Choosing a firm's location | Study notes Economics

Economics 5th year Prof. Q. Wibaut

Firm’s localization choice

Ac co rding to t he a rt ic le : Belgium’s fl exible methods lu re

in te rn at io na l mo to r gi an ts

A firm needs inputs to transform them into outputs through a production function. The inputs imply

costs, while outputs are sold and provide revenues. The gap between total revenues and total costs

constitute the profits, that the firm searches to maximize. Thus, there are 3 ingredients entering a firm’s

profit: inputs (i.e. costs), production function, outputs (i.e. revenues).

1. Transportation costs: Industrial products (output) need to be transported to customers. And

industrial goods are often constituted of many parts, or intermediate goods, that need to be carried

to the plant to be transformed and assembled during a long production process. This production

process is often called a “production chain”, which may take place in many different plants, locations

and from different contractors.

And transportation is costly. Hence transportation of final products and of intermediate parts

constitute an important part of the costs. How to reduce these costs?

Near Demand: By setting the firm close to its customers, for instance in a big country with a

large number of customers. This is a reason for having many (small) plants located in different

countries.

Transport Infrastructure: By setting the firm close to a port, since shipping costs are low; or in a

place well served by a good highway/railway network.

Central point: By setting a central location: though Belgium is a small country, it is located at the

crossroads of Europe, close to many other firms producing the intermediate goods required.

2. Economies of Scale: Producing on a large scale and concentrating production in a single location may

reduce the unit cost (=average cost) of production because of economies of scales: the average cost

(or unit cost) falls with the quantity produced thanks to the use of sophisticated tools. These tools

allow to lower the marginal cost of production but require large investments and fixed costs because

they cannot be undone easily or at once and need to be used during a rather long period. In turn,

large fixed costs need to be spread over a large production quantity.

EXERCISE: represent the marginal cost MC and the unit-cost ATC of 2 different firms, one with

little fixed capital but a relatively high MC, and one with a large fixed capital stock and low MC.

This argument runs counter to the previous one aiming at reducing the transportation cost by

building several plants as close as possible from the demand. Installing two plants at different

locations may reduce the transport costs but will increase the unit cost by spliting the production on

2 different plants running at half their capacity. Hence, depending on the product, the balance

between transport costs and economies of scale may differ, leading to more or less spatially

concentrated industries at the global scale.

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Firm’s localization choice

According to the article: Belgium’s fl exible methods lure

international motor giants

A firm needs inputs to transform them into outputs through a production function. The inputs imply costs, while outputs are sold and provide revenues. The gap between total revenues and total costs constitute the profits, that the firm searches to maximize. Thus, there are 3 ingredients entering a firm’s profit: inputs (i.e. costs), production function, outputs (i.e. revenues).

Transportation costs : Industrial products (output) need to be transported to customers. And industrial goods are often constituted of many parts, or intermediate goods, that need to be carried to the plant to be transformed and assembled during a long production process. This production process is often called a “production chain”, which may take place in many different plants, locations and from different contractors. And transportation is costly. Hence t ransportation of final products and of intermediate parts constitute an important part of the costs. How to reduce these costs?  Near Demand: By setting the firm close to its customers, for instance in a big country with a large number of customers. This is a reason for having many (small) plants located in different countries.  Transport Infrastructure: By setting the firm close to a port, since shipping costs are low; or in a place well served by a good highway/railway network.  Central point: By setting a central location: though Belgium is a small country, it is located at the crossroads of Europe, close to many other firms producing the intermediate goods required.
Economies of Scale : Producing on a large scale and concentrating production in a single location may reduce the unit cost (=average cost) of production because of economies of scales: the average cost (or unit cost) falls with the quantity produced thanks to the use of sophisticated tools. These tools allow to lower the marginal cost of production but require large investments and fixed costs because they cannot be undone easily or at once and need to be used during a rather long period. In turn, large fixed costs need to be spread over a large production quantity. EXERCISE: represent the marginal cost MC and the unit-cost ATC of 2 different firms, one with little fixed capital but a relatively high MC, and one with a large fixed capital stock and low MC. This argument runs counter to the previous one aiming at reducing the transportation cost by building several plants as close as possible from the demand. Installing two plants at different locations may reduce the transport costs but will increase the unit cost by spliting the production on 2 different plants running at half their capacity. Hence, depending on the product, the balance between transport costs and economies of scale may differ, leading to more or less spatially concentrated industries at the global scale.

