety. Increasing returns to scale play an even greater role in a market with substantial product variety, such as toys, than in a market with a homogeneous product, such as DRAM memory chips for computers. The more varieties in a market, the fewer units of any one variety a firm can sell. Thus, without international trade, it is very difficult for the manufacturer of a highly differentiated product to benefit from returns to scale.

The toy industry produces an incredible variety of products, and adds new varieties every year (usually in time for the winter holiday season). Toy producers could lower their average cost by producing fewer toy varieties and using longer production runs for the toys they do produce, so that they could spread the design, setup, and marketing fixed costs over more units of output. However, children love variety and new toys. Even a single category of toys, such as dolls or trucks, has hundreds of different varieties. Because children demand variety, a manufacturer that decides to sell only one product year after year so as to lower its average cost will quickly find that it can sell very few units and will likely go out of business.

How can a toy manufacturer produce differentiated toys and yet take advantage of increasing returns to scale? The only practical way is to sell its product to children in many countries instead of only in its home country.

Mini-Case Barbie Doll Varieties

Barbie, produced by the U.S.-based Mattel, Inc., is perhaps the world’s best-known toy. While other toy fads come and go, Barbie has had remarkable staying power. She was introduced in 1959 and is still a hot product. Although Barbie was invented and first produced in the United States, Mattel has produced Barbie dolls in many other countries, including Indonesia, China, - Malaysia, Thailand, and Mexico. In 2014, Barbie was the top toy import into the United States for the winter holiday season, and was the second most popular toy overall for girls (after Frozenmerchandise) during the 2014 holidays. One key to Barbie’s success is product variety. Mattel’s Barbie Web site lists over one hundred dolls and closely related products. Most products are variations on the original Barbie doll. Mattel also produces many versions of her various friends, including Ken, her on-again, off- again boyfriend.4 4In 2004, Mattel sent out a news release indicating that Barbie and Ken had decided to “spend some time apart” after being together for 43 years, although they would “remain the best of friends” (http://investor.shareholder.com/mattel/releasedetail.cfm?ReleaseID=128705). In 2011, they got back together. Barbie dolls come in many different price ranges. The basic dolls are pink-label dolls, but there are also silver-label, gold-label, platinum-label, and black-label dolls in sequentially higher price ranges. Each label has many different versions, and every year many new versions are introduced while older ones are retired and become collectibles that often increase in value over time. Well over two thousand Barbie doll varieties have been produced since Barbie first appeared. Because of the great variety of Barbie dolls, many consumers have large collections, often numbering in the hundreds. Many Barbie collectors are in their 30s, 40s, and 50s, and the higher-priced dolls are targeted primarily at adults.

This success-based-on-variety model is made possible by international trade. Each variety requires a significant fixed cost in product design and manufacturing setup, so the manufacturer must produce a huge number of each variety of doll to benefit from increasing returns to scale. Due to international trade, a single factory in Indonesia can produce gigantic quantities of a particular variety of Barbie for the entire world market and take advantage of scale economies. A factory in China can do the same thing for a different version of Barbie.

17.2 Exchange Rates How willing people are to trade one type of currency for another affects trade in goods and services. An exchange rate is the price of one currency (such as the euro) in terms of another currency (such as the dollar). Most countries or groups of countries have a unique currency, which can be traded or exchanged for the currencies of other

countries. The euro (€) is the currency of 23 European countries that belong to the Eurozone.5 It can be traded for U.S. dollars ($), Japanese yen (¥), British pounds (£), or many other currencies. In October 2015, one euro could be exchanged for $1.14 in U.S. currency. That is, the exchange rate between the dollar and the euro was 1.14. 5The euro was created by the European Union (EU) and is the currency of 19 of 28 EU - countries, including France, Germany, and Italy. The EU country with the largest GNP that is not using the euro is the United Kingdom, which still uses its traditional currency, the pound (£). Non-EU countries using the euro include Andorra, Kosovo, Monaco, Montenegro, San Marino, and the Vatican City.

Determining the Exchange Rate Because currency is exchanged in a competitive market, we can use a supply-and-demand model to determine the exchange rate or price of one currency in terms of another. In Figure 17.1, the quantity on the horizontal axis is the number of euros that Americans want to buy using dollars. As X increases, the price of a euro in terms of dollars increases, or equivalently, the price of the dollar in terms of euros falls. The price on the vertical axis is the exchange rate, X, which is the number of dollars it takes to buy one euro.

Figure 17.1 Supply and Demand Curves Determine the Exchange Rate The interaction between supply and demand curves determines the exchange rate or price of one currency in terms of another. If U.S. consumers and firms want more euros at any given exchange rate so that the U.S. demand curve for euros shifts to the right from D1D1 to D2D2 while the supply curve of euros remains unchanged, then the equilibrium exchange rate rises from X1X1 to X2.X2. The initial demand curve for euros in the United States is D1.D1. 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 initial equilibrium: the number of euros exchanged, Q1,Q1, and the exchange rate, X1,X1, which was 1.14 in late 2015. If U.S.

consumers and firms want more euros at any given exchange rate, so that the demand curve for euros shifts to the right to D2,D2, then the equilibrium quantity increases to Q2Q2 and the equilibrium exchange rate rises to X2.X2. That is, the price of a euro in U.S. dollars increases. Many factors affect the supply and demand for a particular currency, including financial and macroeconomic conditions. For example, if investment opportunities increase in the United States relative to those in Europe, the exchange rate for the euro falls.

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 as they can now buy more goods for a given number of dollars. Similarly, the demand of European consumers and firms for U.S. goods falls. Thus, a change in exchange rates affects the incentives to trade between countries.

The Brazilian currency is the real, denoted BRL. Suppose that initially one U.S. dollar is worth four Brazilian reals. A volleyball sells for $10 in the United States or 40 BRL in Brazil. Now suppose that the exchange rate changes so that $1 is worth 5 BRL. If transaction and shipping costs are negligible, Brazilian retailers can increase their profits by selling the product in the United States for $10 (now worth 50 BRL), rather than in Brazil for 40 BRL. As the quantity sold in the United States increases, the U.S. price of the ball falls if the U.S. demand curve slopes down. Similarly, as the number of balls sold in Brazil falls, the price in Brazil rises.

This process, called arbitrage, equates the prices of the ball in the two countries in the absence of transaction costs. If the transaction cost is t, arbitrage moves the price in one country to within t of the price in the other country because further arbitrage is unprofitable.

Managerial Implication Limiting Arbitrage and Gray Markets Managers can often increase profits by engaging in international price discrimination (Chapter 10): charging higher prices in countries where consumers have a greater willingness to pay. However, for international price discrimination to be profitable, firms must limit resale or arbitrage across countries. Managers have to be particularly concerned about increased arbitrage opportunities as exchange rates change. If arbitrageurs can buy the good in the low-price country and sell it at a higher price in other countries without incurring transaction costs, their actions eliminate the price differential. Arbitrage will not completely eliminate price differentials if arbitrageurs incur transaction costs. If the price differential between countries for some product is $5 while the transaction cost (including transportation) is $10 per unit, then no arbitrage occurs. Thus, a price difference of $10 or less could persist.

For many goods, the Internet has greatly facilitated arbitrage. A student in the United States can save money by buying textbooks from Amazon’s sites in lower-price countries. People around the world use eBay to trade a wide variety of goods from one country to another. The Internet has reduced but not eliminated international price differences in such products.

One way that a firm’s managers try to prevent arbitrage is to permit only authorized dealers to handle their products. Any authorized dealer that imports the product from another country instead of buying it from the manufacturer could lose its authorization.

Foreign goods shipped to the high price country and sold outside of authorized channels of distribution are called gray market goods. Although Apple’s iPad was the top-selling tablet in China in 2011, nearly half (49%) of these tablets were purchased overseas and then resold by nonauthorized, local vendors in China’s gray market. Initially, the 3G iPad 2 with 64GB storage sold for $829 in the United States but 6,288 yuan or $990 in China, which allowed arbitrageurs to undercut Apple’s price in China while still making a profit. Thus, even though Apple sold the iPad only through authorized dealers, it failed to prevent arbitrage in China. However, it may have reduced the extent of the arbitrage. Managers use a variety of other techniques to successfully prevent gray markets. Managers of perfume firms have called upon governments to enforce their rights under patent, trademark, and copyright laws to prevent arbitrageurs from importing their products. A 2011 ruling in favor of the French cosmetics manufacturer L’Oreal held that European Union trademark law applies to sales on eBay, and that eBay must help identify gray market sellers who do not comply. However, a federal court ruled in 2015 that Costco’s importation of gray-market watches did not infringe on Omega’s copyright, consistent with the 2013 Supreme Court’s textbook decision (see the Mini-Case, “Reselling Textbooks” in Chapter 10). One technique that most camera and electronic equipment manufacturers use is to provide a country-specific warranty. A gray market camera purchased in the United States that was imported from Europe comes with a warranty that is good only in Europe and hence less attractive to U.S. customers. Of course, arbitrageurs responded. Today, many stores offer nonmanufacturer warranties on gray market cameras and electronic equipment. The main lesson for managers in firms selling branded products internationally is that investments in preventing or reducing arbitrage are often profitable.

