CHAPTER ELEVEN
Industrial Structure and Trade in the Global
Economy — Businesses without Borders
I. Fundamental Issues
How do economies of scale help to explain a nation’s specialization in inter-industry trade?
How do economies of scale and product variety provide an explanation for intra-industry trade?
In what way can foreign direct investment affect international trading patterns?
What are alternative industry structures, and how does industry structure matter in the global
economy?
5. Why do companies engage in cross border mergers and acquisitions, and how do international market
linkages complicate measuring the degree to which a few large firms may dominate markets?
6. How do governments regulate international merger and acquisition activities?
1.
2.
3.
4.
II. Chapter Outline
1. Industrial Organization and International Integration
a. Economies of Scale and International Trade
b. Visualizing Global Economic Issues: International Trade and Economies of Scale
c. Product Variety, Imperfect Competition, and Intra-Industry Trade
d. Visualizing Global Economic Issues: Monopolistic Competition in the Short Run and in the Long
Run
e. Visualizing Global Economic Issues: Intra-Industry Trade with Monopolistic Competitive Firms
2. Foreign Direct Investment and Trade Patterns
a. Types of Foreign Direct Investment
b. Trade Effects of Foreign Direct Investment
c. Management Notebook: Is Production Sharing Making Mexico a “Trampoline” for U.S.
Products?
3. Globalization and Industry Structure
a. Barriers to Entry
b. Alternative Forms of Imperfect Competition
c. Online Globalization: Mobile in Mexico
d. Visualizing Global Economic Issues: The Welfare Effects of Monopoly
e. Visualizing Global Economic Issues: Foreign Monopoly and Dumping in a Domestic Market—
Who Gains, and Who Loses?
4. Evaluating the Competitive Implications of Industry Structure
a. Motivations for Cross-Border Mergers and Acquisitions
b. Assessing Market Concentration and Its Effects
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5. Antitrust in an Evolving Global System
a. The Goals of Antitrust Laws
b. Policy Notebook: That Price Is Too Low!—Wal-Mart Meets German Antitrust Policy
c. Antitrust Enforcement Across National Boundaries
6. Questions and Problems
III. Chapter in Perspective
This chapter introduces the effects of imperfect competition on international trade. Absolute and
comparative advantages are useful in explaining inter-industry trade, but we observe large quantities of
both inter and intra-industry trade today. Economies of scale and imperfectly competitive industry
structures introduced in this chapter help explain patterns of intra-industry trade. The terms monopolistic
competition, oligopoly, cartel and monopoly are defined and illustrated. Vertical and horizontal foreign
direct investment are introduced, and several motivations for cross border mergers are given. The chapter
concludes with a brief look at antitrust policies.
IV. Teaching Notes
1. Industrial Organization and International Integration
Understanding industrial organization (IO) is the study of structures and interactions among firms
and markets. IO has grown in importance because understanding IO is necessary to understand
current patterns of intra-industry trade.
a. Economies of Scale and International Trade
If a firm has economies (diseconomies) of scale then the firm’s long-run average cost (LRAC)
declines (increases) with increases in output. If the size of the firm does not affect the average
cost then the firm has constant returns to scale. Long run average cost is calculated as total costs
divided by output over the long run, where the “long run” is defined as the time needed to adjust
quantities of all factors of production. Economies of scale arise from:

Specialization of tasks as a firm grows:
This is the “assembly line” idea. If a firm produces a high enough quantity of output, it may
make sense to specialize the labor force.
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Teaching Tip:
Specialization can also occur across firms by having specialized producers of inputs (suppliers) to
the final product. In certain industries (such as automobile production), quality has been
improved by including suppliers in the design phase. Japanese auto producers have done this for
quite some time.
Teaching Tip:
Linking geographically dispersed markets with methods of transportation and communication can
provide a basis for economies of scale. For example, investment in infrastructure such as roads,
railroads, canals, information production and dissemination, telecommunications, etc. can
increase economies of scale benefits for all firms in the affected regions, providing a comparative
advantage.
