The role of large firms in the world economy is self-evident from a casual reading of news reports, and is confirmed by recent empirical research. Large firms dominate exports, foreign direct investment (FDI), and research and development (R&D) in both developed and less-developed countries. They also account for much of the growth in exports: suggestions to the contrary, that small firms grow faster than large ones, have been shown with both French and American data to stem in part from a statistical illusion that arises when annual data are used: because new firms are active on average for only six months in their first calendar year of operations, their production and exports in their second year of operations appear to have increased significantly faster than those of large firms. Much of this difference disappears when the data are measured on a monthly rather than an annual basis.
Despite this, policy-makers regularly privilege small firms in their public statements, often claiming that they are the engine of growth and the standard bearers of export performance. Moreover, much academic work in economics, including the bulk of work on international trade, adopts a view of international markets in which individual firms do not have market power, and differ, if at all, in scale rather than in kind. This approach has proved very fruitful in addressing a great many problems, but its inability to match many of the major features of the world economy is self-evident. Unfortunately, developing models of international trade that allow for inter-firm differences in more than scale poses major technical problems. In 2012, Professor Peter Neary was awarded a five-year European Research Council Advanced Grant to develop new tools and models for understanding the role of large firms in global markets.
A key theme from the research is the so-called “Matthew Effect”: “to those that have, more shall be given.” In the context of firms in international trade, this applies to the advantages enjoyed by larger firms as the global economy expands. Rather than leading to more competitive markets, the thrust of the findings is that the incumbency advantage of larger firms is enhanced by globalization. The Matthew Effect also applies within firms: globalization typically encourages firms to place more emphasis on their “core competence” products, specialising on these while dropping peripheral products. The exact ways in which firms do this, and the implications for prices depend on characteristics of the markets in which they operate, and in work with fellow trade economists Carsten Eckel, Leo Iacovone, and Beata Javorcik, Peter Neary shows that the empirical evidence confirms the theoretical predictions.
More nuanced findings come from the more technical aspects of the project. Research completed with Monika Mrázová highlights the distinction between “first-order” and “second-order” selection effects; establishing that selection effects of the second kind (where firms must choose between different ways of serving foreign markets) are not robust to assumptions about demand. Moreover, the standard assumption that demand functions have constant elasticity, and that firms are similar in kind, if not in size, are not appropriate to understanding features of real-world economies, such as the choice of how to serve foreign markets. The research identifies insightful ways forward: recognising that firms have the power to manipulate their own market, but are still subject to the vagaries of national and global economic trends; and bringing out how the ability of firms to invest in the quality of individual products they produce, as well as in their “brand” as a whole, gives them a competitive edge in world markets.
RELATED RESEARCH PUBLICATIONS
- Eckel, C., L. Iacovone, B. Javorcik and J.P. Neary (2015) “Multi-product firms at home and away: Cost- versus quality-based competence,” Journal of International Economics, 95:2, March 2015, 216-232.
- Neary, J.P. (2016) “International trade in general oligopolistic equilibrium,” Review of International Economics, 24:4, September, 669–698.
- Mrázová, M. and J.P. Neary “Not so demanding: Demand structure and firm behavior,” American Economic Review (forthcoming).
- Mrázová, M and J.P. Neary “Selection effects with heterogeneous firms,” Journal of the European Economic Association (conditionally accepted).