Trade, FDI and Multinationals: recent developments

1. Trade, FDI and Multinationals: recent developments Lecture 4, bis • By Carlos Llano, • Based on several references: • Helpman 1984; Markusen, 1984; HMY, 2003 • Brackman, Garretsen and Maravevijk books. • Slides prepared by several authors, available in the www: Rod Falvey, Giorgio Barba N., Xiaomin Wu and Xiaopeng Yin.

2. Outline • Multinationals: • OLI paradigm; • model of vertical FDI • model of horizontal FDI • Trade vs FDI with Heterogeneous firms.

3. OLI framework The propensity of an enterprise to engage in international production-trough FDI- rests on 3 main determinants: • Ownership:the extent to which it owns (or can acquire, on more favorable terms) assets which its competitors (or potential competitors) do not possess; • Localization: how far it is profitable to exploit these assets in conjunction with the indigenous resources of foreign countries rather than those of the home country. • Internalization: whether it is convenient to sell or lease these assets to other firms, or to try to produce them (internalize-them) on your own;

4. OLI paradigm • Firms decide to invest abroad if: • they have market power given by the ownership of products or production processes (O); • they have a location advantagein locating their plant in a foreign country rather than at home (L); • They have an advantage from internalizing their foreign activities in the fully owned subsidiary, rather than carrying them out through arm’s-length agreements in the market (I).

5. Advantages over local firms (Dunning, 1973) • MNEs possess adicional advantages over indigenous firms: • an easier/cheaper access to knowledge or information; • an easier/cheaper access to factor inputs; • a better access to markets e.g. brand names; • economies of scale or vertical integration.

6. Optimizing production Critical decisions for companies: • What is the optimal (i.e. profit maximizing) way for them to organize? • Do they opt for geographical concentration or choose to disperse production across their respective markets? 3 ways of answering this questions

7. Geographical concentration or dispersion 1st. Evaluating the cost of Dispersion: Whatare the costs of the split? • Some of the firm’s assets have a “public good” character. These firm-level assets are therefore a source of firm-level increasing returns to scale, and to duplicate them would be wasteful. • Firm-level activities include headquarters staff, finance operations, R&D expenditures and brand development. Many of these assets are intangible. They include “knowledge capital” (scientific know-how, patents, management skills) as well as reputation and brand name.

8. Geographical concentration or dispersion 2nd. Duplicating just a subset of its activities (just for some portion of the production process). • Some activities are therefore duplicated and some plant-level scale economies are foregone. • The distinction between firm- and plant-level scale economiesis important: • Firm-level scale economies: firms will be large, and tend to have sales in many countries. • Plant-level scale economies: firms will not want to split production into many separate units. • MNE are more likely to apear when there are high firm-level scale economies combined with low plant-scale economies (i.e: Coca-Cola; Burger-King) .

9. Geographical concentration or dispersion Table: Average firm- and plant-level size of US manufacturing firm, 1987

10. Geographical concentration or dispersion 3td. Splitting activities by functions. • Each particular component part will be provided in a separate foreign plant. (Fragmentation -vertical division -as the value-added chain is broken) • This may lead to a cost in terms of integration (packaging and transport costs of goods, whereas they did not exist before).

11. Geographical concentration or dispersion Benefits of dispersion: • Market access and competition: • Consumers are dispersed across countries, the costs of reaching them perform as a source of dispersion. • The ability to better adapt the product to local tastes as well as respond to changes in the local markets. • Local presence may also be critical in shaping the firm’s interaction with other competitors in the market. • Moving the production facility to the local market has a strategic effect as it lowers the marginal cost of supplying the product, hence strategically changing the behavior of rival firms. • May force competitors to exit the market. • Market power considerations are a key motivation in domestic and international M&A activity.