Managing Exchange Rate Risk Managing risk (Chapter 14) is particularly important for firms doing business in multiple countries because exchange rate movements increase risk, as we now illustrate. Martin, the manager of a small U.S. producer of medical equipment, signs a contract to provide custom equipment to a hospital in India for 60 million Indian rupees (INR), to be paid in 6 months when the equipment is delivered. At the current exchange rate, 50 rupees can be exchanged for one U.S. dollar, so the equipment would cost the Indian firm $1.2 (= 60/50)$1.2 (= 60/50) million if paid today. Martin is very worried about the risk from a change in the exchange rate. Martin’s firm is going to incur $1.1 million in expenses to build and ship the equipment. Thus, at the current exchange rate, his firm stands to make a profit of $100,000. However, if the exchange rate falls to 60 rupees per dollar in 6 months, Martin’s firm will receive only $1 (= 60/60)$1 (= 60/60) million and suffer a loss of $100,000, which may be enough to bankrupt the firm. Of course, if the exchange rate moves in the other direction, Martin’s firm will earn additional profit. If the rupee appreciates to INR 48 per dollar, Martin’s firm will

earn $1.25 (= 60/48)$1.25 (= 60/48) million, and make a profit of $150,000. Nonetheless, this exchange rate risk, which may lead to bankruptcy, is unacceptable to Martin. Martin has a couple of options. First, he could try to insist that payment be made in U.S. dollars so that the Indian firm bears the exchange rate risk.

Second, Martin can hedge the risk by purchasing a forward contract or a futures contract. Such a contract is an agreement to exchange one currency for another in the future at a specified rate. For example, Martin could contract to exchange INR 60 million for $1.2 million in 6 months. Such a contract is called a forward contract if it is a private agreement with another party, such as a bank. The bank would charge a fee for the contract, say $10,000. Effectively, the bank is selling Martin an insurance policy for $10,000. Futures contracts are similar, except that they are standardized contracts, often called Forex contracts, that sell on organized exchanges. The Chicago Mercantile Exchange is the major trading venue for such contracts in the United States.

17.3 International Trade Policies Although firms and consumers in one country want to trade with people in other countries, governments often prevent free trade between nations. A government may prevent trade so as to protect domestic suppliers from competition by foreign firms. For example, a government may ban trade or set a quota that limits the amount of a good that can be imported. Alternatively, a government may tax imports or exports to raise government revenue. Commonly, governments collect an import tariff (sometimes called a duty), which is a tax on only imported items. Historically, governments have concentrated on restricting imports rather than limiting or encouraging exports. Consequently, we focus on the effects of a country’s trade policies that restrict imports based on prices, government revenue, and total surplus in a competitive, domestic market.

Quotas and Tariffs in Competitive Markets Quotas and tariffs are usually applied to imports by the government of the importing country. A government chooses one of four import 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 ¯¯̄Q.Q¯. Quotas, including bans, change the supply curve. As we showed in our analysis of taxes in Chapter 2, we can think of a tariff or tax as either shifting the supply curve up or shifting the demand curve down.

To illustrate the effects of these various policies, we examine the U.S. market for crude oil. For simplicity, we assume that transportation costs are zero and that the United States is small enough to be a price taker in world markets. We further assume that the supply curve of oil is horizontal at the world price, which is the market-clearing price in the world market. Given these assumptions, the importing country, the United States, can buy as much crude oil as it wants at the world price.

Free Trade Versus a Ban on Imports. Preventing imports into the domestic market raises the price. In Figure 17.2, the estimated U.S. domestic supply curve, Sa,Sa, is upward sloping and the foreign supply curve is horizontal at the world price, which averaged $60 per barrel (an average for the first half of 2015).6 The total U.S. supply curve, S1,S1, is the horizontal sum of the domestic supply curve and the foreign supply curve. Thus, S1S1 is the same as the upward-sloping domestic supply curve for prices below $60 and is horizontal at $60. With free trade, the United States imports crude oil if its domestic price in the absence of imports would exceed the world price. 6The figures are based on Baumeister and Peersman (2013).

Figure 17.2 The Loss from Eliminating Free Trade MyEconLab Video

Because the world supply curve is horizontal at the world price of $60, the total U.S. supply curve of crude oil is S1S1 with free trade. The free-trade equilibrium is e1.e1. With a ban on imports, the equilibrium e2e2 occurs where the domestic supply curve, Sa=S2,Sa=S2, intersects D. The ban increases producer surplus by B≈1.606B≈1.606 billion per day and decreases consumer surplus by B+C≈2.045B+C≈2.045 billion per day, so the deadweight loss is C=439C=439 million per day or $160 billion per year. The free-trade equilibrium, e1,e1, is determined by the intersection of S1S1 and the demand curve, where the U.S. price equals the world price, $60, and the quantity is 17.5 million barrels

per day. At the equilibrium price, domestic supply is 9.6 on S2.S2. Imports are therefore 17.5−9.6=7.917.5−9.6=7.9 million barrels. U.S. consumer surplus is A+B+C,A+B+C, U.S. producer surplus is D, and the U.S. total surplus is A+B+C+D.A+B+C+D. (Throughout our discussion of trade, we ignore welfare effects in other countries.) If imports are banned, the total U.S. supply curve, S2,S2, is the American domestic supply curve, Sa.Sa. The equilibrium is at e2,e2, where S2S2 intersects the demand curve. The new equilibrium price is $199.34, and the new equilibrium quantity, 13 million barrels per day, is produced domestically. Consumer surplus is A, producer surplus is B+D,B+D, and total surplus is A+B+D.A+B+D. The ban helps U.S. crude oil producers but harms consumers. Because of the higher price, domestic firms gain producer surplus of ΔPS=B≈$1.606ΔPS=B≈$1.606 billion per day.7 The change in consumers’ surplus is ΔCS=−B−C≈−$2.045ΔCS=−B−C≈−$2.045 billion per day. Consumers lose $1.27 (= 2.045/1.606)$1.27 (= 2.045/1.606) for every $1 that producers gain from a ban. 7Because the demand and supply curves are nonlinear, we calculated the surplus measures using areas of shapes other than rectangles and triangles. Does the ban help the United States? No. The deadweight loss is the change in total surplus, ΔTS:ΔTS: the sum of the gain to producers and the loss to consumers, ΔTS=ΔPS+ΔCS=−C≈−$439ΔTS=ΔPS+ΔCS=−C≈−$439 million per day or −$160−$160 billion per year.

Mini-Case Russian Food Ban

Starting in 2014, many Western nations imposed a variety of sanctions on Russia because of its military activities in Ukraine. In retaliation, Russia banned imports of many agricultural products from the United States, the European Union, Australia, Canada, and Norway.

Russians, particularly in prosperous cities such as Moscow, depend heavily on imported foods from the West. The previous year, 2013, Russian agricultural imports were about $1 billion from the United States and 11.8 billion euros ($15.7 billion) from the European Union.

The ban imposes substantial costs on Russian consumers. In 2014, food prices soared 11.5%, which was 5.8% higher than the overall inflation rate. Prices for some types of food increased even more. Meat and poultry prices rose 18% over the previous year, while the price of butter shot up by 17%. In early 2015, the Russian Finance Minister said that Russia’s losses from the Western sanctions were $50 billion.

The ban had less effect on firms in exporting nations, which could sell their products elsewhere.

And Russian food-producing firms benefited. For example, in the first quarter after the ban went into effect, the profit of Cherkizovo, a Russian producer of meat, rose eightfold from the previous year.

