Trade in Tasks and the Organization of Firms

1. Trade in Tasks and the Organization of Firms Dalia Marin, Jan Schymik, Alexander Tarasov University ofMunich CESifo Global Economy Conference Munich May 2014

2. The Changing Nature of Organizations and International Trade • Shifting international boundariesofthe firm trade in tasksoroffshoring(Hummels et al 2001, Marin 2006) • Rise in CEO Pay in industrialized countries • Move todecentralizedmanagement in corporations (Rajan and Wulf (2006), Marin (2008), Marin andVerdier (2010), Bloom, Sadun, van Reenen(2010)

3. Question What is the connection between trade in tasks, decentralized management and the rise in CEO pay?

4. Literature on Trade and Organizations • Marin andVerdier (MV) (2008, 2010), Caliendoand Rossi-Hansberg (2012): North-North-trade in final goodsleadstomoredecentralizedmanagement • Marin andVerdier(2012): North-South trade in final goodsleadsto a ‚war fortalent‘ andtotheemergenceofthetalent firm • Grossman and Rossi-Hansberg (GRH) (2008): Trade in tasks (offshoring) mayleadto a rise in wages in rich countries

5. Contribution of this paper We incorporate trade in tasks of GRH (2008) into a small open economy version of the theory of firm organization of MV (2012) to examine how offshoring affects decentralized management and CEO pay in firms

6. By doing so… we show that offshoring of production tasks • leads to decentralized management in firms in an open economy • leads to improved competitiveness in Northern firms as the productivity gains from offshoring translate into gains in market shares

7. By doing so … we show that offshoring of managerial tasks • relaxes the constraint on managers (the labor market effect) lowering CEO wages • but toughens competition (the war for talent effect) increasing CEO wages. • leads to an unambiguous rise in CEO wages in sufficiently open economies

8. Firm Survey of Offshoring Firms We conducted a firms survey among of 660 multinational firms in Austria and Germany with 2200 affiliates in Eastern Europe during 1990 – 2001. 80 percent of German investments in EE 100 percent of Austrian investments in EE

9. The Model

10. A Small Open Economy Two sectors: X-sector, differentiated goods, monopolistic competition Y-sector, homogenous goods, perfect competition Two factors of production: human capital (skilled managers) labor (production workers) In the X-sector firms choose a firm organization

11. Three Firm Organizations P-Organization: P has formal authority in the firm P runs the firm with A’s cooperation A-Organization: P delegates formal authority to A A runs the firm with P’s cooperation O-Organization: P runs the firm without A’s cooperation

12. Firm Organization We consider a firm with a simple hierarchy CEO (P) hires a skilled manager (A) to run the firm and workers to produce, P and A look for projects for the firm There is a conflict of interest between P and A Payoffs of P and A depend on who’s project is implemented

13. Trade-Off between Control and Initiative P supervises the more the larger are her stakes (the larger are profits) A has more initiative the lower P’s probability of intervention Cost of hierarchies: loss of initiative

14. The Choice of Decentralized Management From Marin and Verdier (2012) we get Firms will choose decentralized management (A-organization) at an intermediate level of profits At low and high profits there is no trade-off between control and initiative, hence, firms choose control (centralized management)

15. Next step: Endogenizeprofits: small open economywith monopolisticcompetition

16. Product Market and Trade Environment Consumer preferencesoverthetwogoods X and Y are with Ω, Ωmsetofdomesticandforeignvarieties

17. Product Market and Trade Environment In a small open economy (SOE): thenumberandprices offoreignvarietiesaregiven, foreigndemandfor domesticvarietiesisexogenous Prices in the SMO are n*numberofforeignvarieties, pmpriceofimportedvariety n*(pm)1-σ = IMlevelofimportpenetration, exogenous

18. OffshoringofProductionTasks Productionissector X involves a continuumoftasksofmeasure 1. Performingeachtaskrequiresc(i)unitsoflabor. Itis profitable to offshore taskj, j(0,1)if , t(j)costofoffshoring Marginal costsofthe firm: withtheproductivitygainsfromoffshoring ZX withIXthenumberoftasksoffshored. IX = 0 ZX = 1 Profits of a firm i cB B

19. Factor Markets Factordemanddepends on theequilibriumorganizationP,A,Oand on theorganizational mix offirms. k=Pforlowprofits k=Afor intermediate profits k=Ofor high profits

