Internationalization of Production: FDI and. FDI-Outsourcing

Transcription

1 nternationalization of Production: FD and Outsourcing st Term

2 Plan of the lecture Review Definition of FD Horizontal vs. Vertical FD Traditional theories of FD: the OL framework A model for horizontal FD A model for vertical FD General equilibrium effects of vertical FD A model of outsourcing without internalization

3 Basics The MF definition of FD Critiques and the more accurate OECD definition Horizontal vs. Vertical FD Facts about Multinational: Exports and FD are complements and not substitutes FD are more intense among more similar (industrialized) economies FD are especially concentrated in high sunk-cost sectors (e.g. high-tech sectors)

4 The OL Theory and Scale Economies The OL framework: Ownership of an intangible asset Localization according to the type of FD nternalization to avoid dissipation Plant-level vs. firm-level economies of scale

5 ssues FD means: to exploit firm-level economies of scale in different countries geographical dispersion of production redefining the boundary of the firm (FD vs. subcontracting)

6 Geographical Dispersion Costs: plant-level economies of scale (HFD) foregone economies of integration (VFD) foregone trade costs Benefits: better market access (tariff-jumping and tax differential motives), depends on the target market size and tariff (HFD) lower factor costs (VFD)

7 nternalization What is the boundary of the firm when there are intangible assets? FD vs. subcontracting: asymmetric information and incomplete contracts the hold-up problem dissipation of the intangible asset agency costs

8 Effect of FD Host Home Product mkt productivity, competition productivity, output Factors mkt skills, wages skills, wages Spill over technological transmission technological sourcing

9 Set up Problem of the monopolistic firm: Equilibrium price: p = substitution. Hence: π = max π = p(q)q cq q ɛ ɛ 1c where ɛ is the elasticity of ( ɛ ) ɛ 1 1 cq = c ɛ 1 q = p ɛ q

10 Set up Define the market share s of the firm: s = pq E where E is the market size. Hence: π = c ɛ 1 q = pq ɛ = se ɛ

11 FD vs. Exports Each firm faces a fixed cost H for the headquarter and a fixed cost F for the domestic subsidiary. n order to serve the identical foreign country it chooses between: Exports: it faces trade cost τ that raises the marginal cost to τc and reduces the foreign market share by 0 < φ < 1; hence, profits from exports are φπ FD: an additional fixed cost F to establish a subsidiary abroad, but profits in the foreign market are then the same as home, i.e. π

12 Decision to do FD Total profits from activities home and abroad in the two cases: Exports: π X = π + φπ H F = (1 + φ) se ɛ FD: π M = 2π H 2F = 2 se ɛ H 2F Hence, it becomes a multinational if: π M > π X (1 φ) se ɛ > F H F Note: (1 φ) se ɛ is the increase in revenue if multinational, whereas F is the increase in cost. n terms of effects of trade costs φ, it becomes multinationals if φ strongly reduces the market share abroad: φ < φ 1 F ɛ se

13 Market shares and number of firms Problem: the market share s is not exogenous and depends on the number of firms that decide to become multinationals. Assumption: in each market there are m multinational firms with home headquarter and m with foreign headquarter, n domestic firms and n foreign firms that do exports. Market shares in each market: Hence: Multinationals Domestic national s s foreign s φs 2ms + (1 + φ)ns = 1

14 Endogenize the number of multinationals 2ms + (1 + φ)ns = 1 s = 1 2m + (1 + φ)n Define 2N = 2m + 2n, i.e. total number of firms; θ = 2m 2N = m N is the share of multinationals. Then: s = 1 2θN + (1 + φ)(1 θ)n = 1 N [(1 + φ) + (1 φ)θ)] meaning: the share of multinationals in the market affects the market share of each firm; in particular, the higher the share of multinationals, the lower the market share, i.e. more competition; for the same level of trade costs, the share of multinational lowers. We have a dynamic equation and need to determine the steady-state level.

15 The equilibrium share of multinationals Let us recall that there is indifference between becoming or not multinationals when: R = C (1 φ) se ɛ = F Plug in the endogenous market share, dependent on the share of multinational: s = 1 N [(1 + φ) + (1 φ)θ)] and obtain the equilibrium market share of multinationals: θ = E NɛF 1 + φ 1 φ

16 Set up Production stages at home: component production: cost c for 1 unit of component, needed for 1 unit of final good assembling: cost a to assemble the component into 1 unit of final good Firms are price takers and sell the final good only at home Quantity sold is 1 unit of final good n case of multinational firms: the assembling cost abroad is equal to a = αa 0 < α < 1, but there are trade costs that reduce the total revenue to γp 0 < γ < 1 instead of p Fixed cost of the headquarter H

17 Decision to do vertical FD Total profits from assembly activities home and abroad in the two cases: Home: π N = p c a H FD: π MN = γp c αa H Hence, it becomes a multinational if π MN > π N or: γp c αa H > p c a H (1 α)a > (1 γ)p n terms of reduction of assembly costs α, it becomes multinational when: α < α 1 (1 γ) p a

18 Set up 2 production stages at home as before CRS, fixed-coefficient production functions, different factor intensities for the two production stages: component production: capital-intensive stage, cost c(w, r) for 1 unit of component, needed for 1 unit of final good: c(w, r) = l c w + k c r (l c and k c given) assembling: labor-intensive stage, cost a(w, r) to assemble the component into 1 unit of final good: a(w, r) = l a w + k a r (l a and k a given) where kc l c > ka l a Firms are price takers and sell the final good only at home Quantity sold is 1 unit of final good Consider two possibilities: entire production at home or production fragmentation.