Free Trade Versus a Tariff. Two common types of tariffs are specific tariffs—t dollars per unit—and ad valorem tariffs— a percent of the sales price. In the modern era, tariffs have been applied throughout the world, most commonly to agricultural products.8 For most of the post–World War II period, the United States has had a tariff on oil to raise government revenue or to reduce U.S. dependence on foreign oil. 8After World War II, most trading nations signed the General Agreement on Tariffs and Trade (GATT), which limited their ability to subsidize exports or limit imports using quotas and tariffs. The rules prohibited most export subsidies and import quotas, except when imports threatened “market disruption” (a term that was left undefined). Modifications of the GATT and agreements negotiated by its successor, the World Trade Organization, have reduced or eliminated many tariffs. You may be asking yourself, “Why should we study tariffs if we’ve already looked at taxes (Chapter 2)? Isn’t a tariff just another tax?” Good point! Tariffs are just taxes. If the only goods sold were imported, the effect of a tariff in the importing country would be the same as we showed for a sales tax. We study tariffs separately because a tariff is applied only to imported goods, so it affects domestic and foreign producers differently. Because tariffs are applied to only imported goods, they do not raise as much tax revenue or affect equilibrium quantities as much as taxes applied to all goods in a market. For example, De Melo and Tarr (1992) calculated that almost five times more tax revenue would be generated by a 15% additional ad valorem tax on petroleum products than by a 25% additional import tariff on oil and gas. To illustrate the effect of a tariff, suppose that the government imposes a specific tariff of t=$40t=$40 per barrel of crude oil. Given this tariff, firms will not import oil into the United States unless the U.S. price is at least $40 above the $60 world price. The tariff creates a wedge between the world price and the U.S. price. This tariff causes the total supply curve to shift from S1S1 to S3S3 in Figure 17.3. As the world supply curve for oil is horizontal at $60, adding a $40 tariff shifts this supply curve upward so that it is horizontal at $100. That is, the rest

of the world will supply an unlimited amount of oil at $100 inclusive of the tariff. As a result, the total U.S. supply curve with the tariff, S3,S3, equals the domestic supply curve for prices below $100 and is horizontal at $100.

Figure 17.3 Effects of a Tariff or a Quota MyEconLab Video

A tariff of t=t= per barrel of oil imported or a quota of 4.5 million barrels per day drives the U.S. price of crude oil to $100, which is $40 more than the world price. Under the tariff, the equilibrium, e3,e3, is determined by the intersection of the S3S3 total U.S. supply curve and the D demand curve. Under the quota, e3e3 is determined by a quantity wedge of 4.5 million barrels per day between the quantity demanded, 15.4 million barrels per day, and the quantity supplied by domestic firms, 10.9 million barrels per day, at a price of $100 per barrel. Compared

to free trade, domestic producers gain area B and consumers lose areas B+C+D+EB+C+D+E from either a tariff or a quota. If the government gives the quota rights to foreign producers, the deadweight loss is C+D+E.C+D+E. With a tariff, the government’s tariff revenue increases by D, so the deadweight loss is only C+E.C+E. The new equilibrium, e3,e3, occurs where S3S3 intersects the demand curve. At this equilibrium, price is $100 and quantity is 15.4 million barrels of oil per day. At this higher price, domestic firms supply 10.9 million barrels of oil per day, so imports are 15.4−10.9=4.515.4−10.9=4.5 million barrels of oil per day. The tariff protects American producers from foreign competition. The larger the tariff is, the less crude oil is imported; hence the higher is the price that domestic firms charge. (With a large enough tariff, nothing is imported, and the price rises to the no-trade level, $199.34.) With a tariff of $40, domestic firms’ producer surplus increases by area B≈$412B≈$412 million per day. Because the U.S. price rises from $60 to $100, consumer surplus falls by B+C+D+E≈$654B+C+D+E≈$654 million per day. The government receives tariff revenues, T, equal to area D≈$180D≈$180 million per day, which is t=$40t=$40 times the quantity imported, 4.5 million. The deadweight loss is the loss of consumer surplus, B+C+D+E,B+C+D+E, minus the tax revenue, D, minus the producer surplus gain, B. That is, the deadweight loss is C+E=$62C+E=$62 million per day, or $22.6 billion per year. This deadweight loss is 15% of the gain to producers. Consumers lose $1.59 for each $1 that domestic producers gain. Because the tariff doesn’t completely eliminate imports, the loss of total surplus is smaller than it is if all imports are banned. This deadweight loss has two components. First, C is a production distortion lost from U.S. firms producing 10.9 million barrels per day instead of 9.6 million barrels per day. Domestic firms produce this extra output because the tariff drives up the price from $60 to $100. The cost of producing these extra 1.3 million barrels of oil per day domestically is C+G,C+G, the area under the domestic supply curve, Sa,Sa, between 9.6 and 10.9. Had Americans bought this oil at the world price, the cost would have been only G. Thus, C is the additional cost of producing the extra 1.3 million barrels of oil per day domestically instead of importing it. Second, E is a consumption distortion loss from U.S. consumers’ buying too little oil, 15.4 instead of 17.5 million barrels, because the tariff increases the price from $60 to $100.9 U.S. consumers place a value on this extra output of E+H,E+H, the area under their demand curve between 15.4 and 17.5. The cost of buying this extra oil from the world market is only H, the area below the line at $60 between 15.4 and 17.5. Thus, E is the difference between the value at the world price and the value U.S. consumers place on this extra 1.3 million barrels per day. 9This analysis ignores the effect of oil consumption on the environment.

Free Trade Versus a Quota. The effect of a quota is similar to that of a tariff. In Figure 17.3, if the government limits oil imports to 4.5 million barrels per day, the quota is binding because 7.9 million barrels per day were imported under free trade (see Figure 17.2). In Figure 17.3, if the price equals $100, the gap between the quantity demanded, 15.4 million barrels per day, and the quantity supplied by

domestic firms, 10.9 million barrels per day, is 4.5 million barrels per day. Thus, a quota on imports of 4.5 million barrels per day leads to the same equilibrium, e3,e3, as a tariff of $40. With a quota, the gain to domestic producers, B, and the loss to consumers, C+E,C+E, are the same as with a tariff. The key difference between a tariff and a quota concerns who gets D. With a tariff, the government receives tariff revenue equal to area D. With a quota, the government does not receive any revenue. Instead, if the government gives the rights to sell the quota to foreign producers, they earn an extra arbitrage profit of D because they buy the oil quota, 4.5 million barrels per day, at the $60 world price, but sell it for $100. Thus, the deadweight loss is C+E=$62C+E=$62 million per day with a tariff but C+D+E=$242C+D+E=$242 million per day with a quota. Therefore, the importing country fares better using a tariff than it does setting a quota that reduces imports by the same amount, assuming the quota rights are given away to foreigners. However, the government does not have to give away the quota rights. It can sell the quota rights to either foreign producers or domestic importers for $40 per barrel. Such a quota would have the same effect as the tariff on government revenue and on domestic deadweight loss.

Q&A 17.2 How does a quota set by the United States on foreign sugar imports affect the total American supply curve for sugar given the domestic supply curve, SdSd in panel a of the graph, and the foreign supply curve, SfS f in panel b?

Answer 1. Determine the U.S. supply curve without the quota. The no-quota total supply

curve, S in panel c, is the horizontal sum of the U.S. domestic supply curve, Sd,Sd, and the no-quota foreign supply curve, Sf.S f.

2. Show the effect of the quota on foreign supply. At prices below ¯p,p¯, foreign suppliers want to supply quantities less than the quota, ¯¯̄Qf,Q¯f, as panel b shows. As a result, the foreign supply curve under the quota, ¯¯̄Sf,S¯ f, is the same as the no-quota foreign

supply curve, Sf,S f, for prices less than ¯p.p¯. At prices above ¯p,p¯, foreign suppliers want to supply more but are limited to ¯¯̄Qf.Q¯f. Thus, the foreign supply curve with a quota, ¯¯̄Sf,S¯ f, is vertical at ¯¯̄QfQ¯f for prices above ¯p.p¯.

3. Determine the U.S. total supply curve with the quota. The total supply curve with the quota, ¯¯̄S,S¯, is the horizontal sum of SdSd and ¯¯̄Sf.S¯ f. At any price above ¯p,p¯, the total supply equals the quota plus the domestic supply. For example, at p*, the domestic supply is Q∗dQ∗d and the foreign supply is ¯¯̄Qf,Q¯f, so the total supply is Q∗d+¯¯̄Qf.Q∗d+Q¯f. Above ¯p, ¯¯̄Sp¯, S¯ is the domestic supply curve shifted ¯¯̄QfQ¯f units to the right. As a result, the portion of ¯¯̄SS¯ above ¯pp¯ has the same slope as Sd.Sd.

4. Compare the U.S. total supply curves with and without the quota. At prices less than or equal to ¯pp¯ the same quantity is supplied with and without the quota, so ¯¯̄SS¯ is the same as S. At prices above ¯pp¯ less is supplied with the quota than without it, so ¯¯̄SS¯ is steeper than S, indicating that a given increase in price raises the quantity supplied by less with a quota than without one.

Rent Seeking Given that tariffs and quotas hurt the importing country, why do the Japanese, U.S., and other governments impose tariffs, quotas, or other trade barriers? One reason is that domestic producers stand to make large gains from such government actions; hence, it pays for them to organize and lobby the government to enact these trade policies. Although consumers as a whole suffer large losses, the loss to any one consumer is usually small. Moreover, consumers rarely organize to lobby the government about trade issues. Thus in most countries, producers are often able to convince (cajole, influence, or bribe) legislators or government officials to aid them, even though consumers suffer more-than-offsetting losses.

