ANU Trevor Swan Distinguished Lectures in Economics

1. ANU Trevor Swan Distinguished Lectures in Economics

2. Major Contributions to Economics • 1943 - circulated the first econometric model of the Australian economy • Only previous macroeconomic model was Tinbergen (1936). • 1953 - policy instruments and targets – published 1960 • foreshadowed Mundell (1999 -Nobel prize). • 1955 - “the Swan diagram” – published in 1963 • concerned with achieving both internal and external balance • 1956 – published “Economic Growth and Capital Accumulation” • Known as the “Solow - Swan” growth model. Solow (1956) independently published a similar model (1987- Nobel prize)

3. Trevor: Reserve Bank Board 1975 - 1985

4. Trevor and Pat Swan – early 1940’s

5. ANU Trevor Swan Distinguished Lectures in Economics Understanding International Outsourcing: New Theories of Trade and Organizational Form Barbara J. Spencer University of British Columbia and the NBER March 8, 2007

8. Objective Introduction, IO Theory, International Outsourcing, Conclusion • Provide a perspective on international outsourcing based on the new literature that combines the choice of organizational form with international trade. • partly based on my survey article “International Outsourcing and Incomplete Contracts” CJE, 2005. • Main question: What explains international outsourcing versus other options for procurement? • What explains the decision by firms to outsource rather than vertically integrate? • What explains the decision to outsource abroad? 8

9. Introduction, IO Theory, International Outsourcing, Conclusion Outline of Talk • Introduction – The firm’s choice set: make or buy and location • Domestic outsourcing – Insights from the theory of Industrial Organization • Central concept - Incomplete contracts and the hold-up problem • Three different theoretical approaches • International Outsourcing: • general equilibrium models • partial equilibrium – empirical work on outsourcing to China • Conclusion - Summary and future directions

10. Add location (domestic or foreign) to the firm’s make or buy decision

11. Distinguish between outsourcing of specialized and generic inputs

12. What is meant by organizational form? Introduction, IO Theory, International Outsourcing, Conclusion • The different options for procurement correspond to different organizational forms. • Organizational forms • Vertical integration • produce the input at home • Become a multinational firm by undertaking FDI so as to produce the input abroad • Outsource a specialized input • Contract with a domestic supplier • Contract with a foreign supplier • Outsource a generic input – buy it on the market 12

13. Introduction, IO Theory, International Outsourcing, Conclusion 2. Theory – Domestic Outsourcing • Central concept - Incomplete contracts and the hold-up problem • If contracts are complete (cover every contingency) and are enforceable, vertical structure does not matter • Three theoretical approaches • Property Rights • Transaction Costs • Principal-agent models/ design of incentive systems

14. Introduction, IO Theory, International outsourcing, Conclusion Incomplete Contracts & Hold-up Problem • Relationship-specific investment : investment designed for a particular firm - NO value to other firms. • Since there is no outside market for products arising from the specific investment, the investment is rewarded only through contracts with the particular firm. • Contract is incomplete: not possible to write contracts conditional on the level of the specific investment. • Return that suppliers receive for investment is determined by bargaining between the parties after investment is sunk. • Hold-up problem: investment not fully rewarded • too little investment or effort

15. Star Wars – The Empire Strikes Back Darth Vader & the Holdup Problem • IMPERIAL OFFICER: Skywalker has just landed, my Lord • VADER: Good. See to it that he finds his way here. Lando, take the princess to my ship. • LANDO: You said that the princess would be left in the city under my supervision. • VADER: I am altering the deal. Pray I don’t alter it any further.