Diseconomies of scale may arise as a firm becomes too large. These come about because of
additional complexities in managing large organizations, including communication, lack of
flexibility to adjust to a changing marketplace and higher costs due to superfluous management
positions. One of the reasons for the pervasive economic slowdown in the U.S. in the early 1990s
was because firms were shedding layers of middle management which had proliferated during the
high-growth Reagan years.
The minimum efficient scale (MES) is found at the minimum of the long-run average cost curve.
The cost curve is usually depicted as slightly U-shaped, implying an optimal size for the firm.
It is quite possible that a firm will be unable to achieve the MES solely in a domestic market.
This provides a motivation for international trade, and if it is correct, then it implies that there
will be benefits to domestic consumers from international trade in many industries. It also
implies that the size of the U.S. market may provide a comparative advantage for U.S. industries
that have large economies of scale. The text uses the example of the aircraft production industry.
Because U.S. companies are major consumers of aircraft, Boeing and other U.S. aircraft
manufacturers may have a cost advantage over a foreign aircraft producer. This is probably one
reason why most countries do not even produce aircraft, because of scale economies, Boeing for
example can produce more output at lower cost per unit.
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b. Visualizing Global Economic Issues: International Trade and Economies of Scale
For Critical Analysis: Who would lose if barriers to trade prevented U.S. companies from
exporting aircraft to Israel and other nations? Who would gain? (Hint: In this situation,
U.S. and Israeli aircraft production levels would remain at QUS and QI in Figure 11-1 in the
text.)
Economies of scale provide an incentive for countries to specialize and produce large quantities
of a given product, because it provides cost advantages to do so. Clear losers from trade barriers
would be users of aircraft in Israel and the U.S. (and ultimately the consumer who has to
indirectly pay higher airline passenger and freight costs). Gains and losses to producers depend
on industry structure, but this is an oligopoly, so U.S. producers lose and Israeli producers gain
from the trade prohibition. The global economy loses because we have less efficient production
than we could have under free trade.
c. Product Variety, Imperfect Competition, and Intra-Industry Trade
Gains from intra-industry trade arise from cost efficiencies related to scale economies and from
consumer gains related to an increase in variety of goods and services available
The basic assumptions of perfect competition are:
 Each firm produces an identical product, indistinguishable to customers. Therefore,
competition is purely on price, and there is no incentive to vary price from the “market
equilibrium” price.
 There are large numbers of producers with identical technologies.
 There are no entry or exit barriers.
As a result, all firms produce at the MES, price is equal to average cost, and economic profits are
zero after considering the opportunity cost of being in the industry.
Imperfectly competitive firms produce products that are unique, although they may have close
substitutes. Because the products are not identical, the firm has a unique demand curve, although
the product’s demand curve is affected by the price and quality of substitute products. There are
various types of imperfectly competitive industries. The first we consider is monopolistic
competition.
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Monopolistic competition is an industry structure with the following characteristics:
 The firm produces a unique, distinguishable product
 There is a relatively large number of firms in the industry
 There are few or no entry and exit barriers to enter or leave the industry.
Given these characteristics, economic profits are possible only in the short run when firms do not
have time to enter an industry. As new firms enter such an industry, three things happen:
 Demand for the existing firms’ product falls.
 Demand for the existing firms’ product becomes more elastic as more substitutes become
available.
 Economic profits begin to fall as new firms enter. This continues until economic profits are
zero, or equivalently when revenue equals average cost and the firm’s rate of return is just
equal to the opportunity cost.
If firms in the industry were generating negative economic profits, firms would leave the industry
until profits rose to zero.
