Paul Deng Feb. 15, 2011

1. The Global FirmLecture 3Methodology in Positive Economics (Part I) &OLI Framework to MNE Analysis Paul Deng Feb. 15, 2011 1

2. Big Picture

3. Big Picture

4. Friedman on Positive Economics (Part I) What is positive economics vis-a-vis normative economics? Economic theories and assumptions In part 2, we’ll discuss what is a good theory

5. Friedman on Positive Economics (Part I) What is positive economics vis-a-vis normative economics? • Positive economics • ”what is” • Independent of any particular ethical position or value judgements • Normative economics • ”what ought to be” • Often with value judgement • For example: majority of Karl Marx’s theories; fairness; policy discussions on inequality issues.

6. Friedman on Positive Economics (Part I) What is positive economics vis-a-vis normative economics? • An example of minimum wage – the goal is to raise living standards of poor people or the low skilled, or prevent them being exploited • Normative approach tends to argue the issue from morality and ethics • Positive approach will look at (and analyze) the actual effect of raising minimum wage on poor people’s living standard

7. Friedman on Positive Economics (Part I) wage Labor supply E Labor demand Q What is positive economics vis-a-vis normative economics? • An example of minimum wage • Positive approach will look at (and analyze) the actual effect of raising minimum wage on poor people’s living standard

8. Friedman on Positive Economics (Part I) wage Labor supply E Minimum wage set at a too-low level, won’t acheive policy goal  China’s case Labor demand Q What is positive economics vis-a-vis normative economics? • An example of minimum wage • Positive approach will look at (and analyze) the actual effect of raising minimum wage on poor people’s living standard

9. Friedman on Positive Economics (Part I) wage Labor supply Minimum wage set at a too-high level, creating structural unemployment  the case in most western European countries Dm Sm E Labor demand Q unemployment What is positive economics vis-a-vis normative economics? • An example of minimum wage • Positive approach will look at (and analyze) the actual effect of raising minimum wage on poor people’s living standard

10. Friedman on Positive Economics (Part I) wage Labor supply Minimum wage set at a too-high level, creating structural unemployment  the case in most western European countries Dm Sm E A perfect example of polices of ”good intentions but with bad outcomes”! Labor demand Q unemployment What is positive economics vis-a-vis normative economics? • An example of minimum wage • Positive approach will look at (and analyze) the actual effect of raising minimum wage on poor people’s living standard

11. Friedman on Positive Economics (Part I) Economic theory and its assumptions • How realistic should the assumptions be? • Do unrealistic assumptions lead to bad theories? Or do realistic assumptions necessarily lead to good theories? • How should a theory be judged ultimately? (to be discussed next time)

12. Friedman on Positive Economics (Part I) Economic theory and its assumptions • How realistic should the assumptions be? • Theory, by definition, is abstract from reality, so it cannot be completely realistic, including its assumptions. • The best theory is often the simpliest with the widest applications. So its assumptions often cannot cover every aspect of reality. • Often times, ”unrealistic” assumptions help capture human behavior as if people behave such a way. For example, • the assumption of rationality in human behavior • the assumption of profit-maximization of a firm

13. Friedman on Positive Economics (Part I) The assumption of rationality in human behavior • Rationality is one of the most questioned assumptions in economics • But most criticisms are not to the point • Indeed, psychological studies show that there can be many cases where human behave irrationally, but • in most cases, human beings behave as if they were rational • More importantly, economic theories, mostly based on rationality assumptions, have quite good prediction power in how people are going to behave. • For example, • Denmark’s paternity-leave policies and Danish birth rate • US cigarette tax and its effect on smoking

14. Friedman on Positive Economics (Part I) The assumption of firm’s profit-maximization • Businessmen in classroom often label the assumption one of the ”craziest” . In their own words: ”we never do such optimization, we never draw MR and MC, we don’t even know our own firm’s supply curve, not to mention the demand curve…” • Oh, yes – all above is true, but again they are not to the point • The assumption of profit-maximization just states that firms behave as if they knew the relevant cost and demand functions, calculated MC and MR, etc. • But more importantly, as we will discuss later, the realism of assumptions do not really matter, as long as the theory can predict what’s going to happen, with fairly good precision. • You may contrast what you observe in reality with the predictions you learned in firm theory. They are fairly close --- for example, firm’s profit margin is going to be driven down just as the theory would predict. In this case, firm behaves as if they were under perfect competition. (for more detailed discussion on this, read Friedman, p.21-22).

15. Friedman on Positive Economics (Part I) Economic theory and its assumptions • Do unrealistic assumptions lead to bad theories? Or vice versa? • The answer is NO. • Most good theories have very unrealistic assumptions • If a theory has very realistic assumptions, i.e., assumptions trying to cover every detail of reality, the theory often becomes too complex (the opposite of simplicity) to be comprehended and often without much general use. • This leads Milton Friedman to conclude the following, ”the more significant the theory, the more unrealistic the assumptions.”  sounds like a pretty crazy idea, but think about it... • In other words, a theory or a hypothesis is important ”if it explains much by little”!