12. Geographical concentration or dispersion Benefits of dispersion: • Factor costs: • Access to low cost locations is another major reason for the dispersion of firm’s activity; • Cost and abundance of labor; • Factor prices have to be adjusted for the quality of the factor input. FDI namely rarely goes to the lowest-wage economies, going in preference to countries that have abundant labor with basic education; • Benefits from lower factor costs depend on the variation of factor intensity in the different stages of production: • Primary factor costs are a higher share of total costs in the upstream stages of production;

13. Types of MNEs Horizontal multinationals are firms producing roughly the same product in multiple countries even though foreign plants are supplied with headquarters services; Vertical multinationals are firms producing output that is not the same as that of the home land (headquarters). Headquarters could ship designs and/or intermediate products to a foreign assembly plant,and export the final output back to the homeland.

14. Integrating firm-specific and trade theory • There are early attempts at trying to incorporate firm-specific arguments into trade theory approach: • Helpman (JPE 1984) - vertical FDI • Markusen (JIE 1984) - horizontal FDI • Some common characteristics: • joint inputs (firm level scale economies) • plant scale economies • transport costs / tariffs FDI occurs when 1 and 3 are high relative to 2

15. Vertical FDI model (Helpman, 1984) Two-sector model of trade in differentiated products Identical preferences between countries; Labor input (L) and a general purpose input (H)-firm specific input (e.g. management, distribution, product-specific R&D) Homogenous product considered to be a numeraire (P=1)

16. Vertical FDI model (Helpman, 1984) g(Wl,Wh,hx)= The minimum cost required in order to adapt hx to the desired variety Differentiated good production is more complex; Hire H and adapt it for the production of a specific variety (the input becomes a firm-specific asset); The firm’s single plant cost function is:

17. Vertical FDI model (Helpman, 1984) The model explains the simultaneous existence of intersectoral trade, intra-industry trade and intra-firm trade; Generates affiliate sales in both domestic and host countries; Explains cross-country penetration of MNEs in case of trade barriers This is evident from the fact that the establishment of a new plant for the same variety requires additional fixed costs but saves the costs associated with trade impediments and does not require the hiring of new H factors. Hence, for sufficiently high impediments, cross-country penetration is expected.

18. Horizontal FDI model (Markusen and Venables, 1998) • Two countries, two products (X and Y-numeraire), two factors of production (labor-L and resources-R) • Y sector serves as a residual, providing labor, helping determine the wage rate in both sectors • Two types of firms exist: • national firms, which only produce in the base country and export to the foreign country • multinational firms, which produce in both countries

19. Horizontal FDI model (Markusen and Venables, 1998)

20. Horizontal FDI model (Markusen and Venables, 1998) When countries are similar it is optimal for only multinational firms to exist, When countries differ (edges), the optimal outcome is that only national firms exist in the cheaper country and supply the foreign markets via exports.

21. Horizontal FDI model (Markusen and Venables, 1998)

22. Theory • Markusen’s (2002) partial equlibrium single-firm model of plant location: • Two countries i and j; • Two goods X and Y; • Labor is the only factor of production; • Product Y is produced with CRS by a competitive industry in both countries; • Product X could be produced in different ways: • By a single plant in country i (type-d domestic or national firm), • By different plants in both countries: a type-h (horizontal multinational) firm, • By a single plant in country j : a type-v (vertical multinational)

23. Theory c= constant marginal production cost. G= plant specific fixed cost (measured in units of labor) F= firm specific fixed cost (measured in units of labor) Comparing the three firm types (domestic, MNEh, MNEv), their respective profits are:

24. Theory • The three profit equations offer insight into the key determinants about a firm’s optimal choice in dealing with internationalisation. • If the combined size of the two markets is fixed, profits of a type-h firm will not be affected by the distribution of demand between markets. • On the other hand, profits of a type-d firm are increasing in the share of L in the home market and vice versa for type-v firms. Either of these two will dominate type-h as the size of one country nears zero. • A type-h structure is more likely to be chosen if the countries are of similar size and/or trade costs are sufficiently high and plant-fixed costs are low enough