If domestic producers can talk the government into a tariff, quota, or other policy that reduces imports, they gain extra producer surplus, such as area B in Figures 17.2 and 17.3. Economists call efforts and expenditures to gain a rent or a profit from government actions rent seeking. If producers or other interest groups bribe legislators to influence policy, the bribe is a transfer of income and hence does not directly increase deadweight loss. However, if this rent-seeking behavior—such as hiring lobbyists and engaging in advertising to influence legislators—uses up resources, the deadweight loss from tariffs and quotas understates the true loss to society. The domestic producers may spend an amount up to the gain in producer surplus to influence the government.10 10Tullock (1967) and Posner (1975) made this argument. Fisher (1985) and Varian (1989) contended that the expenditure is typically less than the producer surplus. Lopez and Pagoulatos (1994) estimated the deadweight loss and the additional losses due to rent-seeking activities in the United States in food and tobacco products. They estimated that the deadweight loss was $18.3 billion (in 2015 dollars), which was 2.6% of the domestic consumption expenditure on these products. The largest deadweight losses were in dairy products and sugar manufacturing, which primarily use import quotas to raise domestic prices.

The overall gain in producer surplus was $66.2 billion. In addition, the government gained $2.7 billion in tariff revenues. If all of producer surplus and government revenues were expended in rent-seeking behavior and other wasteful activities, the total loss was $68.9 billion, or 12.5% of consumption, which is 4.75 times larger than the deadweight loss alone. In other words, the loss to society is somewhere between the deadweight loss of $18.3 billion and $68.9+$18.3=$87.2$68.9+$18.3=$87.2 billion.

Noncompetitive Reasons for Trade Policy A government intervenes in international trade for many reasons beyond raising revenues from tariffs or from selling quotas. Often, trade policy is used to create or eliminate market failures that result from noncompetitive markets. First, the government may use trade policy to create market power and capture some of the extra profit. Second, the government may use strategic trade policies to help its domestic industry compete more effectively with foreign firms when selling in a world market. Third, it may use contingent protection policies to prevent predation by foreign firms or to protect domestic firms from foreign competition.

Creating Market Power. A government can exploit monopoly power by using tariffs or quotas, even if the underlying industry is highly competitive. By restricting supply in a competitive market, the government can drive the price to the monopoly level.

The Philippines supplied four-fifths of the world’s coconut oil, so it was large enough to affect the world price of coconut oil. However, because its growers, refiners, and exporters operated in competitive markets, the world price was a competitive price. To create market power, the government imposed a tariff or tax on copra (the part of the coconut used to create coconut oil). Doing so not only increased the world price, but it allowed the government to capture the increased profit as tariff revenue. The government could have achieved the same outcome by limiting exports using quotas that it would sell to the highest bidder.

Strategic Trade Policy.11 11This section uses game theory Chapter 12; however, the rest of this chapter section does not assume knowledge of this material. The following analysis is based on Brander and Spencer (1985) and Krugman (1987). A government’s trade policy can increase the share of the profits in imperfectly competitive industries that goes to its domestic industry. To illustrate this idea, we consider a vaccine market that is large enough to support one producer but not two—a market with a natural monopoly. Each disease requires a different vaccine, and each vaccine is costly to develop. Many vaccines in a given region are produced and sold by a monopoly supplier (Danzon and Pereira, 2011). Ajinomoto (a major Japanese vaccine producer) and Novartis (a Swiss producer) choose whether to enter and produce a particular vaccine for the U.S. market. Table 17.3 shows their profits from the resulting entry game (Chapter 12). Table 17.3 Drug Entry Game

If both firms enter, both lose, making a profit of −5.−5. Therefore, if its rival enters, a firm prefers to stay out of the market. If Novartis enters and Ajinomoto does not, then Novartis earns 90 and Ajinomoto earns nothing. If Ajinomoto also enters, its profit is −5,−5, so it regrets entering. Similarly, if Ajinomoto enters, then Novartis prefers not to enter. Neither firm has a dominant strategy. However, using the game theory analysis from Chapter12, we see that this game has two pure strategy Nash equilibria: Novartis enters while Ajinomoto stays out or Ajinomoto enters and Novartis stays out.12 12The game also has a mixed-strategy equilibrium, in which each firm chooses to enter with a positive probability less than one (Chapter 12). Can a government act to increase the profit of its domestic firm? If only the Japanese government acts by offering a subsidy of 10 to Ajinomoto if it enters, then the profit matrix changes to Table 17.4. This subsidy makes entering a dominant strategy for Ajinomoto. If Novartis enters, Ajinomoto earns 5, which is greater than the zero profit it earns if it does not enter. If Novartis does not enter, Ajinomoto’s profit is 100 if it enters and 0 otherwise. Thus, Ajinomoto should enter regardless of what Novartis does. Knowing that Ajinomoto wants to enter, Novartis decides not to enter, because to do so would cause it to lose 5. Thus, the subsidy results in a Nash equilibrium in which Ajinomoto enters and earns 100, and Novartis stays out. Table 17.4 Drug Entry Game with a Subsidy to Ajinomoto of 10

As a consequence, Japan obtains a net surplus of 90 (= Ajinomoto's= Ajinomoto's profit of 100 minus the subsidy of 10). This surplus is much more than Japan gets if Novartis enters and Ajinomoto does not, or if both firms enter—both of which are possibilities without a subsidy. Using this strategic trade policy, Japan has shifted an uncertain situation in its favor. Both strategic trade policy tools and the trade policies that create market power are beggar-thy- neighbor policies. One country gains at the expense of other countries. Therefore, an important component of international trade agreements is to prevent or limit the use of such trade policies. Consequently, the trade agreements underlying the World Trade Organization specify that signatory countries agree not to use export subsidies.

Contingent Protection. Contingent protection is a trade policy that protects domestic producers from certain actions by foreign firms or governments. The World Trade Organization allows member countries to impose contingent protection using antidumping laws and countervailing duty policies. Many countries have contingent protection laws against dumping, which occurs if a foreign producer sells a product at a price that is below the price that it sets in its home country or at a price that is lower than its cost of production. Under its antidumping law, the United States imposes a tariff (or duty) on the dumped good. A common justification for this law is to prevent a foreign firm from engaging in predation (Chapter 16), keeping its U.S. price low until it drives U.S. firms out of the industry and then raising its U.S. price. Such a story is implausible unless something prevents firms from entering the market after the price rises. Apparently the primary use of antidumping laws is to protect domestic industries from lower-price foreign competition and to prevent foreign firms from price discriminating when such discrimination would favor domestic consumers. Under a countervailing duty policy, a government may impose a duty if an imported good is subsidized by a foreign government through direct cash payments, credits against taxes, below- market rate loans, or in other ways. For example, in 2012, the U.S. Department of Commerce imposed both antidumping and countervailing duties on imports of high-pressure steel cylinders from China in response to a complaint by the Norris Cylinder Company of Texas. The antidumping duties ranged across Chinese suppliers from 6.6% to 31.2%. In addition, the countervailing duties, intended to offset government subsidies in China, were set at 15.8% of the import price. These duties resulted from a legal determination that the price of the Chinese firms’ cylinders was low due to dumping and subsidies, thereby materially injuring, or threatening material injury to, the U.S. domestic industry.13 13This decision is described on the U.S. Department of Commerce Web site at http://enforcement .trade.gov/download/factsheets/factsheet-prc-hpsc-adcvd- final-20120501.pdf.

Mini-Case Dumping and Countervailing Duties for Solar Panels

In 2011, seven U.S. solar panel makers asked the U.S. Department of Commerce to conduct antidumping and countervailing duties investigations of China’s crystalline silicon solar panel industry. SolarWorld Industries America Inc. (a branch of a German firm), the largest U.S. producer of crystalline silicon solar cells and panels, filed the petition on behalf of this group of U.S. manufacturers. SolarWorld contended that the Chinese government provided its industry

with massive subsidies, which were about 20 times the total of U.S. solar subsidies in the past year. As a consequence, the U.S. firms contended, Chinese firms flooded the U.S. market with silicon products that sold at low prices, which drove U.S. firms out of business. According to Gordon Brinser, president of the U.S. SolarWorld branch, “Our domestic industry is under siege. Let’s be clear, China has a plan for our market: to gut it and own it.”

These U.S. firms were concerned because Chinese exports of crystalline silicon solar cells and panels to the United States increased by more than 350% from 2008 to 2010, while worldwide panel prices tumbled 40% during that period. Seven U.S. manufacturers shut down or downsized from 2010 to mid-2011.