16. Property Rights Theory(Grossman & Hart, 1986; Hart & Moore, 1990) • Contracts are incomplete • for both an outside supplier or a manager within the firm • Outsourcing can reduce the hold-up problem • Property rights theory defines a firm by the ownership of assets. • Since a firm can withhold assets if bargaining breaks down, but a manager cannot, the firm has a better bargaining position. • independent suppliers have more incentive to invest • Who should invest? • If specific investment in an input is best done by those directly responsible for its production, then • production should be outsourced to encourage investment. • If investment in an input at the head-quarter’s level by the owner of the firm would be more productive than investment by a supplier, then • vertical integration is more efficient

17. Transaction Costs Introduction, IO Theory, International Outsourcing, Conclusion • Lower transaction costs inside the firm make vertical integration more efficient than outsourcing • Coase (1937); Williamson (1975, 85) • Outsourcing involves costs of search and matching (McLaren 2000) • Thickness of the market • markets are thicker if there are more firms to match with. • More outsourcing in thicker markets • Outsourcing may also involve inefficiencies due to incomplete contracts

18. Principal and agent models Introduction, IO Theory, International Outsourcing, Conclusion • The principal is typically the owner of the firm and the agent is the manager • The principal designs optimal contracts to induce effort by the agent under imperfect monitoring. • The greater ease of monitoring within the firm favours vertical integration

19. Introduction, IO Theory, International Outsourcing, Conclusion 3. International Outsourcing • General equilibrium models • Vertical integration vs. contractual outsourcing of specialized inputs • Antràs (2003)- Property rights Antràs & Helpman (2004) – Property Rights Grossman and Helpman (2004) – Principal & Agent • McLaren (2000), Grossman & Helpman (2002, 2005) -Thickness of market – transaction costs • Simplifying assumptions for general equilibrium • Partial equilibrium • Contractual vs. generic outsourcing • Feenstra and Spencer (2006) – Outsourcing to China

20. Introduction, IO theory, International Outsourcing, Conclusion What is new about the theory? • Traditional general equilibrium trade theory assumes perfect competition • atomistic firms: firm size and vertical structure is not relevant • Monopolistic competition has been widely adopted • Fixed costs determine the size of firms under free entry. • Products are differentiated • But, vertical structure and trade in intermediate goods are not considered. • Theories of trade and organizational form require a theory of the firm in which vertical structure matters. • A major achievement has been to embed contracting models into general equilibrium models of monopolistic competition.

21. Antràs (2003*) – Property rights Introduction, IO Theory, International Outsourcing, Conclusion • Embeds a property rights model of the firm into a general equilibrium model of monopolistic competition and trade. • differences in factor endowments across countries explains the choice of organizational form • Prediction: Capital intensive intermediate goods are likely to be produced by vertically integrated firms rather than outsourced • What drives the model? • Hold-up problem: alleviated if final-good firms contribute capital to suppliers so as to share in the cost of production of specialized inputs. • If the capital contributed is sufficiently large: property rights theory⇨ vertical integration

22. Share of intra-firm US imports and relative factor endowments (Antras, 2003)

23. Property rights vs principal & agent Introduction, IO Theory, International Outsourcing, Conclusion • Antràs & Helpman (2004) - Property Rights • Grossman and Helpman (2004) – Principal & agent • Both papers incorporate monopolistic competition models of trade involving differences in productivity across firms that determine organizational form • Melitz (2003) introduced firm-specific differences in productivity into general equilibrium trade models. • But the Property Rights and Principal and Agent approaches give very different predictions as to the choice of organizational form.

24. 1 3 4 2 N firm -Productivity Rank FDI South Vertically Integrate North Northern Firm North Outsource South

25. GH(2004) 1 2 3 3 4 2 1, 4 N firm -Productivity Rank FDI South Vertically Integrate North Northern Firm North Outsource South

26. B. Thickness of the Market Introduction, IO Theory,International Outsourcing, Conclusion • Transaction cost approach:hold-up problem solved by vertical integration • Outsourcing due to a fixed cost of vertical integration • Multiple equilibria possible (McLaren, 2000): • a thicker market increases outsourcing, which in turn makes the market thicker • Grossman &Helpman (2002) • Combines thickness of market with general equilibrium monopolistic competition • Outsourcing based on incomplete contracts. • Closed economy

27. B. Thickness of the market: Domestic vs. International Outsourcing Introduction, IO Theory,International Outsourcing, Conclusion • Grossman & Helpman (2005) • No vertical integration • Countries with more labour attract outsourcing • due to thicker markets. • Complex results due to general equilibrium interactions: - an expansion in Southern labour actually reduces the wage gap between the North and the South.

