Chapter 8 Firms in the Global Economy

INTRODUCTION

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Firm Heterogeneity • In the monopolistic competition model: – Firms are identical (same revenue and price) – Under free trade, all firms export • In reality: – Exporters are larger (in terms of revenue and employment) – Only a fraction of firms export

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Firm Heterogeneity

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Firm Heterogeneity

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Firm Heterogeneity • Does firm heterogeneity affects the predicted impacts of trade? • We extend the monopolistic competition model of trade to include firm heterogeneity. We need a model of trade consistent with the following facts: – Some firms are larger than others – Only a fraction of firms export – Exporters are bigger • We start from the assumption that some firms are “better” then others at producing a given product, i.e., they face lower marginal production cost. ECON 40710 –University of Notre Dame

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Firm Heterogeneity

TC i = F + Ci Q

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Firm Heterogeneity Assume that the residual demand for firm i is given by:

Q is the quantity of variety i demanded S is the size of the market Pi is the unit price for firm i P is the average price e > 1 is the price elasticity of demand.

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Firm Heterogeneity

P i = R i - TC i = (Pi - Ci )Qi - F > 0

C0

Û

(Pi - Ci )Qi > F

C0

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Firm Heterogeneity Π R (C i ) P (C i ) = -F e

C0

Exit

C > C0

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0

C0

Cmax

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Firm Heterogeneity • So far introducing heterogeneity in production cost provides the following insights: – More productive firms produce more output – More productive firms have greater revenue • These results are well aligned with the data • We complete the model by introducing international trade

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Firm Heterogeneity • Suppose for simplicity that there are 2 identical countries. • Trade Costs: We assume that to sell output in the foreign country, firms must pay additional costs – A fixed export cost (Fx) – to develop a supplier network. – A per unit transport cost (t) – to ship their units to the foreign country.

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Firm Heterogeneity • Under these assumptions, it follows that (see PS#5): – Firms charge higher prices and sell less units in the foreign market than in the domestic market – This implies that revenue and profits from export are lower than their domestic counterparts – Selection: only firms that can generate high enough foreign sales revenue can overcome the trade barriers (Fx and t)

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Firm Heterogeneity • Export profits are decreasing in marginal cost (C)

R (C i ) -F e R ( C) P X (Ci ) = i e -1 - FX et P (C i ) =

Π

• There is a break-even firm C X • In the “normal” case

CX

C0

C X < C0 ΠX ECON 40710 –University of Notre Dame

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Firm Heterogeneity Π

• The least productive firms Π exit C > C0 ΠX

• “Medium” firms sell in the domestic market only C X < C < C0 • Very productive firms sell in the domestic and in the foreign market

Exporters Domestic CX

C0

Exit C

C < CX ECON 40710 –University of Notre Dame

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Trade Liberalization with Firm Heterogeneity • The model replicates the most important features of the data: – Only a fraction of firms export – Exporters are bigger than non-exporters • This provides some confidence that the predictions of the model are reliable. • With that in mind, we use our model to analyze the impact of trade liberalization – reduction in trade costs.

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Trade Liberalization with Firm Heterogeneity When trade costs are lower:

Π

ΠX

• Export profits are higher. It becomes “easier” to be profitable in the export market:

Start to export

• The cutoff C X goes up 1 X

C

C 2X

• A larger fraction of firms export

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Trade Liberalization with Firm Heterogeneity • Since trade costs are lower, firms charge lower prices in the foreign markets and capture larger market shares • This implies that exporters produce more output than before – To do this, they need to hire more workers – This increases the demand for labor – Since the supply of labor is fixed the wage rate goes up – An increase in wage is equivalent to an increase in production costs à the less productive firms are no longer profitable and exit the industry – This frees up workers for the exporting firms ECON 40710 –University of Notre Dame

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Trade Liberalization with Firm Heterogeneity A decrease in transport cost:

Π

ΠX

Π

1. Leads to exit of least productive firms

Exit

C 0 goes down

2. Increases the share of exporting firms

c 0X

c0

ci

C X goes up

Start to export ECON 40710 –University of Notre Dame

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Trade Liberalization with Firm Heterogeneity Trade liberalization (a decrease in trade costs) leads to an increase in aggregate industry productivity. This happens for 2 reasons: 1. Selection (Exit of least productive firms) 2. Reallocation of market share towards more productive incumbent firms (in particular, exporting firms become larger)

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Summary Including firm heterogeneity: – Allows us to match additional features of the data: only a fraction of firms export and exporters are bigger – Trade liberalization has an additional impact: it increases the average productivity of an industry by forcing less efficient firms to exit.