Not all U.S. firms supported this request. “Growth is a result of declining prices,” said Arno Harris, CEO of Recurrent Energy. “We’re not going to shift a bunch of jobs to the U.S. by putting in tariffs. All we’re going to do is shrink the market and slow the growth.” He went on to say that “One manufacturer who can’t compete with today’s solar panel prices is basically looking to put in place trade barriers to make the U.S. a safe market for their own more expensive solar panels.” Indeed, although the firms represented in the SolarWorld suit lost money and many had to close, other solar firms did well enough that the U.S. solar industry was a net exporter to China in 2010. Harris concluded that “It’s not in any way in the interest of American consumers . . . and it’s certainly not in the interest of slowing global climate change.”

In 2012, the U.S. International Trade Commission (ITC) ruled that Chinese solar manufacturers had received illegal subsidies from their government and sold products in the United States at prices 18.32% to 249.96% below the fair market value. The ITC imposed tariffs that ranged from 24% to 255% on Chinese solar modules. However, the tariffs apply only to solar modules and panels made with Chinese-origin cells, so Chinese companies can avoid the tariffs by assembling the modules in China using cells from other countries. Another ITC decision in 2015 cut the tariff on most Chinese PV (photovoltaic) panel manufacturers to about 15%.

Trade Liberalization and the World Trading System The World Trade Organization (WTO), an organization comprised of most of the world’s trading nations, coordinates international trade and limits trade policies that create distortions, such as tariffs and quotas used to create market power. The WTO was created by several international agreements. The most important of these agreements is the General Agreement on Tariffs and Trade (GATT). The GATT was originally drafted and signed in 1947, partly in reaction to the costly trade wars of the 1930s and partly to reestablish commercial relations among the nations that were disrupted during World War II. The WTO was established in 1995, although it was, in essence, a formalization of the administrative structure that had developed around the GATT.

The most important aspect of the GATT and the WTO has been to promote trade liberalization, which allows firms and consumers to benefit from trade. The WTO imposes various

requirements on member countries that facilitate international trade, including limits on tariffs and quotas. Over time, countries gradually accepted the WTO free-trade principles. 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. Most of the other countries in the world have observer status in the WTO and hope to become full members. Reducing trade barriers, particularly tariffs and quotas, has been the most significant achievement of the GATT and the WTO. When the GATT was first created, many countries had prohibitive trade barriers, which prevented any trade with a wide range of potential trading partners. The immediate contribution of the GATT during its early years was to enable any trade at all between many countries. However, even as late as the 1980s, tariffs, quotas, and other trade barriers were still significant impediments to trade. Since then, trade barriers have continued to fall. From 1986 through 2010 the world average tariff rate fell from 26.3% to 8.1%. In high- income countries, the average tariff fell from about 10% to under 3%.14 14These tariffs are unweighted averages (http://go.worldbank.org/LGOXFTV550). Countries that belong to the WTO are allowed to establish preferential trading arrangements between groups of WTO member countries, including free trade agreements that eliminate tariffs and quotas altogether. The United States participates in the North American Free Trade Agreement (NAFTA) with Canada and Mexico, and the Dominican Republic-Central America-United States Free Trade Agreement (CAFTA-DR) with Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua, and Dominican Republic. In addition, the United States has bilateral free trade agreements with Australia, Bahrain, Chile, Colombia, Israel, Jordan, Morocco, Oman, Panama, Peru, Singapore, and South Korea. Not surprisingly, trade liberalization has increased the amount of international trade. However, perhaps less obviously, trade liberalization has made it easier for firms to use inputs from many different countries to produce their final products. General Motors, Westinghouse, Sony, and other companies can manufacture parts in one country and assemble them in another because tariffs and other trade barriers are low or nonexistent. High tariffs would make such supply chain arrangements much less attractive. Thus, a major effect of trade liberalization has been to increase the globalization of supply chains. Many efforts have been made to assess the costs and benefits of trade liberalization. Virtually all such studies find that these trading nations gain significantly from liberalization (Feenstra, 2010). Trade liberalization has been a major driving force behind the recent dramatic improvements in the standard of living in China, India, and other developing countries.

Trade Liberalization Problems Critics of freer trade raise concerns about a variety of negative effects, particularly relating to environmental standards and to wages and labor standards. Freer trade might exacerbate environmental problems caused by environmental externalities or open-access common property (Chapter16). Because most developing countries have weaker environmental laws than do the United States and other high-income countries, critics predict that freer trade will cause these developing countries to become pollution havens: Firms based in developed countries will move their manufacturing to these developing countries, save money due to avoiding the cost of environmental regulation, and then export their products to their home countries. Such issues were important when Mexico joined Canada and the United States in the North American Free

Trade Agreement (NAFTA) in 1994, which removed tariffs on goods traded by these countries. Many U.S. companies moved operations across the Mexican border, including major auto producers such as Ford and General Motors and major producers of electrical equipment such as Honeywell and General Electric.15 15Proponents of NAFTA noted that it incorporated specific agreements on environmental regulation that were intended to improve environmental policy in Mexico. They also argued that because NAFTA would raise incomes in Mexico, Mexico would be more likely to institute greater environmental protections. Analysis of the Mexican experience following its entry into NAFTA indicates neither a notable increase in environmental problems nor a notable decrease (Gallagher, 2004; Lipford and Yandle, 2011). Some areas close to the U.S. border experienced an increase in pollution problems, but improvements occurred in other areas. Critics of freer trade similarly argue that U.S. firms might move operations to developing countries with low wages and weak labor standards. However, these cases differ in a critical manner. The pollution haven problem is based on market failure, and liberalizing trade and investment can make this market failure worse—reducing total surplus in the global economy. Low wages do not, in themselves, imply a market failure. Freer trade should be faulted only if it results in lower wages or labor standards in developing nations. So far, little evidence exists showing such a negative effect (Salem and Rozental, 2012).

17.4 Multinational Enterprises The managers of companies that produce in many countries must decide how much to trade and what prices to use when trading internationally between their units. These decisions turn critically on differences in tax laws across countries.

Most of the world’s largest companies are multinational enterprises (MNEs): enterprises that control productive assets in more than one country.16MNEs play a dominant role in world trade flows, accounting for approximately 90% of U.S. exports and imports (Antràs and Yeaple 2014). 16MNEs are sometimes called transnational corporations (TNCs) or multinational corporations (MNCs). Multinationals normally have a parent company and a number of foreign affiliates. According to the definitions used by international agencies including the United Nations Conference on Trade and Development (UNCTAD) and the International Monetary Fund (IMF), any company in which the parent has an ownership share of 10% or more is regarded as an affiliate. An affiliate in which the parent has an ownership share of 50% or more is called a subsidiary. Many subsidiaries are wholly owned by the parent. Toyota is one of the world’s largest MNEs. The parent Toyota Motor Corporation is based in Japan and has subsidiaries throughout the world, including in the United States. Typically, a multinational enterprise is not a single corporation. Rather, the parent company is a corporation and each subsidiary is itself a corporation, with its own CEO and senior managers. The only shareholder of a wholly owned subsidiary is the

parent corporation. Thus, a multinational enterprise, such as Toyota, is an interlocking network of corporations connected through ownership.

The management of 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. Each subsidiary is normally treated as an independent profit center: The managers of each subsidiary seek to maximize the profits of their subsidiary and do not consider the profits of other subsidiaries. However, the parent corporation may intervene in business decisions of subsidiaries to achieve better performance for its bottom line, even if that imposes costs on particular subsidiaries.

Very few firms start as multinational enterprises. A start-up firm typically initially focuses only on its domestic market. After it is well established, it may export its products. After its exports become numerous enough, the firm may decide that it is more cost-effective to produce its good or services in another country, and it becomes a multinational enterprise.

Becoming a Multinational A firm becomes a multinational through foreign direct investment (FDI). The two types of FDI are greenfield investments and the purchase of foreign assets. A greenfield investment creates a new production facility in a foreign country, such as in an undeveloped, green field. For example, in 2015, Ford announced two greenfield investments in Mexico, including a new $1.1 billion engine plant in Chihuahua and a new $1.2 billion transmission plant in Guanajuato. These plants were expected to export engines and transmissions to Ford assembly plants in the United States, Canada, South America, and Asia. The other type of FDI is the acquisition of existing productive assets such as a plant or a firm. When a foreign firm acquires 10% or more of a domestic company’s voting stock, the purchase is categorized as a direct investment, and is sufficient to classify the parent company as a multinational in official statistics. For example, in 2014, Japan’s Suntory Holdings, a major producer of alcoholic beverages in Japan, paid $16 billion to purchase Beam Inc., the U.S.-based producer of Jim Beam bourbon and other alcoholic beverages. The acquired company was renamed Beam Suntory and operates as a wholly owned U.S. subsidiary of Japanese parent company Suntory Holdings.

Traditionally, a major motive for a firm to acquire or build foreign productive assets is to lower its cost of supplying that foreign market by producing in that market rather than exporting to it. Toyota originally built plants in the United States to produce for the American market largely because it was less expensive than shipping cars from Japan. Producing locally allows the company to reduce transport costs and avoid tariffs or quotas on imported goods.