20. Equilibrium

21. Intuition Upward sloping HH curve: B/w increases, excess demand for managers, q/w has to rise q/w increases, few firms are looking for a manager, excess supply of managers, number of firms n has to rise which happens when B/w increases Upward sloping EE curve (war for talent curve): As B/w rises, firm entry, number of firms is fixed by H, competition for managers, q/w rises

22. How are changes in openness affecting the equilibrium?

23. Figure 2 An increase in openness

24. How are changes in offshoring of productiontasks affecting the level of decentralized management?

25. Offshoring of Production Tasks

26. Intuition Two opposing effects: Zx  wc(i)/Zx profits rise  (productivity effect) Other domestic firms become more productive as well, revenues  and profits  (revenue effect) In an open economy the productivity effect dominates the revenue effect and B/w rises

27. Effect on Organization When profits rise, P starts to monitor more potentially destroying A’s initiative, When profits rise sufficiently, the trade-off between control and initiative favors initiative, P delegates authority to the skilled manager, decentralized management

28. Empirics

29. Measuring Decentralized Management ‘Who decides in your company over the following decisions…..? Please rank between 1 … 5’ 1 taken at headquarters (CEO) 5 taken by the divisional manager

30. Level of Decentralization of Corporate Decisions

31. Measuring Offshoring of Production Tasks intra-firm imports from all subsidiaries in percent of parent sales instrument for offshoring of production tasks: ‘standardized foreign input’

32. Prediction Prediction 1: In a cross section of firms in an economy open to trade, multinational firms will have more decentralized management, when they are offshoring more production tasks to low wage countries.

34. Economic Magnitude Offshoring firms are 33.4 percent more decentralized than non-offshoring firms when we instrument offshoring with ‘standardized foreign input’.

35. Offshoring of Managerial Tasks Managers perform a continuum of tasks of measure 1 requiring one unit of managerial labor. Foreign managers do not receive authority in the firm. Fraction of managerial tasks offshored is exogenous and given by IS. Itis profitable to offshore managerialtasksif q > q* q, q*managerwages at homeandabroad q(1- IS) + q* IS costofmarketentry

36. Offshoring of Managerial Tasks Proposition 3:In the P-equilibrium, there exists a cutoff level of openness of the economy denoted by IM, such that for IM > IMp: B/w and q/w are increasing in Is; and for IM < IMp: B/w is declining in Is, while the impact of Is on q/w is ambiguous.

37. Offshoring of Managerial Tasks: IM > IMP

38. Offshoring of Managerial Tasks: IM < IMP

39. Intuition Three effects of a rise in Is: war for talent effect: Is  cost of market entry   firm entry, fix H  q/w and B/w labor market effect: Is  demand for skilled managers q/w  competition effect: more firms find a manager n  competition  B/w

40. Overall Effect on B/w depends on the level of openness IM large openness IM > IMp: positive war for talent effect dominates the competition effect, profits rise with Is small openness IM < IMp: competition effect dominates the war for talent effect, profits decline with Is

41. Overall effect on q/w depends on the level of openness: large openness IM > IMp: war for talent effect pushing up q/w dominates the labor demand effect pushing down q/w,as a result q/w  small openness IM < IMp: labor demand effect large (large shift in HH) but war for talent effect also large (steeper HH), effect on q/w 

42. Empirics

43. Measuring Offshoring of Managerial Tasks ‘How many managers of your parent company have been sent to the affiliate firm?’ offshoring of managerial tasks = 1 – managers sent in 57 percent of all direct investments at least one managers has been offshored on average 2.63 managers are offshored per investment project max 39 managers offshored

44. Measuring q/w Total compensation per board member of the firm (Kienbaum management consultancy) relative to average wage of the firm (firm survey)

45. Prediction Prediction 2: In a cross section of firms in sectors sufficiently open to trade, multinational firms will have more decentralized management when they are offshoring managerial tasks to low wage countries.

47. Economic Magnitude An increase in the sample mean of the fraction of managers offshored (1.48) reduces the level of decentralized management by 3.1 percent but increases the level of decentralized management by 4 percent in industries with a level of openness above the 25th percentile of the openness distribution.

48. Prediction Prediction 3:In a cross section of firms exposed to international trade, multinational firms will pay their CEOs lower wages when they are offshoring managerial tasks to low wage countries and they will pay their CEOs higher wages when the number of firms in the domestic market increases.

50. Economic Magnitude One additional manager offshored lowers CEO pay relative to workers by 6.9 percent (labor market effect). This implies that relative CEO compensation is lower by 13 – 18 percent due to managerial offshoring. One additional manager offshored allows one additional firm to enter which increases relative CEO pay by 2 percent (war for talent effect).