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EMPIRICAL APPLICATION

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CUSFTA and NAFTA • The monopolistic competition models deliver three important predictions about the impact of international trade: 1. Increase in welfare due to access to additional varieties and decreases in price 2. Selection effect: Some firms will exit the industry 3. Scale effect: Surviving firms will increase their output • Do these predictions hold in practice? – We look at evidence from the Canada-US Free Trade Agreement (CUSFTA) and the North American Free Trade Agreement (NAFTA) ECON 40710 –University of Notre Dame

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CUSFTA and NAFTA • Canada–U.S. Free Trade Agreement (CUSFTA) signed in 1988 • North American Free Trade Agreement (NAFTA) between Canada, Mexico, and the United States came into force in 1994 • These free trade agreements (FTAs) remove most barriers to trade and investment among the United States, Canada, and Mexico. • We use these shocks to test out theories ECON 40710 –University of Notre Dame

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CUSFTA • The Canada-U.S. Free Trade Agreement offers several advantages for assessing the benefits of trade liberalization 1. The policy experiment is clearly defined (i.e., it is not part of a broad reform package) 2. Reliable information on changes in tariffs is available 3. It covers most industries (both import-competing sectors and export-competing sectors)

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CUSFTA

• The impact of CUSFTA on policy barriers – Tariff rates are on a downward trend – The decrease is more pronounced between US and Canada ECON 40710 –University of Notre Dame

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CUFTA A. Head and Ries (1999) •

Plant-level data on 230 Canadian industries for the period 1981 to 1994 to evaluate the impact of CUSFTA on Canadian firms.

•

Scale Effect: Surviving firms will increase their output – During the eight years leading up to CUSFTA, output per plant increased by about 3%. – In the 1990s, output per establishment increased by 34%.

•

Selection Effect: some firms will exit – In the 1990s, the number of establishments declined by 21% from 1988 to 1994.

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CUSFTA

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CUSFTA

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CUSFTA and NAFTA B. Trefler (2004) •

Plant-level data on 213 Canadian industries for the period 1980 to 1996 to evaluate the impact of CUSFTA and NAFTA on Canadian firms.

•

Selection Effect: the least productive firms will exit the industry – Labor productivity in manufacturing increased by about 7.4% over eight years; compound growth of 0.93% per year. – There is no evidence that plant-level productivity changed, which suggest that productivity gain is coming from market shifts favoring highproductivity plants.

•

Price effect: average price in the industry goes down – Find a modest reduction in import prices

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NAFTA C. Feenstra (2014) Welfare effect: Access to more varieties •

To understand how NAFTA affected the range of products available to U.S. customers, we will look at imports from Mexico in 1990 and 2001.

•

To obtain an estimate of gains from trade coming from variety: – Compute changes in number of variety – Transform into a dollar equivalent (i.e., Ask how much would U.S. consumer be willing to pay to have access to the additional varieties NAFTA made available

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NAFTA •

How do we measure variety?

•

We do not have information on trade at the variety-level. – For the analysis, we define a variety as a product-exporter category (e.g., computers-Canada vs. computer-Mexico) – This measure does not take into account the amount that each countries sell of each product just the number of different types of varieties imported by the US.

•

To get a sense of the increases in varieties coming from Mexico, we can compute the share of varieties purchased from Mexico.

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NAFTA Mexico’s Export Variety to the United States

• From 1990–2001, the range of products that Mexico exported to the U.S. expanded by 1.3% to 4.6% per year. • Export variety grew faster in electronics and slower in machinery and transport.

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NAFTA

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NAFTA

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NAFTA Adjustment Costs • Trade Adjustment Assistance (TAA): offers assistance to workers in manufacturing who lose their jobs because of import competition. – From 1994-2002: 58,000 workers per year lost their jobs and were certified under the TAA program – NAFTA is responsible for about 13% of the total displacement in manufacturing over that period. ECON 40710 –University of Notre Dame

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NAFTA • Income loss – Average income in 2000: $31,000 – On average, workers are reemployed within 3 years. Therefore (direct) loss of about $93,000. – Total cost: 58,000 workers per year x $93,000 per worker = $5.4 billion for first decade • This is about the same as the estimated gains from trade. • If the gains continue then NAFTA would increase welfare.

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NAFTA Summary • NAFTA had the following impacts: – – – –

Increase in plant scale and productivity in Canada Decrease in the number of plants in Canada Decrease in import price Increase in the number of varieties exported from Mexico to US

• Some evidence that the long run may gains exceed the short run adjustment costs ECON 40710 –University of Notre Dame

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CONCLUSIONS

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Conclusions Firm Heterogeneity – Not all firms export and exporters are larger and more productive – Trade liberalization increases industry productivity – New sources of GFT: An increase in aggregate industry productivity decreases average price and raises welfare NAFTA – Exit of plants – Increase in plant scale and productivity – Increase in the number of varieties and decrease in price ECON 40710 –University of Notre Dame

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