However, as tariffs and transportation costs have fallen in recent years, and international communication has become easier, a second motive has become relatively more important: comparative advantage in the supply chain. Increasingly, multinationals have found it efficient to

produce various components or other inputs to production around the world, selecting the best location for each component.

Mini-Case What’s an American Car?

U.S. car manufacturers and labor unions regularly lobby the U.S. government for trade policies that favor their cars over imports. However, one might ask which firms are the true all-American manufacturers.

No car is entirely built in the United States using only U.S. parts. In 2015, nine cars and trucks tied for having the most American content at 75%. Three of these were manufactured by the Japanese firms Toyota and Honda, including the Toyota Camry, which is assembled in Georgetown, Kentucky, and Lafayette, Indiana. Of the major U.S. auto manufacturers, General Motors had five of the nine, Fiat Chrysler had one, and Ford had none.

For all manufacturers, the share of U.S. parts in their vehicles varies annually in response to changes in relative prices, disruption of supply lines due to natural disasters, and other factors. The U.S. content of the Ford F-150 was 60% in 2011, but 75% in 2012 (after Japan’s major 2011 earthquake and tsunami). The 2015 Ford Focus, which is supposed to be a poster car for Ford’s global One Ford strategy, had only 40% domestic parts. Moreover, many of the main U.S. auto manufacturers’ models are assembled in Canada or Mexico, in large part due to the North American Free Trade Agreement, which eliminates tariffs when the assembled vehicles are shipped to the United States.

International Transfer Pricing An MNE can gain many tax and other advantages by having its subsidiary in one country sell its goods or services to a subsidiary in another country. Typically, an MNE lets its subsidiaries make most decisions independently. However, the parent firm may lose profit if it lets one subsidiary set a very high transfer price: the price used for an intra-firm transfer of goods or services.

Toyota provides an example of such intra-firm transfers. Toyota Motor Engineering & Manufacturing North America (TEMA), a subsidiary of the parent firm, Toyota Motor Corporation, produces most of the Toyota motor vehicles sold in the United States. The cars are marketed and sold primarily by Toyota Motor Sales, U.S.A., Inc. (TMS), another subsidiary of the parent Toyota Motor Corporation. TEMA sells 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.

Toyota subsidiaries also engage in international transfer pricing. For example, Toyota Motor Manufacturing Canada Inc. (TMMC) is another Toyota subsidiary, based in Canada, which sells vehicles to TMS for sale in the United States using an international transfer price.

We illustrate the key issues in international transfer pricing by examining how TMMC sets its transfer price to TMS for a Toyota RAV4 crossover SUV, which is produced by TMMC. For simplicity, we assume that the RAV4 is essentially a monopoly product (the only such vehicle in its class).

Profit-Maximizing Transfer Pricing. How should TMMC set its transfer price? We consider two possibilities. First, we ask how TMS would set its monopoly price if it were a vertically integrated firm (Chapter 7) that both manufactured and sold cars. Second, we examine how TMS would price the car if TMMC sets a monopoly transfer price to TMS, which then sets a monopoly price to final consumers. If TMS were vertically integrated—if it produced the RAV4 instead of obtaining it from TMMC—it would apply a monopoly markup M based on the demand curve of its U.S. customers to its marginal cost of producing a car, m, to obtain its profit-maximizing monopoly price, p1=M×m.p1=M×m. 17 We know that the markup M exceeds 1 because a profit- maximizing monopoly sets its price above its marginal cost. 17Equation 9.5 shows that the monopoly’s marginal revenue is MR=p(1+1/ε),MR=p(1+1/ε), where εε is the elasticity of demand. Thus, as Equation 9.8 shows, the monopoly sets MR=p(1+1/ε)=m.MR=p(1+1/ε)=m. Therefore, its profit-maximizing monopoly price is p=m/(1+1/ε).p=m/(1+1/ε). That is, its markup is M=1/(1+1/ε).M=1/(1+1/ε). For simplicity in this section, we assume that εε is constant, so that M is a constant. It does not change even if a change in m causes the firm to move to a different point on its demand curve. If εε is not constant (such as with a linear demand curve), M varies as m varies. We use a linear demand curve in Q&A 17.3. However, the two subsidiaries are not vertically integrated. They act independently. Because TMMC is the monopoly supplier of the RAV4 to TMS, TMMC maximizes its profit by setting a monopoly transfer price for the cars it manufactures and sells to TMS. TMMC applies a markup of M* to its marginal cost, m, setting its transfer price to TMS at p∗=M∗×m.p∗=M∗×m. TMS views this transfer price, p*, as its marginal cost (rather than m). TMS applies its markup, M, to its marginal cost p* to determine the final price to consumers: p2=M×p∗=M×M∗×m.p2=M×p∗=M×M∗×m. Thus, the final price reflects a double markup, M×M∗,M×M∗, instead of the single markup, M, if the companies were vertically integrated. Because both markups are larger than one, the double markup price, p2,p2, is greater than the price of the vertically integrated company with a single markup, p1.p1. As a result, TMS sells fewer cars at a higher price than if it were a vertically integrated firm. Because p1p1 is the profit-maximizing monopoly price, charging a higher-than- monopoly price reduces the parent company’s total profit. For this reason, the parent company would not want TMMC to set a monopoly transfer price. The transfer price that maximizes combined profits of TMMC and TMS equals TMMC’s marginal cost of production. This price maximizes combined returns to the two subsidiaries.

However, Toyota might have a tax-based incentive to use a different transfer price—one that does not equal marginal cost. Using an alternative transfer price can help Toyota avoid taxes.18

18Toyota might also want to make sure that TMMC does not incur a loss, which occurs if TMMC incurs fixed costs such that a transfer price equal to marginal cost does not cover its total costs. Car production has high fixed costs (plant, equipment, and managerial staff). Q&A 17.3 MyEconLab Q&A

Reebok Vietnam (RV) is a subsidiary of the German multinational corporation Adidas. RV makes shoes in Vietnam and sells some of these shoes to Adidas Japan (AJ), another Adidas subsidiary, at the transfer price p*. AJ sells the shoes to Japanese consumers. For simplicity, we assume AJ has a monopoly in Japan. Suppose that the inverse demand function in Japan for Reebok shoes is p=100−Q,p=100−Q, where Q is measured in tens of thousands of pairs per month and p is the price per pair of shoes. RV’s cost of production is CR=20Q,CR=20Q, so its marginal cost of producing shoes is $20 per pair in Vietnam. If the parent Adidas Corporation directs RV and AJ to maximize their combined profit, what are the price, quantity, and resulting profit? What happens if, instead, RV sets its transfer price at p∗=60?p∗=60?

Answer 1. Determine the profit-maximizing quantity and price for shoes if RV and AJ act like a

single profit-maximizing firm, and calculate the profit.Because the demand curve is linear, the marginal revenue curve has the same intercept and twice the slope of the inverse demand function: MR=100−2Q.MR=100−2Q. To maximize its profit, Adidas operates where its marginal cost, 20, equals its MR: MR=100−2Q=20=MC.MR=100−2Q=20=MC.

By solving this equation for Q, we find that the firm’s optimal Q=40.Q=40. Substituting that quantity into the inverse demand function, we learn that Adidas sets a price in Japan of p=100−40=60.p=100−40=60. Its profit, π,π, is the difference between its revenue and cost: π=R−C=(60×40)−(20×40)=1,600.π=R−C=(60×40)−(20×40)=1,600.

2. Determine AJ’s profit-maximizing quantity and price for shoes and the profits of RV and AJ if RV sets a transfer price of p∗=60.p∗=60. The transfer price is AJ’s new marginal cost. It operates where its marginal revenue equals its marginal cost: MR=100−2Q=60.MR=100−2Q=60. Thus, the quantity that maximizes AJ’s profit is Q=20.Q=20. Substituting that quantity into the inverse demand function, we find that AJ’s price is p=80.p=80. AJ’s profit is πJ=RJ−CJ=pQ−(p∗×Q)=(p−p∗)Q=(80−60)×20=400.πJ=RJ−CJ=pQ−(p∗× Q)=(p−p∗)Q=(80−60)×20=400. RV’s profit is πR=RR−CR=(p∗×Q)−20Q=(60×20)−(20×20)=800.πR=RR−CR=(p∗×Q)− 20Q=(60×20)−(20×20)=800. The sum of the profits of AJ and RV is 400+800=1,200.400+800=1,200.This sum is considerably less than the profit of 1,600 that they earn if they act like a single firm.

