Business in the Global Environment

Dr. Veronica Rappoport

Lecture 5

Topics Covered in this Course

1. Is the world flat?

2. Long-term trends

3. Business practices across countries

4. Global strategies:

- International trade

- Foreign direct investment

5. International capital flows

6. Global imbalances and the Great Recession

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03/11/2013

Recall last class

• Under free trade countries have an incentive to specialize in their comparative advantage sector

– Home has an incentive to specialize in Grain

– Foreign has an incentive to specialize in Cloth

• Intuition: Specializing according to comparative advantage makes each country better off

– They can import their comparative disadvantage good for a lower price than they can make it themselves

– How do we quantify “better off” in the model?

3

Recall last class

Cloth

Home

Cloth

Foreign

PG/PC= 2/3

PG/PC= 2/3

PG= 1/2

P G= 1

Grain

• Full specialization: Home produces G and Foreign produces C

• Consumption and Production differ (C ≠ Y)

• Slope given by international price

Grain

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03/11/2013

Perfect Competition and Homogeneous Goods

• Very few markets resemble this ideal

– Firms produce an homogenous variety of Clothes

• Their production is perfectly substitutable

– Firms are small

• They take the price of their product as given and choose how much to produce

• They can increase supply without affecting world prices

• Firms produce until Marginal Cost is equal to Price

• Typically this is not the case

– The decision of how much to produce and at what price are interconnected.

5

Today: Global Strategies

• Differentiated vs. Homogenous Goods

– Tool: Optimal pricing decision

– Application: Problem Set 3

• Debate: Wine Exports in Argentina

– From an homogenous to a differentiated product

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03/11/2013

Differentiated Goods

• Markets are typically neither pure monopolies nor perfect competition

– Small firms producing differentiated goods.

Markups depend on:

• How close are alternative substitutes?

• How connected are prices and quantities?

– For large firms, markups also depend on:

• Market share

7

Math Tool: Derivatives

• Some useful derivative rules: f(x) a ax +b axb g(x) + f(x) ag(x) + bf(x) g(x) f(x)

f’(x)

Comment a is a number a and b are numbers a and b are numbers

0 a baxb-1 g’(x) + f’(x) ag’(x) + bf’(x) a and b are numbers g’(x) f(x) + g(x) f’(x)

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03/11/2013

Price and Quantity Decisions

Profits = P Q – C

Revenues

Cost

– If +1 unit implies that Extra Rev > Extra Cost à rise Q

– If +1 unit implies that Extra Rev < Extra Cost à lower Q

– Optimum: Extra Revenue = Extra Cost

• Taking Derivatives:

– Mg Cost: extra cost of increasing Q infinitesimally

Cost = F + c Q à Mg Cost = c

– Mg Revenue: extra revenue of increasing Q infinitesimally

Rev = P Q à Mg Rev = P’ Q + P

• P’: Change in P when Q increases infinitesimally

• P’ = 0 in perfect competition

9

Price and Quantities in Monopolistic Competition

P(Q): Demand face by each firm

Consumers will pay higher price if quantity is lower P(Q)

That is: P is downward sloping. Mathematically: P’ MgCost

Can get extra profit by increasing Q

PO

MgCost

P(Q)

MgRev < MgCost

Can reduce losses by lowering Q

MgRev

QO

Q

13

Equivalent Approach

• Choose Q to maximize profits

– Derivative of profits with respect to Q equals 0

Prof(Q)

d Prof = d Rev – d Cost = 0 dQ dQ dQ MgRev MgCost

Mg Rev > Mg Cost

Mg Rev < Mg Cost

QO

Q

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03/11/2013

Example

• N firms producing differentiated goods in a given industry. – Demand of one firm decreases with own price (P), relative to the average price of similar products (P*): P – P*

– No fixed cost. Firm’s unit cost of