Chapter 8
Firms in the Global Economy: Export
Decisions, Outsourcing, and
Multinational Enterprises
◼ Chapter Organization
The Theory of Imperfect Competition
Monopoly: A Brief Review
Monopolistic Competition
Monopolistic Competition and Trade
The Effects of Increased Market Size
Gains from an Integrated Market: A Numerical Example
Case Study: Patterns of Foreign Direct Investment Flows Around the World
The Firm’s Decision Regarding Foreign Direct Investment
Outsourcing
Case Study: Shipping Jobs Overseas? Offshoring and Unemployment in the United States
Consequences of Multinationals and Foreign Outsourcing
Summary
40 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
◼ Chapter Overview
In previous chapters, trade among nations was motivated by their differences in factor productivity or
relative factor endowments. The type of trade that occurred, for example of food for manufactures, is
based on comparative advantage and is called interindustry trade. This chapter introduces trade based on
internal economies of scale in production. Such trade in similar productions is called intraindustry trade
and describes, for example, the trading of one type of manufactured good for another type of manufactured
good. It is shown that trade can occur when there are no technological or endowment differences but when
there are economies of scale or increasing returns in production.
In markets described by monopolistic competition, there are a number of firms in an industry, each of which
produces a differentiated product. Demand for its good depends on the number of other similar products
available and their prices. This type of model is useful for illustrating that trade improves the trade-off
between scale and variety available to a country. In an industry described by monopolistic competition, a
larger market—such as that which arises through international trade—lowers average price (by increasing
production and lowering average costs) and makes a greater range of goods available for consumption.
Although an integrated market also supports the existence of a larger number of firms in an industry, the
model presented in the text does not make predictions about where these industries will be located.
Another important issue related to imperfectly competitive markets is the practice of price discrimination,
namely charging different customers different prices. One particularly controversial form of price
discrimination is dumping, whereby a firm charges lower prices for exported goods than for goods sold
Chapter 8 Firms in the Global Economy: Export Decisions, Outsourcing, and Multinational Enterprises 41
The chapter concludes with a discussion of foreign direct investment (FDI). FDI may be horizontal or
vertical. With horizontal FDI, a firm replicates its production process in multiple locations. With vertical
FDI, a firm breaks up its production chain across multiple locations. The decision by a multinational to
engage in FDI is driven by a proximity-concentration trade-off. Internal economies of scale give an
◼ Answers to Textbook Problems
1. With internal economies of scale, there is imperfect competition, and firms set marginal revenue
equal to marginal cost. Unlike the case of perfectly competitive markets, under monopoly, marginal
2. To solve this problem, we need to first find the equilibrium number of firms in the three country
integrated market by setting average cost equal to price across all markets. We do this by first noting
that average cost can be written as AC = (nF/S) + c and price can be written as P = c + (1/bn), where
n is the number of firms, F is the fixed cost, S is the market size, c is the marginal cost, and b is a
constant. Setting the average cost equal to price yields the following expression:
42 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
3. We are given the following information (with all dollar amounts in thousands):
F = 5,000,000,000
c = 17,000
SUS = 300,000,000 SEU = 533,000,000
P = c + (1/bn) = 17,000 + (150/n)
a. The condition we derived in Problem 2 was n = [(1/b) S/F]. Looking at the price equation above,
we see that 1/b = 150. Plug in the relevant parameters to solve for the equilibrium number of
firms in the United States and the European Union:
nUS = [150 300,000,000/5,000,000,000]1/2 = [9]1/2 = 3
nEU = [150 533,000,000/5,000,000,000]1/2 = [16]1/2 = 4
4. a. We can model this decision by defining the technology in the following terms: If a firm invests in
the technology, it will face a fixed cost T, but face a marginal cost cT which is lower than its
marginal cost c without the technology. Thus, we define the firm’s total cost with and without
the technology as:
Cost without Technology = TC = cQ + F
Cost with Technology = TC
= cTQ + F + T
A firm will choose to adopt this technology whenever TC
TC:
Chapter 8 Firms in the Global Economy: Export Decisions, Outsourcing, and Multinational Enterprises 43
5. a. We know that the number of firms competing in a market increases as the size of the market
rises. At the same time, the price charged in a market falls as the number of firms competing in
that market rises. Thus, as the number of firms increases, the price charged by exporters (and
6. a. $10 million of IBM stock is nowhere near 10 percent of the total market value of IBM. Thus, this
is not considered Foreign Direct Investment.
b. A New York apartment building is considered an asset, so its purchase (100 percent ownership)
7. a. This would be a horizontal FDI outflow from the United States and a horizontal FDI inflow
into Europe.
b. This would be a vertical FDI outflow from France and inflow into Cameroon.
c. This would be a horizontal FDI outflow from Germany and inflow into the United States.
d. This would be a vertical FDI outflow from Switzerland and inflow into Bulgaria.
8. Even with internal economies of scale, there may still be an advantage to producing the same good
in multiple production facilities. This is an example of the proximity-concentration trade-off. The
9. This question relates to the decision by a multinational to outsource production or to engage in direct
production through foreign affiliates. A multinational may prefer to use a foreign affiliate if it has a
44 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
10. Intrafirm trade will be higher in industries with a high degree of vertical FDI. As capital-intensive