When the possibility of international trade is introduced, we then have the potential for the
domestic firm to experience an increased demand for its product as foreign buyers seek to
purchase it. Of course, foreign firms enter the domestic market and this can dampen the demand
in the domestic market. Nevertheless, firms can exploit economies of scale by exporting the
product, and thereby lowering the product price, competition should ensure this result. On net,
domestic residents can consumer more product at a lower price, so can foreign residents. Both
domestic and foreign residents also benefit from greater product variety. As for the producers, in
the long run, economic profits will still tend towards zero.
Graphical analysis of monopolistic competition:
Because a monopolistically competitive firm has a unique demand curve that is downward
sloping its marginal revenue curve is downward sloping and lies below the demand curve. The
firm’s optimal production level is where marginal revenue equals marginal cost. Letting
average cost hold constantly, economic profit can easily be depicted graphically as shown on the
left graph below (Panel a), where economic profit is equal to (PS – ACS)* QS:
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Panel a
Panel b
P
P
MC
MC
PS
AC
AC
PL = ACL
ACS
D
MR
QS
MR Firm
Q
QL
D Firm
Q
As new firms enter the industry, the demand and marginal revenue curves will shift left and
become more shallow, until at the margin we reach the graph on the right above (Panel b) where
at the new equilibrium QL, found where MR=MC, the new price PL is equal to the average cost
ACL and economic profit is zero.
d. Visualizing Global Economic Issues: Monopolistic Competition in the Short Run and in the
Long Run
For Critical Analysis: What would happen if so many new firms initially entered the
industry that the firm’s demand curve were to “overshoot” point L, so that the firm finds
itself operating at a low (a negative) economic profit?
If so many firms enter that economic profits are negative (revenue is less than average cost) firms
will begin to leave the industry (recall that are no exit barriers) until economic profits rise to zero.
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e. Visualizing Global Economic Issues: Intra-Industry Trade with Monopolistic Competitive
Firms
For Critical Analysis: This firm earns an economic profit equal to zero in the long run
without or with intra-industry trade, so what is its incentive to export? (Hint: what would
happen if the firm chooses not to export but faces increased competition from foreign firms
that do choose to engage in intra-industry trade?)
This is a good question and is one that is likely to trouble students; however, the answer is
straightforward. If the firm chooses not to engage in trade then other firms who do will gain from
economies of scale as they grow and will be able to out-compete on price the firm who remains
solely domestically focused. In addition, there will likely be short-term economic profits that can
be exploited.
One could take another tack with this answer by asserting that even if economic profits are zero,
the firm is still earning the opportunity cost on a higher level of output, so additional value has
been added. If managers are rewarded more highly for increasing value as measured by size (and
they are), then that is incentive enough to ensure the result.
2. Foreign Direct Investment and Trade Patterns
a. Types of Foreign Direct Investment
b. Trade Effects of Foreign Direct Investment
There are two types of foreign direct investment (FDI): horizontal and vertical FDI. A firm
engages in horizontal FDI when it acquires or builds a foreign subsidiary to produce goods or
services that are similar to the home country product. Horizontal FDI tends to substitute for trade
and may not substantially increase measured international trade. Horizontal FDI tends to
originate in developed countries and locate in developed countries. A firm engages in vertical
FDI when it has a foreign subsidiary that produces or assembles certain components of the value
chain (see Chapter 3). Vertical FDI tends to originate in developed countries, but is more likely to
locate in developing countries that have a comparative advantage in certain aspects of production
such as assembly due to low labor costs. Note that both result in capital flows in the affected
countries.
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c. Management Notebook: Is Production Sharing Making Mexico a “Trampoline” for U.S.
Products?
For Critical Analysis: How could a large and increasing U.S. trade deficit with Mexico be
good news for the U.S. economy?
If this is because of the trampoline effect then a trade deficit could imply that U.S. firms are
generating large profits, because much of the value coming out of Mexican subsidiaries will
accrue to the U.S. owners. This would increase U.S. income. This example highlights the very
important point that measuring trade flows is perhaps not the best way to examine the strength or
weaknesses of an economy given the size and breadth of operations of many of the world’s
multinational firms. It is value added that matters and this is a better determinant of how well an
economy is performing. It is still likely that value added in the United States is greater than the
value added in Mexico, moreover many of the Mexican exports are sold in the United States,
further indicating that in this case the U.S. economy would be doing well.