25. Theory • In cases when trade costs are low compared to the fixed costs of setting up foreign production facilities, either type-d or type-v firms will be prefered: • When the domestic market is relatively large compared with the foreign market type-d is prefered; • When the foreign market is relatively large compared with the foreign market type-v is prefered;

26. Summary of outcomes • Assuming high trade costs • if countries similar in size and endowments •  type h firms dominate • if countries similar in endowments but different in size •  type d firms dominate from larger country, especially when also it is a skilled-labour abundant one • if countries similar in size but different in endowments •  type vfirms dominate with HQ in skill-abundant country

27. Summary of outcomes Assuming low trade costs no type h firms as trade costs go to zero if countries are similar in endowments  type d firms dominate if countries are very different in endowments  type vfirms dominate with HQ in skill-abundant country

28. 2. Trade and FDI with heterogeneous firms

29. 1. Motivation Growing literature on: “Exceptional exporters’ performance” (Bernard and Jensen, 1999; Pavčnik, 2002; Bernard, Eaton Jensen and Kortum, 2003) Heterogeneity of firms (Montagna 2001; Melitz 2003) Exports vs. FDI with heterogenous firms (Helpman, Melitz, Yeaple, 2004; Head and Ries 2003) Recent empirical evidence for a number of countries

30. 2. Main Literature Review • Heterogeneity of firms is shown as the difference of productivities of firms. Their difference determines largely whether a firm can entry/stay in a market, and whether it can be an exporter (Melitz, 2003; Bernard, Eaton, Jensen& Kortum, 2005). • Not every firm can export. The size and level of productivity of a firm will affect/determine the behavior of exporting for a firm (Helpman, Melitz and Yeaple; 2004）

31. 2. Main Literature Review (brief) • Among factors: entry cost and heterogeneity(Bernard & Jensen, 2001), or fixed cost of exporting and heterogeneity (Helpman, Melitz & Yeaple; 2004). • From (Melitz , 2003; Helpman, Melitz & Yeaple; 2004): • lowest productivity firm will quit from the market, • the high one will stay; • the higher one will export to the foreign market, • the highest one will do FDI , rather than exporting.

32. Theoretical framework domestic firms Π = (p-c)qh – F exporting firms Π = (p-c)qh + (p-c-t)qf – F – E multinational firms Π = (p-c)qh + (p-c)qf – 2F – E dom exp mul mul

33. Probability Purely domestic firms Exiters Exporters Firm level Productivity Contract Leave Expand Domestic threshold open Export threshold Domestic threshold autarky Probability of internationalization v productivity level of firms

34. Empirical evidence • Confirming the self-selection hypothesis… • Bernard & Wagner (1996)-Germany (1978-1992); • Clerides et al. (1998)-Colombia, Mexico, Morocco (1986-1990); • Bernard & Jensen (1999)-USA (1984-1992); • Castellani (2002)-Italy (1989-1994); • Delgado (2002)-Spain (1991-1996); • Baldwin & Gu (2003)-Canada (1974-1996); • Girma et al. (2004)-Ireland (2000); • Kimura & Kiyota (2004)-Japan (1994-2000); • Damijan et al. (2004)-Slovenia (1994-2002); • Alvarez & Lopez (2005)-Chile(1990-1996); • Girma et al. (2005)-Great Britain (1988-1999);

35. Empirical evidence • … and lacking evidence of learning-by-exporting • Bernard & Wagner (1997); • Clerides et al. (1998); • Isgut (2001)-Colombia (1981-1991); • Wagner (2002)-Germany (1978-1989); • Farinas et al. (2003)-Spain (1990-1999); • Greenaway et al. (2003)-UK (1989-2002); • Damijan et al. (2004)-Slovenia(1994-2002); • Greenaway et al. (2005)-Sweden (1980-1997); • Baldwin & Gu (2003); • Blalock & Gertler (2004)-Indonesia (1990-1996); • Kimura & Kiyota (2004)…