Partial versus total disintegration of exporting firms

1. Partial versus total disintegration of exporting firms Gianpaolo Rossini Department of Economics University of Bologna 5° Europaeum Workshop Helsinki October 27-28, 20061

2. Vertical integration (VI) and disintegration (VD) • VD and VI are strategic choices of firms operating in non perfectly competitive environments (Hart and Moore, 1990; Acemoglu, Aghion, Griffith and Zilibotti, 2005; Acemoglu, Johnson and Mitton, 2005; Antras and Helpman, 2004).

3. Vertical relationships between Upstream (U) sections of the vertical chain and Downstream (D) sections can take many forms. • In case of VI inputs are internally transferred at their opportunity cost, i.e. the marginal cost. • With VD, linear pricing, fixed franchise fee or other arrangements may take place.

4. In the case of simple linear pricing there arises an externality (Spengler, 1950; Rossini, 2005) whereby the increase in the price of the final good sold by the D firm affects negatively the profit of the U firm (double marginalization).

5. A different link between U and D if both parties bargain over the terms of trade of the input (McLaren, 2000; Antras and Helpman, 2004). The solution, from a social point of view replicates VI, where the vertical distribution of profits is indeterminate, or irrelevant from the firm's point of view, but not from the managers' standpoint.

6. When trade enters the picture: • VD and VI <-> internationalization of firms (Amiti and Konings, 2005; Amiti and Shang-Jin, 2005; Antras and Helpman, 2004; Hummels, Ishii and Yi, 2001; Markusen, 2002; McLaren, 2000; Rossini, 2007; Rossini and Ricciardi, 2005). • Producers go multinational (MNF) via FDI or outsource some inputs from a foreign independent firm. • Related possibility: to get an input from a foreign firm that sells also to rival companies. This company may be jointly owned with rival D firms. Frequent in the automotive sector: outsourcing via joint input production (JIP). A partial collusive agreement since they maximize joint profits in U. Affinities with research joint ventures (RJV) (Banerjee and Lin, 2001).

7. The aim of this paper • To assess the choices of vertical arrangements of exporting firms in oligopoly under uncertainty, international transport costs and home bias.

8. The results: • even with linear pricing, VD may be preferred to partial VD if there are some vertical restraints. • If VI is not feasible partial VD-VI may be the solution of the game

9. A three stage game framework • Firms interact in the D stage as Cournot duopolists (third stage). • They vertically interact either in a VD, VI, partial VI-VD, JIP fashion in U (second stage). • To begin with, firms must choose the vertical arrangement (first stage).

10. A duopoly with two firms based in two separated countries H and F selling a differentiated good (differentiation signal of home bias) alters the degree of competition. • Demand uncertainty of the additive type. We examine cases where volatility differs across countries. • The two firms export part of their production of the final good to the other country. • Each firm can either produce or buy the input required to manufacture the final good.

11. Four strategies • 1. Each firm adopts VI and produces its own input at home while exporting part of the output to the country of the rival. • 2. The input is internally produced only to the final production sold domestically, while, for the manufacturing of exports each firm buys the input abroad from the foreign rival. In this second strategy there is partial VD and partial VI and we label it VI-VD. • 3. Each firm buys the entire input requirement from an independent foreign producer. • 4. As 3, but the independent firm is a joint venture of the two D rivals doing joint input production (JIP).

12. The first strategy (VI - VI) • The demand functions for the final good in H: • pH = a – hh – s t f + eH pH is the market price in country H. a is the size of the H market or marginal willingness to pay of average H consumers. hh is the quantity of the final good domestically produced and sold in the domestic market. f is the quantity of the good imported in H and produced abroad by the foreign rival t є(0,1] is the transport cost (TC) iceberg type (Anderson and Van Wincoop, 2004; Laird and Yeats, 1990; Samuelson, 1954; Lambertini and Rossini, 2006), whereby a portion t of the good exported is used up in transport. s є (0,1] is the differentiation parameter (Singh and Vives, 1984; Pepall and Norman, 2001) which may be thought of as a measure of home bias, which grows as s tends to zero. eH is the error term of market H. eF is the error term of market F. We assume that the additive shock term has zero expected value and constant second moment, i.e.: EeH = EeF = 0; EeF² = σ²; EeFeH = σ². where E is the expectation operator. Symmetrically for the F country final demand.

13. the profit functions of the two firms are: πH1= pH hh + t pF h - z(hh + h) and πF1= pF ff + t pH f - z(ff + f), z is the common constant marginal production cost of the input. The assembly of the final good has zero cost.

14. The two D firms producing the final good in the two country compete in a Cournot Nash fashion (Brander and Krugman, 1983; Spencer and Jones, 1991). • In the case of symmetric VI the game is two stage since the vertical interaction is internally solved without interaction between D and U.

15. VI -VD • An international vertical restraint whereby a firm has to buy the input in the country of destination of exports.

16. VD • The input is produced by two independent firms, one in F and the other in H, operating in the U section of the vertical chain of production.

17. JIP • joint input production (JIP) by the two D rivals

18. The game in normal form

19. Scenario 1: no uncertainty • (VI, VI) solution in dominant strategies

20. Scenario 2: Asymmetric uncertainty: more volatility in F • (VI, VI) solution. • However, if only strategies VD and VI-VD are available, U and D firms may choose VD. In this case they are able to get a larger aggregate profit (Pareto superior).

21. Scenario 3: High home bias • (VI;VI) is the solution. • If VI is not possible the solution is (VI-VD;VI-VD)

22. Scenario 4: H large, F small • VI-VI • If VI not feasible: one Nash equilibrium given by (VI-VDH;VDF) where the two firms adopt different strategies

23. Scenario 5: joint input production (JIP) • VI may no longer be the dominant strategy