3. Globalization and Industry Structure
a. Barriers to Entry
Entry barriers are factors that inhibit or prohibit new firms from entering an industry.
Economies of scale, ownership of resources, product differentiation and government barriers are
four common barriers mentioned in the text.
Teaching Tip:
Other barriers include:
• capital requirements, due to economies of scale or problems with accessing distribution
channels at small size
• learning curve effects, particularly in skilled industries
• regulations favoring established firms and limiting entry, such as bank chartering
requirements,
• product differentiation, particularly brand values
– According to www.news.ft.com (the Financial Times website) the top five global brands
in terms of brand value in 2000 were:
· Coca-Cola
$72.5 (billion U.S.$)
· Microsoft
$70.2
· IBM
$53.2
· Intel
$39.0
· Nokia
$38.5
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•
•
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substantial exit barriers—these usually take the form of low value of equipment if the firm is
forced to liquidate, either because the assets in question are specialized (such as certain
mining equipment) or because they quickly depreciate. Exit barriers may also include land
reclamation and pollution control. Note that high exit barriers serve as an entry barrier by
raising the risk of entry.
proprietary technology or patents
access to restricted markets, including exclusive relationships with retailers or transporters
(generally termed the channels of distribution) or access to otherwise limited international
markets.
b. Alternative Forms of Imperfect Competition
In the presence of entry barriers, other forms of competition must be considered:
•
Oligopoly:
An industry structure where only a few firms supply the total output of the industry. This
implies significant barriers to entry. In an oligopoly, the firm must consider how rivals will
respond to the firm’s decisions, particularly in response to pricing strategies and advertising
(called oligopolistic interdependence). Firms may engage in strategic pricing. For
instance, price wars (often taking the form of low cost financing) are common between
automobile producers.
Oligopolies may seek to act as a monopoly by forming a cartel. A cartel is a group of
oligopolistic firms that collude to restrict output to fix the price at an artificially high level. It
is rare for cartels to last, however. Each firm in the cartel has an incentive to cheat and
increase output beyond its quota. Even the most famous cartel of our time, OPEC, has a hard
time preventing members from cheating.
•
Monopoly:
A monopoly is an industry that consists of only one firm. A monopolist (and a cartel) can
reduce consumer welfare by restricting output and charging a higher price than would prevail
if there were competition. Since there is no one else to supply the output they have curtailed,
they can get away with this. This would reduce consumer surplus.
Teaching Tip:
Optimally, a monopoly would engage in price discrimination if it were allowed to, perhaps
by conducting an auction for its product and charging different buyers different prices. In
this way, the monopolist could theoretically capture all of the consumer surplus.
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c. Online Globalization: Mobile in Mexico
For Critical Analysis: In Tunisia, the two existing Internet service providers are both
closely connected to the national government. What might Tunisia learn from Morocco’s
experience?
In Tunisia, the ISPs are government sponsored monopolies. As stated above monopolies tend to
restrict output and charge higher prices than warranted. Tunisia might wish to follow Morocco’s
example and privatize the telecommunications industry to introduce competition and innovation.
d. Visualizing Global Economic Issues: The Welfare Effects of Monopoly
For Critical Analysis: Does the monopoly capture the entire amount of the “lost” consumer
surplus in the form of profit?
PQ0
Consumer
surplus under
Monopoly
Deadweight
loss under
Monopoly
PM
PPC
MC = ATC = SupplyPC
D
MR
QM
QPC
Q
Under perfect competition consumer surplus equals the area of the triangle PQ0PPCQPC which is
found as ½[(PQ0 – PPC)* QPC]. Under the monopoly, consumer surplus is reduced as indicated to
the area of the triangle PQ0PMQM found as ½[(PQ0 – PM)* QM]. Not all of the lost consumer
surplus is captured by the monopolist. The area of the rectangle PMPPCQM (found as (PM – PPC)*
QM) is the consumer surplus that is captured by the monopolist. The area of the triangle found as
½[(PM – PPC)* (QM – QPC)] is former consumer surplus that is a deadweight loss after the
monopoly is formed.
