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The Economics of multinationals: Theory of Vertical FDI Lessons 1 and 2

The Economics of multinationals: Theory of Vertical FDI Lessons 1 and 2. Giorgio Barba Navaretti Gargnano, June, 11-14 2006. Objectives and background. OBJECTIVES Investigate different forces affecting the choice of fragmenting production Investigate effects of production fragmentation

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The Economics of multinationals: Theory of Vertical FDI Lessons 1 and 2

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  1. The Economics of multinationals:Theory of Vertical FDILessons 1 and 2 Giorgio Barba Navaretti Gargnano, June, 11-14 2006

  2. Objectives and background • OBJECTIVES • Investigate different forces affecting the choice of fragmenting production • Investigate effects of production fragmentation • BACKGROUND • Simplified version of Helpman (1984) adding VFDI to HO => FPE • Extension in the spirit of Feenstra and Hanson (1996) => Not necessarily FPE

  3. Setting • Production is split in two stages: components (c) and assembly (a). • Perfect competition • Two factors, labour and capital, used in both stages with prices in country i wi and ri • Constant returns to scale, so unit cost functions for each stage are c(wi, ri) and a(wi, ri). • Production of one unit of a uses one unit of c (no substitution between c and primary factors) • Trade costs are incurred on shipping final products and components

  4. Cost functions Cost of a unit of output delivered to country k if components are produced in country i and final assembly takes place in j: and for

  5. When do firms fragment production? • Countries 1 and 2. • 1 is North, has higher wages • 1 has advantage in integrated production • Assembly is labour intensive (carried out in 2 if production is fragmented) • Trade costs same in both directions

  6. Trade costs and production regimes Combined increases in tc and ta HFDI VFDI export

  7. Trade costs and effects on trade

  8. Effects: fragmentation and factor prices in partial equilibrium

  9. Fragmentation in general equilibrium • Extension by Helpman and Helpman and Krugman of the H-O model to include FDI • 2 countries, 2 goods, 2 factors model • Qs: • Under what circumstances does FDI occur? • What is the effect of FDI on factor prices? • ta =1 and tc=1 (free trade in components) or = 4 (no trade in components) • Endowments of factors in countries 1 and 2 L1, K1, L2, K2 • One sector is manufacturing (divided in components and assembly) which has fixed factor intensities • The rest of the economy is sector Y: employs the entire endowment minus factors employed in M

  10. Fragmentation in general equilibrium, other assumptions Output and mkt clearing factor prices in Y: • DEMAND: • Incomes in each country are the sum of the returns to the two factors, wiLi + riKi, i = 1, 2. • Consumers have identical homothetic preferences • Goods have the same price in both countries • => Trade is only driven by international differences on the supply side

  11. Fragmentation and factor price convergence How to explain the Nafta paradox (skill premium rising in Mex and US - Feenstra Hanson)?

  12. Fragmentation and factor prices in general equilibrium

  13. Effects on skill structure when firms are heterogeneous Barba Navaretti, Bertola Sembenelli, 2006

  14. Main issues • Vertical investment depend on transport costs and relative factor costs • The effects of VFDI on factor prices depends on the relative factor intensities of M’s activities and on the relative factor endowments of countries

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