MGRECON401 Economics of International Business and Multinationals LECTURE 4

1. MGRECON401Economics of International Business and MultinationalsLECTURE 4 Multinational Investments, Outsourcing, and Ethics

2. Lecture Focus • What are the trends in FDI? • What determines the choice between FDI, exporting, and licensing? • What are the benefits of a multinational? • Why is there often resistance to a multinational in a developing country?

3. Multinationals and Foreign Direct Investment (FDI) • MNC = a firm with significant operations in more than one country. • FDI = when a firm invests directly in facilities to produce and/or market a product in a foreign country. • Once a firm undertakes FDI it becomes a multinational corporation (MNC).

4. Foreign Direct Investment (FDI) • FDI takes two forms: • Green-field investment: establishing a wholly new operation in a foreign country. • M&A: acquiring or merging with an existing firm in the foreign country. • Investing in foreign financial instruments (Foreign Portfolio Investment) IS NOT FDI.

5. Forms of FDI Horizontal FDI = FDI in the same industry as the firm operates at home. Vertical FDI = FDI in either an industry that is backward (e.g., provides an input) or forward (sales and distribution) of a production/sales process.

6. Flow: The amount of FDI undertaken over a given period of time (usually one year). Stock: Total accumulated value of foreign-owned assets at a given time. Flow and Stock of FDI

7. World exports, GDP, and FDI World GDP and FDI 1990-2001 (index = 100 in 1990)

8. Inward FDI flows by region

9. Inward FDI Flows as a Percentage of Gross Fixed Capital Formation, 2000

10. FDI Flows by Region

11. US: FDI Inflow as a Percent ofGross Fixed Capital Formation

12. US: Inward FDI Stock as a Percent GDP

13. Obtaining Data on FDI United Nations Conference on Trade and Development (UNCTAD): www.unctad.org.

14. Country Characteristics of FDI • FDI has grown rapidly. 2001 and 2002 saw a dramatic drop. • Developed countries account for overwhelming portion of outward and inward FDI.

15. Country Characteristics of FDI • Two-way FDI flows are common between pairs of developed countries, even at the industry level. • Most FDI is horizontal: most of output of foreign country is sold in foreign country.

16. Country Characteristics of FDI • Political risk and instability seems to be an important deterrent to inward FDI.

17. Firm and Industry Characteristics of FDI • Large differences exist across industries in the degree to which production and sales are accounted for by MNCs. • MNCs tend to be important in industries and firms that: • Have high levels of R&D to sales, • Employ large numbers of professional and technical workers as a percentage of their total workforces, • Produce new and/or technically complex products, and • Have high levels of product differentiation and advertising.

18. Firm and Industry Characteristics of FDI • MNCs tend to be firms in which the value of the firms’ intangible assets is large relative to its market value. • FDI is positively related to the existence of trade barriers that differ across industries.

19. Characterization of MNCs in Developing Countries • Prevalent in labor-intensive stage of production in Developing Countries • MNC pay higher wages than local firms • MNCs offer significant training • MNC create demand for related and supported industries • MNC enhances productivity in developing countries.

20. Characterization of MNCs in Developing Countries • Developing countries historically resisted MNCs • Political uncertainly leads to high expropriation risk (Latin America, Iran, …) • Thought they could go it alone; underestimated the importance of human capital and technology • Developing countries now frequently offer substantial inducement to MNC • Tax holiday, infrastructure, tariff protection • Flow of FDI to developing countries is also consequence of lower expropriation risk (increasing recognition of importance of MNC).

21. Characterization of MNCs in Developing Countries • No clear evidence that MNC alter conditions of local competition • Some tendency to buy out local competition • But MNC tend to locate in concentrated industries • Elimination of local competition may be due to a change in optimal allocation of resources. • Sometimes MNC will spread out R&D, but mostly not • Little evidence on technology transfer

22. Alternatives to FDI • Exporting and licensing are the two main alternatives to FDI. • Licensing = when a domestic firm (licensor) awards a foreign firm the right to use its product, production processes, brand name or trademark. In return, the licensor receives fees and royalties.

23. Export or FDI • Domestic Firm wishes to sell Y in a Foreign country. • Fixed cost G to set up a plant in the Foreign country. • Per unit transportation cost tto ship the good. • Unit labor costs: chome and cforeign • FDI if: cforeignY+ G < (chome + t)Y or G/Y < t +chome -cforeign

24. Video Clips • Open for Business: How India Has Opened Its Economy to Foreign Markets • McDonald’s Everywhere

25. License or FDI • Internalization: Ownership and Control • What is the optimal span of ownership of a company? • When should it license to a foreign producer v. create a foreign subsidiary? • When should it purchase v. produce intermediate goods? • Example: Henry Ford • steel mill • Glass factory • Rubber tree plantation in Brazil • Iron mine in Minnesota • Railroads and ships for transport

26. Market Imperfections • Relationship-specific Investment (Hold-up problem): an investment is specific to a relationship if it is of less value to parties outside the relationship. • Leads to ex-post monopoly power • Example: auto supply parts company. • Solution: long-term contracting, reputation, or ownership. • Hold-up problem leads to vertical integration. • Examples without vertical integration: IKEA, Benetton, and Nike.

27. Market Imperfections • Downstream Incentive Problem: • Double marginalization • Suppose mc = mc1 + mc2 • Optimal for combined firm to set mr = mc • Firm 1 (upstream) charges p > mc1 to downstream firm (due to monopoly power) • Then Firm 2 perceives mc = p + mc2, which will lead Firm 2 to overprice the final product. • Example: Coke and Pernod-Ricard (distributor) in France.

28. Market Imperfections • Transfer of knowledge. • Difficult to sell • Creates future competitors

29. Market Imperfections • Loss of control and difference in incentives can create a conflict. • Attitudes towards risk may differ • Incentive to abuse reputation of parent company • Unforseen contingencies: cost of haggling.

30. Cost of Internalization • Spanning Costs and core competence. • Optimal risk sharing and incentives.

31. Strategic Aspects of FDI • Prevent competitors from achieving a first mover advantage. • More costly to enter later once a competitor is established. • Option of waiting is also valuable.

32. Starbucks • Corporate icon known the world over. • Has evolved from Seattle-based coffee house to global food & retailing powerhouse. • Has changed the way Americans think about coffee – no longer a 50 cent drink!

33. Starbucks • Sales of $3.3 billion in 2002. • Sales growing by more than 20% annually!! • Stock has soared more than 2,200% over past 10 yrs – better than Wal-Mart!!! • Today, there are 6,000 Starbucks worldwide and company is gunning for 10,000 outlets by 2005. Howard Schultz

34. Starbucks in Asia • Began overseas expansion in ‘95 with licensing deals in Japan. • Switched to JVs after it was disappointed with licensing. • Invested $10 million and transferred employees from North America. • Followed same strategy in Thailand and Korea.

35. Video Clip • Starbucks: Building Relationships with Coffee Growers

36. Nike • Describe the sense in which the monopolistic competition model captures the interaction of firms in the athletic shoe industry. • How does the monopolistic competition model explain the rise in the variety of athletic shoes that we have seen over the last decade or so? • Why do we not see intra-industry trade between the US and the rest of the world in the athletic shoe industry?

37. Nike • How has Nike used its foreign production of shoes as a source of competitive advantage? • As Nike and other athletic shoe companies produce their shoes in other countries, why have they chosen to outsource their production instead of relying on foreign subsidiaries?

38. Nike • Should the WTO allow countries to impose a tariff on imports from countries that do not abide by “fair labor practices?”

39. Video Clip • Nike CEO Phil Knight