Firms, Location and Distance

Chapter 6

Distance in economics The relevance of transportation costs (Table 6.1)

CIF (cost, insurance, freight) FOB (free on board)

Empirical evidence (Hummels, 1999) Shipping costs are higher in

countries located further away from major markets, and landlocked countries.

Transport costs have not declined uniformly over time (costs of distant travel have declined relative to proximate travel).

Also see Box 6.1.

Table 6.1 Regional trade pattern of Europe; percent of total, 1860-2009

Export to: Europe United States China Japan Rest of world

1860 1910 1999

67.5 67.9 69.1

9.1 7.6 8.5

0.9

1.6

23.4 24.5 19.9

2004 68.5 7.8 1.6 1.4 20.7 2009 66.7 6.2 2.5 1.1 23.5

Import from: Europe United States China Japan ROW

1860 1910 1999

61 60

66.2

14.3 14 7.5

2.4

3.4

24.7 26

20.4 2004 66.0 5.3 4.3 2.5 22.0 2009 63.9 4.8 6.5 1.7 23.1

Source: Baldwin and Martin (1999) for 1860 and 1910 data, other data from Eurostat; China excludes Hong Kong.

Figure 6.1 Ad valorem trade costs by exporting country, 2008 (%)

Ad valorem trade costs (%) and per cent rank by exporting country, 2008

0

5

10

15

20

0 20 40 60 80 100rank

trad

e co

sts

Ireland

average

UKGermany

Netherlands USA

China

Burkina Faso

Brazil

Australia

Philippines

Papua New Guinea

Source: based on data for 134 countries from Sourcin and Pomfret (2012).

Figure 6.2 Container port traffic; mn TEU (20-foot equivalent units), 2000-2010

Container port traffic; million TEU 20-foot equivalent units, 2000-2010

130

41

China

42United States

29Singapore

18Japan15Germany

0

20

40

60

80

100

120

140

2000 2002 2004 2006 2008 2010

Source: world bank development indicators online

Table 6.2 The world’s largest container ports; mn TEU, 1989 and 2009

1989 2009 1 Hong Kong 4.5 Singapore 25.8 2 Singapore 4.4 Shanghai (China) 25.0 3 Rotterdam (Netherlands) 3.9 Hong Kong 20.9 4 Kaohsiung (Taiwan) 3.4 Shenzhen (China) 18.2 5 Kobe (Japan) 2.5 Busan (South Korea) 11.9 6 Busan (South Korea) 2.2 Guangzhou (China) 11.2 7 Los Angeles (USA) 2.1 Dubai (Un Arab Emirates) 11.1 8 New York (USA) 2.0 Ningbo (China) 10.5 9 Keelung (Taiwan) 1.8 Qingdao (China) 10.2 10 Hamburg (Germany) 1.7 Rotterdam (Netherlands) 9.7 11 Long Beach (USA) 1.5 Tianjin (China) 8.7 12 Yokohama (Japan) 1.5 Kaohsiung (Taiwan) 8.5 13 Antwerp (Belgium) 1.5 Antwerp (Belgium) 7.3 14 Tokyo (Japan) 1.4 Port Klang (Malaysia) 7.3 15 Felixstowe (Britain) 1.4 Hamburg (Germany) 7.0 16 San Juan (Puerto Rico) 1.3 Los Angeles (USA) 6.7 17 Bremen (Germany) 1.2 Tanjung Pelepas (Malaysia) 6.0 18 Oakland (USA) 1.1 Long Beach (USA) 5.0 19 Seattle (USA) 1.0 Xiamen (China) 4.6 20 Manila (Philippines) 0.9 Laem Chabang (Thailand) 4.6 Source: The Economist Aug 24, 2010

Figure 6.3 Developments in world air transport freight; mn ton-km, 1975-2010

World air transport freight

0

50,000

100,000

150,000

200,000

1975 1980 1985 1990 1995 2000 2005 2010year

mill

ion

ton-

km

Source: world bank development indicators online

Firm in Homeserve foreign markets / source from abroad?

Stay domestic

Export

Export or local production?

Import or local production?