19 Entire production at home Unitary cost of production: g h (w, r) = a(w, r) + c(w, r) Given the price of the final good p and perfect competition, then p = g h (w, r) gives the locus (w, r) of compatible factor prices ( schedule in the picture): p = (l a + l c )w + (k a + k c )r Given the factor prices at home, w 1 and r 1, this determines one point on the locus (point 1 in the picture).

20 Production ntegrated w 0 r

21 Production ntegrated w 0 r

22 Production ntegrated w (k a + k c )/(l a + l c ) 0 r

23 Production ntegrated w (w 1 ;r 1 ) (k a + k c )/(l a + l c ) 0 r

24 Production fragmentation Home country 1 keeps component production at home at the cost c(w 1, r 1 ), but transfer abroad the assembling. The unitary cost of production is then: g a (w, r) = a(w, r) + c(w 1, r 1 ) Given the price of the final good p and perfect competition, then p = g a (w, r) gives the new locus (w, r) of compatible factor prices (AA schedule in the picture): p = l a w + k a r + (l c w 1 + k c r 1 ) Note: this goes through point 1 in the picture when foreign factor prices are the same; the slope is lower than the previous locus since assembling is labor-intensive.

25 Production Fragmented w A (w 1 ;r 1 ) k a /l a A (k a + k c )/(l a + l c ) 0 r

26 Production fragmentation An alternative is to transfer component production abroad and keep assembling. Then, the new locus (w, r) of compatible factor prices is the following (CC schedule in the picture): p = l c w + k c r + (l a w 1 + k a r 1 )

27 Production Fragmented w A C (w 1 ;r 1 ) k a /l a A C (k a + k c )/(l a + l c ) 0 r

28 Production Fragmented w A C (w 1 ;r 1 ) k a /l a A C (k a + k c )/(l a + l c ) 0 r k c /l c

29 Production fragmentation Conclusion: now production is less costly when assembling is transferred to countries where the combinations of factor prices shows relatively lower labor cost (area above and below AA schedules). Component production is instead transferred abroad where the relative cost of capital is lower (area above and below CC schedules).

30 Production Fragmented w A C (w 1 ;r 1 ) Outsourcing assembling k a /l a A C (k a + k c )/(l a + l c ) 0 r k c /l c

31 Production Fragmented w Outsourcing components A C (w 1 ;r 1 ) k a /l a A C (k a + k c )/(l a + l c ) 0 r k c /l c

32 Production fragmentation For instance, when transferring assembling to country 2 with w 2 and r 2 (point 2 in the picture), then the unitary cost lowers to p = a(w 2, r 2 ) + c(w 1, r 1 ). The new locus A A represents all combinations (w; r) equivalent to that of country 2 when components are produced at home at (w 2 ; r 2 ) and the total cost is p.

33 Production Fragmented w A C (w 1 ;r 1 ) A (w 2 ;r 2 ) C 0 r

34 Production Fragmented w A C (w 1 ;r 1 ) A C (w 2 ;r 2 ) A A 0 r

35 Production fragmentation A similar unitary cost would need much lower wages and cost of capital in case of non-fragmented production ( in the picture): p = (l a + l c )w + (k a + k c )r

36 Production Fragmented w C A A (w 1 ;r 1 ) C (w 2 ;r 2 ) A A 0 r

37 Effects of production fragmentation Transferring abroad the more labor-intensive stage of production (effects on employment). Can we be better off if government raise trade barriers to fragmentation (i.e. increase in trade costs)? Possible effects: Other countries may not put impediments and fragmentation occurs from competitors Long-run effects of specialization Entire production can be transferred to other countries, like the one with (w 3 ; r 3 ) in the picture, that would be kept out of the market with fragmentation, but not with entire production at home

38 Production Fragmented w C A A (w 1 ;r 1 ) (w 3 ;r 3 ) C (w 2 ;r 2 ) A A 0 r

39 Effects on factor rewards more FPE, since trade in tasks increases the spectrum of productions, hence specialization and more forces towards FPE in an HO-type world (see Helpman and Krugman, 1985) less FPE, since factors skills are different in different countries and low-skill stages in the North may be high-skill stages in the South increase in the relative demand of skilled vs unskilled in both countries and the skill premium may rise everywhere (see chp. 7 in Feenstra and Taylor, 2008).

40 Set up Production stages at home: component production: unitary cost c assembling: unitary cost, a at home Firms are price takers and sell the final good only at home Quantity sold is 1 unit of final good Two possible ways of internationalization: FD, cost a for assembling within a subsidiary subcontracting, lower cost pa = αa 0 < α < 1, but contract costs η (like trade costs) lower the price of the final good to ηp (0 < η < 1) Fixed cost of the headquarter H

41 Decision to be multinational vs outsourcing Total profits from assembly activities within the multinational and via subcontracting: Multinational: π MN = p c a H Subcontracting: π S = ηp c αa H Hence, it becomes a multinational if π MN > π S or: γp c a H > ηp c αa H (1 η)p > (1 α)a n terms of contract costs η, it becomes multinationals if this is low enough: η < η 1 (1 α) a p