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e. Visualizing Global Economic Issues: Foreign Monopoly and Dumping in a Domestic
Market—Who Gains, and Who Loses?
For Critical Analysis: Sometimes companies charge that foreign firms sell some of their
output in domestic markets at a price below their average production costs. Are there ever
any circumstances in which this could be either a short-run or a long-run profit-maximizing
strategy for these foreign firms?
Foreign firms may engage in selling below average cost to exploit economies of scale, perhaps to
build competitive advantage in the home market (if they are not a monopoly). Depending on the
product involved, building market share and brand recognition can provide a long-term
advantage, which may be worth suffering some short-term losses.
4. Evaluating the Competitive Implications of Industry Structure
a. Motivations for Cross-Border Mergers and Acquisitions
During the 1960s and 1970s, mergers were thought to generate large synergistic effects. The
large number of conglomerate mergers in this time period led to large numbers of spinoffs,
selloffs and other divestitures in the 1980s. The investment bankers however, who recommend
and manage these restructurings profited enormously. The rationale for mergers since the 1990s
has been economies of scale and scope.
Mergers and acquisitions may also result in greater market power, enhancing the merged or
buying firm’s ability to increase product prices and reduce consumer surplus. Note however that
if rivalry increases as a result of a merger (an outcome that is borne out in many cases) then price
cutting may ensue, resulting in consumer benefits.
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b. Assessing Market Concentration and Its Effects
Market concentration ratios are often used to measure market power. The two main methods are:
• The four-firm concentration ratio:
Simply add up the market shares of the top four firms in the industry. This is flawed, in that
it ignores distribution of market shares beyond the top four.
• The Herfindahl-Hirschman Index:
The HH index is calculated by squaring the market share of each participant in the industry
and then summing the squared values.
In both cases, the lower the result the less concentrated the industry is and the less likely the
leaders can exert market power. The main problems with these measures are that it is difficult to
determine the relevant market, which should include all viable substitutes, including
international competitors, and interpreting the measures is subjective because there is no
objectively determined cutoff beyond which market power may be said to exist.
5. Antitrust in an Evolving Global System
a. The Goals of Antitrust Laws
Antitrust laws are statutes designed to assure that the benefits of competition are not usurped by
firms with monopoly power. In application, this usually means preventing firms from exerting
pricing power. Hence, cartels are illegal, and even attempting to form a monopoly can be illegal.
Price discrimination is usually restricted. Price discrimination can take on two forms. First,
charging different customers a different price, and second, charging a customer a different price
based on the quantity purchased. Notice that volume discounts (a form of price discrimination)
are commonly allowed. Predatory pricing is usually outlawed. As mentioned above, predatory
pricing is setting the price low enough to drive competition out of business, at which point the
predator could then exert monopoly pricing power. Industrial policies designed to promote
certain industries can conflict with antitrust laws because these policies often favor producers at
the expense of consumers.
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b. Policy Notebook: That Price Is Too Low!—Wal-Mart Meets German Antitrust Policy
For Critical Analysis: German authorities argued that in the long run, consumers would be
hurt if Wal-Mart’s lower prices drove rival firms from the grocery market. Evaluate this
reasoning.