Comment: The transfer price p∗=60p∗=60 maximizes RV’s profit given that the subsidiaries act independently.19

19Because AJ views the transfer price p* as its marginal cost, it sets its marginal revenue equal to p∗: MR=100−2Q=p∗p∗: MR=100−2Q=p∗ or Q=50−0.5p∗.Q=50−0.5p∗. That is, for any transfer price p*, AJ will purchase Q=50−0.5p∗Q=50−0.5p∗ from RV. This relationship is the demand function facing RV. It is referred to as a derived demand because it is derived from the downstream consumer demand for shoes. RV’s corresponding marginal revenue function is MR=100−4Q,MR=100−4Q, which it equates to its marginal cost of 20: 100−4Q=20.100−4Q=20. Thus, it maximizes its profit when Q=20.Q=20. Substituting this quantity into RV’s derived demand function, we know that 20=50−0.5p∗,20=50−0.5p∗, so p∗=(50−20)/0.5=60.p∗=(50−20)/0.5=60. Thus, RV’s profit-maximizing transfer price is p∗=60.p∗=60.

Tax Avoidance. If corporate tax rates differ across countries, Toyota prefers to earn most of its profit in the low- tax country. The transfer price determines the allocation of profits between TMMC and TMS. As the price increases from marginal cost toward the monopoly price, TMMC’s profit rises and TMS’s profit falls.

If the Canadian corporate income tax, which is paid by TMMC, is 20%, while the U.S. corporate tax rate, which is paid by TMS, is 30%, then Toyota prefers to earn its profits in Canada rather than in the United States.20 Accordingly, the Toyota parent prefers a relatively high transfer price. 20Corporate tax rates in the United States vary from state to state and in Canada from province to province. The actual amount paid depends on a host of special deductions and other tax code provisions. Consequently, U.S. firms often locate offices in low-tax states to reduce state taxes. For example, although Apple’s corporate headquarters are in California, it set up a small office in Nevada to collect and invest its profits because California’s corporate tax is 8.84% and Nevada’s is zero. Suppose that TMMC initially produces a vehicle at a marginal cost of $30,000 and transfers that vehicle to TMS at a transfer price of $30,000, so that TMMC earns no profit in Canada. TMS resells the vehicle to an independent locally owned American dealership at a (wholesale) price of $32,000, so that its before-tax profit margin on this car is $2,000. Given that the U.S. corporate tax rate is 30%, TMS pays 30% of its profit on the vehicle—$600 to the U.S. tax authorities— yielding an after-tax profit of $1,400 (= $2,000−$600),$1,400 (= $2,000−$600), which goes to the parent, Toyota. Now suppose that the transfer price on the vehicle is raised to $32,000. TMMC earns a before- tax profit of $2,000, on which it pays taxes of $400 at the Canadian rate of 20% per vehicle, yielding a net profit of $1,600. TMS earns no profit and therefore pays no U.S. corporate income tax on this vehicle. Toyota now earns an after-tax profit of $1,600 on this vehicle instead of the $1,400 it earned with the lower transfer price in place.

Thus, the higher transfer price has the effect of shifting profit from the U.S. to the Canadian subsidiary, where the profit is taxed at a lower rate. As the parent Toyota Motor Corporation is the owner of both TMMC and TSM, it benefits from this increased transfer price, other things equal.

But other things are not equal. A trade-off exists between the tax advantage of high transfer prices and the inefficiency of having a transfer price above marginal cost. The after-tax profit per vehicle transferred rises with the higher transfer price, but TMS imports fewer vehicles. If the marginal benefit of raising the transfer price from avoiding taxes exceeds the marginal cost from a non-optimal price signal to a subsidiary, the firm should raise the transfer price. The profit- maximizing transfer price would be where the marginal cost and marginal benefit of increases in the transfer price were just equal.

An MNE might be able to avoid this distortion. For example, it could use a marginal cost transfer price as the real price between the subsidiaries, but tell the tax authorities that the price was higher so as to reduce its tax liability. However, such a practice is not legal. Tax authorities pay careful attention to transfer pricing to restrain the ability of companies to reduce tax liabilities. Specific rules vary from country to country, but the general rule is that transfer prices must reflect normal pricing practices that apply in the absence of tax incentives. Presumably because of an inability to determine a single “correct” transfer price, tax authorities set a reasonable range. Within that range, companies have some ability to use transfer price variations to reduce taxes. Such a practice is called tax avoidance: a legal way of reducing taxes. Illegal methods of reducing tax payments, such as keeping fraudulent financial records, are called tax evasion.

Mini-Case Profit Repatriation

A U.S. parent firm that uses transfer pricing to avoid paying taxes in the United States may face a serious problem that much of its profit is overseas. If it brings the money back to the United States, it would normally have to pay taxes on this transfer as the United States, unlike most other countries, taxes its multinational corporations on their repatriated foreign earnings (earnings brought back to the United States). U.S. companies can avoid these taxes as long as the profits remain overseas.

Sophisticated managers use transfer pricing to shift profits to low-tax countries and then invest these profits offshore. Goldman Sachs estimated that corporations held $2.5 trillion outside the United States in 2015. As of 2015, Apple’s overseas cash hoard was $158 billion, General Electric has $110 billion, and Microsoft has $82 billion.

Periodically, large U.S. corporations lobby for a repatriation holiday, where the federal income tax owed on returned profits would fall from the usual 35% to something much lower, in the range of 5% or 6%, for one year. These firms argue that the tax break would stimulate the economy by inducing multinational corporations to inject $1 trillion or more into the economy, creating hundreds of thousands of jobs.

Many doubt this claim because the American Jobs Creation Act of 2004 provided a temporary repatriated profits tax rate of 5.25% but did not result in significant domestic investment. In 2005, 800 firms repatriated $312 billion back to the United States, paid $16 billion in taxes, but returned 92% of the repatriated money to shareholders in dividends and stock buybacks rather than use this money to expand domestic operations. Indeed, 15 of the largest MNEs repatriated

60% of the returning money, and many of these firms laid off domestic workers, closed plants, and shifted even more of their profits and resources abroad, presumably waiting to cash in again on the next repatriation holiday. Merck, the pharmaceutical giant, retrieved $15.9 billion in profits but cut its workforce and reduced capital spending in this country over the next three years. Similarly, Hewlett-Packard repatriated $14.5 billion, and then announced that it was eliminating 14,000 domestic jobs.

President Obama’s 2016 budget proposal called for raising $238 billion by imposing a one-off, 14% tax on U.S. company earnings sitting overseas. He also proposed assessing 19% on future overseas earnings. So far, Congress has not seen fit to enact these proposals.

17.5 Outsourcing Probably no international trade issue has been more controversial than international outsourcing, where a firm buys goods and services from foreign suppliers that the firm would otherwise provide internally. In extreme cases, a manager who outsources abroad to reduce costs may face a boycott by consumers, which can hurt the firm’s bottom line. Less controversial and more common is domestic outsourcing. For example, a restaurant may outsource its cleaning needs to a company that provides janitorial services rather than hire its own cleaning staff. No firm produces all its own inputs and provides all the necessary services to sell its product. All firms outsource to some degree.

International outsourcing used to be rare. However, trade liberalization under the World Trade Organization and other international agreements has made it much easier for firms to outsource internationally. Manufacturing firms import inputs rather than producing them in their home countries, and call centers in India and other nations provide phone support service for many U.S. firms.

Multinational enterprises often engage in foreign outsourcing by shifting production of a needed input from a subsidiary in one country to one in another country. For example, Toyota’s wholly owned U.S. production subsidiary imports some parts from Toyota affiliates in China rather than produce them domestically. However, a firm does not need to be a multinational enterprise to engage in foreign outsourcing. Some firms with purely domestic production operations import inputs that they previously produced themselves.

When a firm starts outsourcing abroad, it lays off domestic workers who produced a needed input and instead imports that input from another country, where new workers are hired. Many U.S. groups are upset by this outsourcing of U.S. jobs, particularly workers in the service sector. By some reports, U.S. financial services firms save $2 billion per year by outsourcing to India, giving this sector a strong incentive to outsource.