ImportMultinational activity:

horizontalMultinational activity:

vertical

no

yes, serve foreign market

yes, source from abroad

exportlocal

productionimportlocal

production

Figure 6.4 Home firm decision tree

Simplifying assumptions1. Firms can locate production in two (identical) countries.

2. Production uses only one input.

3. MCs in terms of labor are constant.

4. There are firm-specific fixed costs (F); related to knowledge capital. These costs are only imposed once.

5. Setting up a plant gives rise to plant-specific fixed costs (P).

6. Transportation costs (in terms of labor) are t per unit exported.

7. Markets are segmented (i.e., no risk of arbitrage).

8. Headquarters also use resources, which are covered by firm-specific fixed costs (F).

A

0 x

p

D

MR

AC

MCh

B

0 x

p

D

MR

MCh

MCh + t

Home Foreign

A

0 x

p

D

MR

AC

MCh

B

0 x

p

D

MR

MCh

MCh + t

Home Foreign

Figure 6.5 Profits in the Home and Foreign market: national exporting firm

C

0 x

p

D

MR

AC; F + P

MCh

D

0 x

p

D

MRMCf

Home Foreign

AC; P

C

0 x

p

D

MR

AC; F + P

MCh

D

0 x

p

D

MRMCf

Home Foreign

AC; P

Figure 6.6 Going multinational: the horizontal case

E

0 x

p

D

MR

AC; F

MCf

G

0 x

p

D

MRMCf

Home Foreign

AC; PMCf + t

E

0 x

p

D

MR

AC; F

MCf

G

0 x

p

D

MRMCf

Home Foreign

AC; PMCf + t

Figure 6.7 Going multinational: the vertical case

Hybrid cases

• Combination of market seeking (horizontal) and efficiency and/or natural resource seeking (vertical) multinational activity.– Export platform multinational activity– Strategic asset seeking multinational activity

The Gravity Model of International Trade

Link between distance and trade Introduces a spatial or geographical element. If the two countries are large and are close

to each other then bilateral trade (between them) will be large.

Is geography destiny?1. The role of infrastructure and technology.

2. No center of production remains a center forever.

Liability of foreignness and multiple types of distance

Geographic distance Cultural distance (also see box 6.3) Economic distance Institutional/legal distance

Figure 6.8 Geographic distance and foreign sales of US multinationals

Asia

All countries

Europe & Africa

Americas

Fo

reig

n s

ale

s o

f US

mu

ltin

atio

nals

(20

08)

0 5000 10000 15000 20000Geographic distance (kilometers)

Figure 6.9 Cultural distance and foreign sales of US multinationals

Canada

New Zealand

China

Russia

Fo

reig

n s

ale

s o

f US

mu

ltin

atio

nals

(20

08)

HighLowCultural distance

Figure 6.10 Institutional quality and foreign sales of US multinationals

Venezuela

Nigeria

Russia

China

Switzerland

Sweden

Finland

Fo

reig

n s

ale

s o

f US

mu

ltin

atio

nals

(20

08)

Low HighInstitutional quality of host country

Figure 6.11 Liability of foreignness for a horizontal multinational

0

10

0 5

a

bp0

c

de

f

demand

marginal revenue

marginal cost

average cost local

average cost multinational

cost of doing business abroad (lost profit)

pric

e

outputq0

Firm strategy, structure, and rivalry

Related and supporting industries

Demand conditions

Factor conditions

Figure 6.12 Porter’s diamond model

Dunning’s Ownership-Location-Internalization (OLI) Model

Dunning’s observation (in the 1950s) that

the US subsidiaries in the UK had higher

productivity relative to UK competitors.– Was the higher productivity due to higher efficiency by

US managers regardless of location (ownership-specific effect) or due to superior resources of the US economy (importance of location).

– But why do firms exploit their ownership-specific effect internally (internalization aspect, keeping foreign activities in house) instead of keeping these activities at arm’s length?

Outsourcing

3 main advantages of sub-contracting1. Forgoing the plant specific fixed costs.2. Cutting storage costs.3. Access to experience and knowledge of the

foreign firm.Main disadvantage Increased economic uncertainty due to

dependence on the foreign partner and political and economic conditions in the partner’s country