Germany accused Wal-Mart of selling below cost. If this was true, Wal-Mart was engaging in
predatory pricing that generated losses that would have to be recaptured at some point,
presumably after local sellers were forced out of the market. If this claim was true, the German
response requiring Wal-Mart to raise its prices was correct. If on the other hand, Wal-Mart was
selling below the cost of other German producers, perhaps because Wal-Mart’s size (they are the
world’s largest retailer) generates larger economies of scales, then the German response penalizes
German consumers at the expense of relatively inefficient local producers. This kind of
protection tends to reduce innovation that would benefit producers and consumers.
c. Antitrust Enforcement Across National Boundaries
U.S. and EU policymakers have come into conflict in recent years because the goals of antitrust
laws differ in the two regions. U.S. antitrust policy has generally been focused on disallowing
mergers only if consumers would be harmed by the merger. EU policy however would disallow a
merger if consumers would be harmed and/or if the merger strengthens (or creates) a dominant
position in an industry. EU antitrust policy is thus stricter than the U.S. policy.
Teaching Tip:
Suppose an industry’s cost structure is such that its firms have high fixed costs and extremely low
variable costs. What is the implied shape of the long run average cost curve with respect to
optimal quantity of output? Does this have implications for optimal antitrust policy? This
example is not so farfetched. Some Internet-based operations arguably have this type of cost
structure.
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6. Answers to End of Chapter Questions
1. In this situation, U.S. e-commerce firms such as eBay and Amazon replicate the situation illustrated
in Figure 11-1 on page 345, so this is the diagram that applies, as does the related explanation.
2. On one hand, the demand for the typical U.S. e-commerce firm’s product will increase as residents of
other nations begin consuming the product. On the other hand, the firm will now face competition
from e-commerce firms located abroad, so consumers will be able to choose among more substitute
products, and this makes the demand for a U.S. firm’s products more elastic. In long-run equilibrium,
therefore, U.S. firm will increase its output, which reduces its average production cost, thereby
yielding a lower long-run product price.
3. The domestic government’s decision to erect barriers to trade in this industry results in a falloff in
demand for the product of each domestic firm. At the same time, however, the policy action also
reduces the range of substitute products available to domestic consumers, so the demand for each
firm’s product becomes more inelastic. In the short run, each domestic firm can thereby boost its
revenues and profits by raising its prices and cutting back on production. In the long run, each firm
will earn zero economic profits at a price equal to its higher average production cost at a reduced rate
of output.
4. Engaging in horizontal direct investment entails establishing facilities to produce the firm’s existing
product in another nation. Vertical direct investment involves construction of facilities for producing
intermediate components in another country for use in final assembly of the existing product.
5. Much of the inflow of capital may relate to vertical direct investment, so that production of final
export goods has not changed very much.
6. It may be that capital inflows involving horizontal direct investment have taken place, so that the
nation may have new facilities for producing final goods and services for export and for marketing
distributing imported goods and services.
7. This is an example of an oligopoly, in which only a few firms account for the lion’s share of a
market’s output. An oligopoly typically exists because of barriers to entry.
8. In this case, it may well be true that the foreign firm charges a higher price in its home country
because it is protected from competition there, yet charges a lower price abroad where it confronts
more competition. Nevertheless, under the legal definition of dumping, all that matters is that it
charges a lower price in the domestic market. Thus, this firm can be found to have engaged in the
practice and subjected to antidumping penalties.
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9. a. The four-firm concentration ratio (sum of market shares of firms 1, 7, 8, and 9) is 89 percent.
The Herfindahl-Hirschman index (sum of squared market shares of all domestic and foreign
firms) is 2,638.
b. This yields the following table applicable to domestic producers only:
Firm
Sales
%
%2
————————————————————
1
750
75
5625
2
50
5
25
3
50
5
25
4
50
5
25
5
50
5
25
6
50
5
25
——
Total 1,000
Thus, the four-firm concentration ratio is now 90 percent, and the Herfindahl-Hirschman index is
now 5,750.
10. Although the four-firm concentration ratios happen to be almost the same, the Herfindahl-Hirschman
index is much higher when only domestic firms are considered to be within the relevant market.
Thus, treating measures of concentration, such as the Herfindahl-Hirschman index, as useful
measures depends on confidence that one has identified the relevant market for application of these
measures.