The Profit-Maximizing Firm as Multinational Corporation

Abstract

This note lays out a microeconomic framework of monopolistic competition to think about profit-maximizing firms that are vertical or horizontal multinationals.

Excerpt

UVA-G-0623

August 14, 2009

The Profit-Maximizing Firm as Multinational Corporation

This note presents a microeconomic framework to think about the operation of multinational corporations (MNCs). We assume that multinationals' decisions are ultimately driven by their desire to make profits. We describe how a multinational's actions (the price it charges, the output it produces) are a function of the economic environment it faces (the market structure, the strength of demand at home and abroad, and the costs of production factors such as labor) and its own particular cost structure. MNCs appear in many different forms, and they have many different cost structures. Needless to say, there are vast differences between, say, the German car producer BMW, which sources parts from all over the world, and Citigroup, which may, to some extent, provide similar services locally in many countries. In this note, we present two basic forms that multinational activity can take. Although it is helpful to separate both forms conceptually, multinational operations often include elements of both. On one hand, we look at horizontal multinationals that primarily relocate operations abroad to produce closer to the customer. Characteristically, they produce virtually the same good or service abroad that they produce in the home market. Think of Wal-Mart going to France and providing (trying to provide) the same services there that it provides in the United States. On the other hand, we also look at vertical multinationals that relocate only part of the production process abroad. For example, in order to take advantage of the lower wages abroad, a multinational may offshore labor-intensive parts of production to China and then import these intermediate goods before finishing the product. We conclude the note with a few remarks on the optimal mode of operating a firm.

The Horizontal Multinational Corporation

Although foreign direct investment (FDI) flows to China have steadily increased in recent years, the bulk of FDI still flows between developed countries. In other words, it cannot be the case that the primary or the only objective of multinationals is to take advantage of lower production costs abroad. Consider Figure 1, which sketches the operations of a horizontal MNC.

The multinational in Figure 1 produces differentiated goods, which is why it faces its own downward-sloping demand and why it has some price-setting power. (If we were analyzing the case of standardized products, the demand curve would be flat: The price would be given, and the firm would not have any impact on price.) We assume that there is demand for the firms' product at home (left side) as well as abroad (right side). The marginal revenue curve depicts the additional revenue from each additional unit sold at home and abroad. It is the downward-sloping line inside the demand curve.

Figure 1. A horizontal MNC.

. . .

Keywords: multinationals, monopolistic competition