28. Simplifying assumptions: general equilibrium Introduction, IO Theory,International Outsourcing, Conclusion • Requires a simplified model of contracting • The parties share in profit through lump-sum transfers. • May better capture profit-sharing joint ventures than contractual purchase of inputs from independent firms. • If suppliers commit to a quantity up-front, the price of an input is zero. Otherwise inputs are priced at marginal cost. • Realism? Customs officials could view as suspicious.

29. Implications for Boeing 787?

30. Problems: Airbus A380

31. Introduction, IO Theory, International Outsourcing, Conclusion 3. International Outsourcing: partial equilibrium • Feenstra & Spencer (2006), “Contractual versus Generic Outsourcing” • Variety in intermediate goods – A final good producer, such as an automaker, requires a continuum of parts. • parts are ordered on the continuum in terms of increasing productivity of specific investment by suppliers. • Property Rights approach - all parts are outsourced • Free entry of suppliers, but one final-good producer • More structure in the model of contracts. • Trade-off between specialized and generic parts is built into the Nash bargaining process.

32. Feenstra and Spencer (2006)

33. 33

34. Variety or Volume? Introduction; IO Theory; International Outsourcing; Conclusion • Feenstra and Spencer (2006) explore the effect of distance on the variety of exports covered by each organizational form. • Data: manufacturing exports from each province in China to all destination countries (1988 – 2003) • Enormous literature of the effect of distance on the volume of international trade (gravity equations), but consideration of variety is relatively recent.

35. Introduction, IO Theory, International Outsourcing, Conclusion Empirical Results • Two measures of distance • Internal distance from the province to the nearest port • External distance from the port to the destination country • As predicted, greater internal distance reduces the proportion of exported varieties from China that • are contractual (processing exports) rather than generic (ordinary manufactures) • involve contracts with multinationals • External distance from the port to the destination county has essentially no effect. • As in standard gravity equations, the value of exports to more distant countries are reduced.

36. Introduction, IO Theory, International Outsourcing, Conclusion 4. Summary and Concluding Remarks • Why contract with foreign firms rather than produce at home? • Lower costs of foreign production- lower wages • Greater physical distance reduces the variety of goods that are outsourced abroad rather than at home (Feenstra and Spencer, 2006). • Industries with a low capital intensity of production outsource to countries where capital is scarce (Antràs, 2003) • Reduced costs of international transactions • Lower costs of international search and matching (Grossman & Helpman, 2005) • Thicker markets due to the combining of economies with the formation of free trade areas(McLaren, 2000) • Improvements in communications (internet)

37. Why contract with foreign firms rather than produce through FDI Introduction, IO Theory,International Outsourcing, Conclusion • High fixed costs of FDI • Shifting of costs to component suppliers (Grossman & Helpman, 2004) • Nature of differences across firms • Moderate productivity level (Antràs & Helpman, 2004) • Very high or very low productivity (Grossman & Helpman, 2004) • Relatively low productivity of investment(Feenstra and Spencer) • Low capital intensity of production (Antràs, 2003) • Greater geographic distance (Feensta & Spencer)

38. Future Directions Introduction, IO Theory, International Outsourcing, Conclusion • More partial equilibrium modeling so as to focus on the effects of policy on organizational form • Explore the strategic motives that affect outsourcing by large oligopolistic firms • Empirical research: • distinguish between role of thicker markets and better institutions for the enforcement of contracts • on the factors (distance, quality of institutions, worker skill) that link the variety of exports with organizational form.