The U.S. government does not systematically report the number of jobs outsourced overseas. It is widely believed that most international outsourcing is by information technology firms. Deloitte’s 2012 survey of large corporations reported that 76% of information technology firms outsourced, but that only 11% of firms in sales or marketing support did. Deloitte’s 2014 survey found that only 16% of large firms had moved or planned to move work back to their home country. The preferred locations for outsourcing were (in order) India, the United States, China, and Poland.21 21The 2012 report can be downloaded from http://www.barebrilliance.com/deloittes- 2012- global-outsourcing-and-insourcing-survey. The 2014 report is at http://www2.deloitte.com/content/dam/Deloitte/us/Documents/strategy/us- 2014-global-outsourcing-insourcing-survey-report- 123114.pdf. Brown et al. (2013), which surveyed U.S. full-time workers, suggests that the debate exaggerates the degree of outsourcing. Half the surveyed employees worked in organizations that have some domestic outsourcing for a major business function and almost one-quarter work at organizations that outsource internationally. However, the share of business costs from domestic outsourcing and offshoring is small: Nearly all (93%) of the costs for major business functions continue to be within the firm or organization’s operations in the United States. By one estimate (see Mankiw and Swagel, 2006), every dollar of outsourcing results in an increase of U.S. income of $1.12 to $1.14. Ultimately, outsourcing is a consequence of comparative advantage—particular tasks get shifted to locations where they have the lowest opportunity cost. While the debate rages in the United States about jobs moving to India and other foreign countries, Europeans are protesting that high-paying R&D jobs are being outsourced to the United States from Europe. Indeed, insourcing, where foreign companies buy U.S. services—particularly legal services—has grown increasingly common. Most economics textbooks dealing with international trade emphasize that trade, including outsourcing, leads to more efficient market outcomes due to comparative advantage. Does it follow that people who attack free trade and outsourcing are simply ignorant or venal? No. Once a nation starts trading, it reduces the production of some goods and services so that it can concentrate on those in which it has a comparative advantage. As a consequence, some people gain and some people lose from free trade. Firms in noncompetitive sectors may lose sunk capital. Their workers may suffer from at least temporary unemployment. The gains in the other sectors are large enough to compensate the losers. However, if society fails to compensate them, they will be adamantly (and reasonably) opposed to free trade.

As the Doonesbury cartoon illustrates, we can see the gains from trade in services by imagining that domestic workers rather than firms outsource. Suppose that you are hired to design a Web page for $25 an hour. You know that Ivan, a very competent, reliable Russian worker, can do the job as well as you can, and he is willing to work for $10 an hour. You can subcontract with Ivan, pocket $15 an hour, and, with your free time, take on an additional job or enjoy your extra leisure. Clearly, you would favor this plan. However, if your firm fired you and outsourced your job to Ivan, you would be outraged over your loss. This example illustrates that much of the debate on

outsourcing jobs concerns who reaps the benefits and who suffers the losses rather than whether or not society has a net gain. As with any desirable trade, the winners can in principle compensate the losers so that everyone benefits, although such compensation often does not take place.22 22An Amazon employee, Dina Vaccari, reported that she used her own money to pay a freelancer in India to enter data so that she could get more done. Kantor, Jodi, and David Streitfeld, “Inside Amazon: Wrestling Big Ideas in a Bruising Workplace,” New York Times, August 15, 2015.

Doonesbury © 2003 G. B. Trudeau. Reprinted with permission of Universal Uclick. All rights reserved. Rather than giving up the benefits of free trade, both domestic proponents and opponents of free trade are now calling for more compensation for the losers. The U.S. Trade Adjustment Assistance program provides up to $220 million to train workers who lost their jobs due to foreign competition for new jobs. However, the United States spends only 0.5% of its gross domestic product to assist displaced workers, compared to 0.9% in the United Kingdom, 3.1% in Germany, and 3.7% in Denmark (Farrell, 2006).

Managerial Solution Responding to Exchange Rates 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?

Earlier in the chapter, we discussed why arbitrage causes a price to react completely to changes in exchange rates. Wheat is a nearly perfectly competitive market. Japan receives 15% of U.S. exports. If the U.S. supply curve of wheat is horizontal at a dollar price of p in the United States and the exchange rate is 122 yen per dollar, then arbitrage forces the yen price in Japan to be 122p. If the exchange rate goes to 150 yen to the dollar, the U.S. price remains constant and the Japanese price shifts in proportion to 150p. Consequently, the yen-denominated price and the dollar-denominated price are equivalent.

It is not much of a stretch to think of Rolls-Royce as a monopoly. Obviously no one “needs” a Rolls-Royce, but it is perhaps the world’s best-known luxury product and is a must for people who want “the best of everything.”

New vehicles are sold in Britain and the United States at only a handful of authorized dealers. Given the desire for warranty protection among customers and the high cost of shipping a Rolls across the Atlantic Ocean, the company does not worry excessively about resale or international arbitrage. As a consequence, the U.S. and the U.K. prices may differ.

The figure shows the U.S. demand curve for a Phantom Coupé. Rolls-Royce acts like a monopoly, equating its marginal revenue, MR, to its marginal cost, MC1=$150MC1=$150 thousand, to determine its profit-maximizing quantity, Q1.Q1. At that quantity, the dollar-denominated price is $500 thousand.23 This price is equivalent to about £333.3 thousand at an exchange rate of 1.5 dollars to a pound. This U.S. price is less than the British price, which was £360 thousand in 2015. 23This figure is based on the assumption that the U.S. inverse demand function (in thousands of dollars) is p=850−Q.p=850−Q. Thus, the marginal revenue function is MR=850−2Q.MR=850−2Q. Given that the marginal cost is MC=150,MC=150, then profit is maximized where MR=850−2Q=150=MC,MR=850−2Q=150=MC, or Q=350.Q=350.Substituting this quantity into the inverse demand function, we find that the price is p=$500p=$500 thousand. At the exchange rate R1=1.5,R1=1.5, the price in pounds is p∗≈£333.3p*≈£333.3 thousand. Now suppose that the dollar becomes less valuable relative to the pound so that the exchange rate changes to 2 dollars to a pound. The change in the exchange rate causes the U.S. marginal cost to rise by a third (= [2−1.5]/1.5)(= [2−1.5]/1.5) to MC2=$200MC2=$200 thousand. In the figure, this increase in the marginal cost causes the profit-maximizing U.S. price to rise to $525 thousand, or £262.5 thousand.24 Thus, when the exchange rate increases by a third, the dollar- denominated price increases by only 5% (≈ [525−500]/500)5% (≈ [525−500]/500) and

the pound-denominated price falls by 21.2% (≈ [262.5−333.3]/333.3).21.2% (≈ [262.5−333.3]/333.3). 24Continuing our example from the last footnote, if the exchange rate increases to 2 dollars to the pound, the dollar-denominated marginal cost increases to MC=200.MC=200. Thus, the profit-maximizing solution is determined by MR=850−2Q=200=MC,MR=850−2Q=200=MC, so Q=325Q=325 and p=$525p=$525 th ousand. In the competitive wheat example and in the Rolls-Royce example, the price in the exporting country remains constant in response to a change in the exchange rate. In the wheat market, the foreign (Japanese) price adjusted fully to a change in the exchange rate. In contrast, in the noncompetitive Rolls-Royce example, the foreign, U.S. price only partially adjusted to a change in the exchange rate. Indeed, if the Rolls were manufactured in the United States as well as in Britain (as is the case for a Rolls-Royce jet engine), then the exchange rate change would have no effect on the U.S. price.

Summary 1. Reasons for International Trade. One key reason for international trade is

comparative advantage. If producers in Country A can produce relatively more of Good 1 than Good 2 from a given amount of input, while producers in Country B are relatively better at producing Good 2, both countries can benefit from trading. A second important reason for trade is increasing returns to scale. Rather than producing everything at a small scale in a single country, producers can take advantage of increasing returns to scale by producing a large quantity of some good in one country and exporting much of the output to other countries. Increasing returns to scale are particularly important in industries where product variety is important. Allowing each country to produce and export a few varieties while its consumers enjoy a wide range of variety based on production in many countries underlies much of the trade we see.

2. Exchange Rates. An exchange rate is the price of one currency, such as the euro, in terms of another currency, such as the dollar. An increase in an exchange rate can cause large changes in which goods and services are traded and at what prices. After an exchange rate changes, arbitrage causes the prices across countries for a given good to move closer together. The possibility of exchange rate fluctuations creates additional risk for firms engaged in international trade and investment. Such risks can be reduced by using forward or futures contracts.

3. International Trade Policies. Governments intervene in the movement of goods across borders. The most important types of intervention are tariffs—taxes on imports (or, rarely, on exports), and quotas, which limit the quantity of a good that can be imported (or exported). Tariffs produce government revenue, as do quotas if the government sells them to importers or exporters. Governments sometimes intervene to create market power for domestic exporters or to help domestic firms compete with foreign firms in world markets. Trade policy is also

often used to protect domestic firms from certain contingencies, such as dumping (selling at unreasonably low prices) by foreign firms.

4. Multinational Enterprises. Multinational enterprises are firms that own production facilities in more than one country. Such enterprises are responsible for the majority of the world’s international trade and investment flows. Most firms that become multinationals initially produce in a single country and then expand into other countries by purchasing productive assets in those countries or by building new production facilities in those countries (greenfield investments). Trade between units of a multinational enterprise is significantly affected by variations in tax rates across nations. These firms may reduce their taxes by adjusting the transfer price that one unit charges another for a good shipped internationally.

5. Outsourcing. A firm outsources if it buys an input from another firm rather than producing it internally. Although most outsourcing occurs within a single country, global outsourcing is increasing and is controversial. Critics complain that sending work overseas causes a loss of domestic jobs. Firms outsource to lower their production costs. International outsourcing reflects comparative advantage.