Vertical FDI, outsourcing and contracts Lessons 5 and 6

1. Vertical FDI, outsourcing and contractsLessons 5 and 6 Giorgio Barba Navaretti Gargnano, June, 11-14 2006

2. The issue • Once the decision to produce in a foreign country has been taken, how is foreign production carried out? • Wholly owned subsidiary • External contractual relationship • e.g. why McDonald’s franchises and Gap owns?

3. The broad trade off TRADE OFF: • Costs of setting up own facilities: • Fixed costs • Lack of info • Lack of knowledge of the local market • Inefficient scale • Costs of an external agreement: • Contractual failures

4. Summary of the costs of external transactions

5. Types of contractual failures: hold-up • Type of action: Carrying out one stage of production • Conditions: • Incomplete contracts: not all contingencies taken into account • Product specificity: products with specific characteristics produced on commission for principal • Problem: • High risk of re-negotiation • Supplier underinvests • Solution: • Share rents with local agent • internalise

6. Types of contractual failures: Agency • Type of action: Carrying out one stage of production • Conditions: • Incomplete information: the actions of local agents cannot be observed by the principal • Incomplete information: conditions of the local market cannot be observed by the principal • Problem: • Agent minimises effort (Moral Hazard) • Agent withholds information on the state of the market (Adverse selection) • Solution: • Share rents with local agent • internalise

7. Types of contractual failures: Dissipation of intangible assets • Type of action: Transferring knowledge or goodwill • Conditions: • Asset too difficult to transfer • Asset too easy to transfer • Limited protection of intellectual property rights • Problem: • Costly transfer of knowledge • Dissipation of assets: agent acquires knowledge and starts production on his own • Solution: • Share rents with local agent • internalise

8. General setting • Production involves two activities, x and y • Revenue is given by R(x,y) and it is an increasing and concave function of x and y • The MNE (M) has an advantage in x (e.g R&D, components etc.): • Unit cost if undertaken by the MNE: c • Unit cost if undertaken by another firm: gc with g>1 • The local firm (L) has an advantage in y: • Unit cost if undertaken by L: a • Unit cost if undertaken by M: aa with a>1

9. Efficient allocation of resources • No contractual problem: M carries out x and outsources y to L • Centralised problem: Choose x and y so as to maximize joint profits: . , . F.O.C.: Decentralised problem: M sells x to L at price q: Efficient allocation of resources if M and L price takers and q=c

10. Hold up: setting • Investments are relation specific: • x and y can be sold outside the relationship at: • Contracts are not complete: • =>incentive to engage in opportunistic behaviour

11. Hold up Internalised solution: wholly owned subsidiary Max: FOC: , . External solution: outsourcing Profits of M: FOC of M: Profits of L: FOC of L:

12. Hold up special case with the optimised value of revenue is: If production is internalised input costs are: and profits: If production is outsourced input costs are: and profits:

13. Hold up special case Parameter values:  = 0.5, a = c = 1, ra = rc = 0.5, α = 2 and  = 0.8

14. Hold up and industry equilibrium in outsourcing • What happens when we move away from bilateral relations? • What determines the number of firms in equilibrium (multinationals and local contractors)? • Why in reality we do observe both outsourcers and internalizers? • What determines the number of ‘outsourcers’ vs. the number of ‘internalizers’ (multinational are heterogeneous)? • How does the hold-up enter into this picture? • Grossman and Helpman (2002, 2003), Antras (2004) and Antras and Helpman (2004)

15. Trade off • Benefits from outsourcing • reduces marginal costs and creates competitive pressure on non outsourcers (and reduces margins from further outsourcing) • Costs of outsourcers: • matching between outsourcers and local firms • Hold up

16. Market for multinational products • Dixit Stiglitz model of monopolistic competition: • n firms and varieties, • s>1 is the elasticity of substitution between varieties • Pk and Rk respectively price and revenues earned by kth variety • G is the price index and E total expenditure:

17. Profits of the MNE under outsourcing and internalization • MNEs can internalize (I) or outsource (O). • r is the share of MNEs that outsource • Prices have a constant mark up (s-1)/s and profits are a constant fraction of revenues • => PI=(RI/s) and Po=(Ro/s) • Profits in the two regimes are given by:

18. Matching of multinationals and local component manufacturers

19. Features of matching • Modification costs incurred by component manufacturers (m) at a distance z away from their location: mz • Each component manufatcurers can serve 2nz0 multinationals where z0 is the maximum profitable distance they can cater to • Proportion of multinationals that outsource: r = 2mz0

20. Determining z0, m and n Define maximum distance that can be catered by component manufacturers without incurring losses: Define number of component manufatcurers m: Define number of multinationals n

21. Describing the equilibrium

22. Zero profits lines for component producers Zero profits line for manufacturers

23. Summing up • It is possible that only a fraction of the multinationals will outsource • This fraction will depend on exogenous parameters like fixed entry costs Fm and Fn and the modification cost m