EXERCISE: What in this text shows you that economies of scales are at work for Ford when deciding for Genk location? (2 examples from the text) EXERCISE: Give two different goods whose economies of scale in production and transportation costs are very different and try to know about their geographical concentration.

Cluster : There are also “external” economies of scales, which pushes many firms producing the same kind of product (=part of the same industry) to concentrate in the same region. This is called a cluster. Indeed, when one firm settles in a region, it leads to a. the provision of several public goods and infrastructures for this firm by the public sector of this region. For instance, if the firm needs a better highway network the State may decide to improve it for the firm to settles there. The same for education and the training of specific skills, which can be paid or subsidized by the State. Other firms of that industry can also beneficiate from these provisions. b. But the same mechanism also exists on a private basis. The first firm attracts  skilled people from elsewhere;  contractors providing inputs for its production;  contractors dealing with the transport of its output. Example: DHL installed in Liège is a gain for thousands of firms located in the region, encouraging other to follow suit. But the location of DHL in Liège results from the presence of so many firms in the region.  When new other similar big industrial firms settle in the region, they also beneficiate from this existing network of smaller firms and availability of skilled labor force and knowhow. These external economies of scale mean that adding more producers of that industry in the same region facilitates production and reduces the costs for all firms located in that region. And the more firms of that industry you have, the lower the average cost to produce there, and the more likely it is that other firms of that industry will continue settling there. This phenomenon is called clustering. A business cluster is a geographic concentration of interconnected businesses, suppliers, and associated institutions in a particular field. Clusters are considered to increase the productivity/lower average cost with which companies can compete, nationally and globally. Because it pushes firms of the same industry to locate in the same place, it also explains a large share of international trade: big shares of the whole production of any industry are concentrated in a very few places (sometimes a single one). Indeed, there is little incentives for a country to start developing its own production of a good from scratch if there are already large firms producing in another country at a much lower cost. However, according to that principle, developing economies would have almost no chance to start producing goods themselves, and therefore get on a development track. For that reason, “infant or nascent industries” in industrializing countries may need to be protected against worldwide competition in order to get a sufficient size and be able to compete on equal terms with their large foreign competitors.

represent incomes for other business and workers and possibly even indirect jobs for those who sell the goods and services. Thus, it gives rise to more expenditure by these suppliers too, and so on and on again. These second-round effects bring more consumption and income tax revenues for the State. Hence, it may be highly profitable for the Sate to grant tax waivers and pay subsidies to convince international firms to settle in its own country. Fiscal competition?

More generally, the quality of the respect of the rule of Law may be very different across countries. That covers many different things, such as the possibility for a private firm to win a case against the State (thanks to independence of the court system) and the absence of corruption.
Neutrality. Belgium has a tradition of political neutrality on the international scene. It has important implications for the decision of an international firm to locate in Belgium. Consider for instance the recent trade war between the US and China. All firms (whether American, European or other) having decided to set their plants in China to export their output in the US now have big difficulties doing so because of the trade war (starting with rising tariffs before possibly getting worse and escalating into trade interdictions or quotas). The same for firms having located in the US and exporting to China. Therefore, settling in a country that usually remains on the sideline of any international conflict is a clear advantage.
Trade Openness. Belgium has a long tradition of free trading: it has been exporting (and importing) a very large share of its production (and consumption). It is a fervent advocate of free trade and is very unlikely to wage a trade war or to limit international trade. (Anyway, it would have too much to lose doing so, given its existing trade openness).
Single Market : “1992 approaches”. The creation of the single market was both an opportunity and a risk for the Motor industry in Belgium. Mobility of goods, services, labor and capital. Risks come from the main disadvantage of this location: traditionally high labor costs which incent firms to move abroad where labor costs are lower. This is facilitated by greater goods mobility. One usual advantage of Belgium (trade-openness) is now shared by other European countries, with much lower wage levels, such as Spain and Portugal. This means that transportation costs (from border crossing) will be substantially reduced with the Single Market. Fiscal Competition?
Departure to Valencia to cut costs. Explain how this is possible using diagrams.

Choosing a firm's location, Study notes of Economics

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Firm’s localization choice

According to the article: Belgium’s fl exible methods lure

international motor giants