16. OLI Framework in MNE Analysis Introduction A theoretical example: Ethier (1986)

17. Introduction to OLI Framework What is OLI? • Ownership • Location • Internalization A basic theoretical framework, proposed by John Dunning, to explain • the incentives for MNEs to go overseas • the organizational forms of MNEs • MNE’s location choices • decision choice between FDI and its alternatives, such as international trade, licensing and outsourcing

18. Introduction to OLI Framework Before we get into the advantages of being a MNE, let’s understand two basics: 1. FDI vs. portfolio capital investment • Portfolio investment seeks higher returns to capital • MNE is often formed to take advantage of specific business opportunities, rather than secondary benefits of interest rate differential, or investment returns 2. The disadvantages of being a MNE vs. domestic firm • Communication and transportation costs • Language and cultural differences • Adaptation costs to different regulations, government procedures,etc. • Additional risks: exchange rate, political stability, degree of property rights protection  Because of these inherent disadvantages, it’s natural to assume that MNEs must be more productive (or they must enjoy some special advantage) over their domestic counterparts.

19. Introduction to OLI Framework According to Dunning (1977, 1981), for a firm to become multinational, it must enjoy or attempts to get access to the following: • Ownership advantage --- product, design, patent, trade secret and resources --- link this to Hart’s property rights approach • Location advantage --- cheap input factors, transport cost, trade barriers • Internalization advantage --- the additional benefits from establishing a foreign subsidiary vs. joint venture, licensing, etc. Dunning’s theory so far assumed away government intervention. In the case of an interventionlist government, a less productive doemstic firm may, however, become multinational, if it gets: • Special government (or bank) financing • Various subsidies, such as R&D, preferred tax rates.  A recent example: China’s State-Owned-Enterprises (or SOEs) going abroad (see Zilibotti, 2011).

20. Ethier (1986), A theory based on OLI framework A model that explains and predicts the emergence of MNE due to internalization advantage In other words, this model aims to endogenize ”internalization” --- the ”I” in OLI framework This is a general equilibrium (or eqm) model • Manufacturing eqm in three stages of production: research, upstream production, and downstream production --- a vertical integrated firm • Labor market eqm between two countries through traded good (wheat in the paper)

21. Ethier (1986), A theory based on OLI framework The core idea of the model • The uncertainty in research outcome and the complexity of technology itself produce uncertainty in its valuation between home producer and foreign user (in downstrea operation). • This problem is further exacerbated by information asymmetry. To save transaction costs (such as large flow of information exchange and potential low-bid for technology), multinationals have every incentive to internalize the whole production process.

22. Ethier (1986), A theory based on OLI framework

23. Ethier (1986), A theory based on OLI framework

24. Ethier (1986), A theory based on OLI framework

25. Ethier (1986), A theory based on OLI framework

26. Ethier (1986), A theory based on OLI framework

27. Ethier (1986), A theory based on OLI framework

28. Ethier (1986), A theory based on OLI framework

29. Ethier (1986), A theory based on OLI framework General Equilibrium I will pass the derivation of labor market equilibrium, or LE. For details, please refer to p. 817 in Ethier’s paper. As shown in left graph, the general equilibrium point, E, lies below 1/aH. This may not be always the case, E can also lie between 1/aLand1/aH.

30. Ethier (1986), A theory based on OLI framework

31. Ethier (1986), A theory based on OLI framework  The dotted lines highlighed are the general eqm under arm’s length contract. The contract must be designed (costly to do) in a way that calls for state-invariant quality. (see discussion on p. 823).

32. Ethier (1986), A theory based on OLI framework

33. Ethier (1986), A theory based on OLI framework

34. Ethier (1986), A theory based on OLI framework This is the case where M deviates from A, when 1/aH<w<1/aL. The optimal choice is M over A. Note that in this case, w* under M is greater than w* under A. This is because under M, the internalization gives the right incentive for greater research efforts and better quality, leading to higher wages in both home and foreign countries in manufacturing sector.

35. Some Further Thoughts on Ethier (1986) Ethier’s model predicts multinational activities take place between countries where relative factor intensity (such as labor/land or labor/capital) is similar (see again on p.827). This is generally in line with what we observe --- direct investments in industries that require high skills and more knowledge capital are mostly concentrated among developed countries, which are similar in factor intensity. But because there is only one wage rate across different sectors in the model, the theory failed to capture the fact that some direct investments happen simply because there are dissimilarities in factor intensity (see Markusen-Helpman model in reference list). Lately, we even observe that investments in knowledge capital can also happen when factor intensity significantly differs ---case in example: MNE’s establishment of R&D centers in China and India, where human capital is as productive but much cheaper.

36. Potential Empirical Test on Ethier (1986) To test Ethier’s core idea on the relation between uncertainty of research outcome and incentives to internalize, one possibility is to look at whether FDI is partly driven by industry’s skill intensity. Skill intensity could be measured by share of research workers relative to total number of workers in an industry, or could be measured by share of R&D investments relative to industry’s total value-added. This test could be done both for a single country, such as the U.S. or for a group of countries, such as OECD countries.