Industrial Agglomeration, Business Globalization and Productivity: An Empirical Study on Taiwanese Firms

1. Industrial Agglomeration, Business Globalization and Productivity: An Empirical Study on Taiwanese Firms Yih-Luan Chyi, Yi Lee, Eric S. Lin, Shih-Ying Wu Department of Economics National Tsing Hua University November, 2009

2. Seminar_Chung Cheng Univ Outline • Introduction • Literature Review • Theoretical Model • Empirical Specification & Results • Conclusion

3. Seminar_Chung Cheng Univ Approved Taiwanese Outward FDI (1990-2006)

4. Seminar_Chung Cheng Univ Kernel Distribution of TFP, by Year

5. Seminar_Chung Cheng Univ Motivation • Stylized Fact: the starting period of FDI outflows to China outpacing those to other destinations coincided with a rightward shift of the entire productivity distribution of Taiwanese firms, 2001~2006 • Supporting literature of outward FDI boosting multinationals performance; for example, firms tend to perform FDI for the benefit of cross-country knowledge spillovers (among others, Branstetter, 2006) • Apart from them, many empirical studies confirm connection between agglomeration and productivity. • Does FDI in China improve firm productivity or any other factor contribute to it?

6. Seminar_Chung Cheng Univ Research Goal • Marshallian externalities • localized industry-level knowledge spillovers Taiwanese high-tech clusters with knowledge spillovers for firms in close geographical and technological proximity. • labor pooling Number of employees in HSP had increased more than ten times during 1986 to 2004. • input-output linkages Integrated Circuit Industry in Hsinchu Science Park • Research Goal: investigating agglomeration and FDI effects on productivity after controlling firm attributes

7. Seminar_Chung Cheng Univ Literature Review of agglomeration economies: Mechanisms • Originated from Alfred Marshall (1890); recent studies (Duranton and Puga, 2004) suggest: • similar firms have better chances of sharing suppliers; • thick labor markets contribute to easing firm-level shocks or matching jobs; • localized firms are more likely to benefit from technologies and innovations of others. • A shared prediction: “the concentration of firms and workers in space makes them more productive." (Duranton, Gobillon, Puga, and Roux, 2009, p. 3)

8. Seminar_Chung Cheng Univ Literature Review of agglomeration economies: Two strands of Empirical studies • Firms and workers in larger cities generally are more productive. (Henderson, 2003; Combes, Duranton, and Gobillon, 2008) • doubling city size raises productivity by 2~8% (Rosenthal and Strange, 2004; Combes, Duranton, Gobillon, and Roux, 2007) • District effect: firms located in an industrial district can benefit from agglomerative advantages, (Bagella and Becchetti, 2000; Fabiani et al., 1999) • Cainelli (2008): firm productivity growth mainly attributes to its memberships of an industrial district and product innovations. • Unanimous results on the positive effects of agglomeration on firm performance using various econometric specifications and data sets.

9. Seminar_Chung Cheng Univ Literature Review of FDI: Proximity-concentration Tradeoff • Brainard (1997) provides a mixed equilibrium where some firms undertake FDI and others export. The results support the proximity-concentration hypothesis, but no role of firm heterogeneity. • Helpman et al. (2004) add a role for productivity differences into this proximity-concentration trade-off. • Given certain assumptions on fixed costs, relative production costs and transportation costs, the most productive firms will prefer FDI over exporting. • Empirical finding: the ratio of industry exports to FDI sales is positive correlated to plant scale economies, but negative correlated to trading costs and the dispersion of productivity.

10. Seminar_Chung Cheng Univ Literature Review of FDI: Technology Sourcing • Fosfuri and Motta (1999): a technologically less advanced firm tend to undertake FDI to acquire technology from its more efficient competitor located within the same country. • Empirical supportive evidence of Technology sourcing • Pottelsberghe de la Potterie and Lichtenberg (2001): investing in R&D intensive countries improves a country's productivity by using 13 OECD countries’ data . • Branstetter (2006): a positive relationship between the number of Japanese subsidiaries in the U.S. and the extent of U.S. patent citations. • Grith et al. (2006): U.S. R&D stock had a strong impact on the total factor productivity(TFP) of U.K. firms with lead inventor in the U.S. • Yeaple and Chung (2008): country-industries with similar technical profiles are more attractive to U.S. outward FDI.

11. Seminar_Chung Cheng Univ Literature Review of FDI: Technology Transferring cost • Keller and Yeaple (2009): a theoretical model focusing on the role of technology transferring costs on firms' foreign operation. • MNEs can choose to export the intermediates to their foreign affiliates or producing them in their foreign subsidiaries. • Industries with higher technological complexity are less likely to produce abroad. • Chang and Lu (2009): how the risk of FDI failure affects the dynamics of FDI entry for Taiwanese firms; assuming the success probability of FDI as a non-monotonic function of firm productivity where more productive firms face higher risk of investment failure and loss more if failure. • the negative effect of investment failure will dominate the positive effect of a larger market share on variable profits for the most productive firms. • predicts that the least productive and the most productive firms will not choose FDI. The risk of FDI failure decreases with the number of FDI firms, and therefore the productivity range for FDI firms increases over time.

12. Seminar_Chung Cheng Univ Model-Set up • Heterogeneous firms are entailed with different productivity level, r. • Firms can acquire external knowledge (fg) from other firms in the local area. (agglomeration) • Firms engage in R&D. • Firms can offer goods to a foreign market through exporting or FDI. • If exporting, firms need to pay an iceberg transportation costs, t. • If FDI, there is an extra fixed investment costs, fl , to set up a plant in country l. • Countries differ in their factor input prices.

13. Seminar_Chung Cheng Univ Model-Set up: Factors affecting Productivity • Agglomeration economies: firms acquire external knowledge (fg) from other firms in the local area; firm located in g entailed productivity level q = r ∙fg. • Technology sourcing effect: firms gain from foreign knowledge spillovers (qg, where 0 < g < 1) through FDI. • Technology transferring cost or risk of technology diffusion in the foreign country (q-b , where 0 < b < 1). • R&D investment: firms raise their productivity by investing in research and development. • Exporting firms’ productivity levels: qx q∙rdd • FDI firms’ productivity levels: qf q[1+(gb)]∙rdd

14. Seminar_Chung Cheng Univ Model- Demand, Supply • Demand: CES Utility function; inversed demand for product i in l • Supply: • Production function:one input-labor, qi = qiLi • constant MC, • MC = wl/q , if producing in location l. • MC = wlt/q , if producing in location l and exporting to a foreign country. • Three stage decisions: • Undertaking FDI or not, • Optimal R&D level, • Deciding the production output level. • Backward induction is used.

15. Seminar_Chung Cheng Univ Model- Firm Behaviors, deciding the production output level • Optimal pricing rule for CES-induced demand function: • Firm i’s profit of selling products in location l: • Profits for exporting firms (px ) and FDI firms (pf ): (Eq. 3, pp. 12)

16. Seminar_Chung Cheng Univ Model- Firm Behaviors, optimal R&D level • Cost of R&D: C(rd) = rdhCl • Profit functions for exporting and FDI firms (Eq. 4, pp. 13) • Optimal R&D investments (Eq. 5, pp. 13) • Profit under optimal R&D level: Pl = f(Bl, wl, q, Cl)∙A (Eq. 6, pp. 14) • Pl>0 if h-d(s-1)>0 • Pl increases in market size (Bl) and q; • Pl decreases in costs (production, transport and R&D)

17. Seminar_Chung Cheng Univ Model- Firm Behaviors, FDI or export • Firms choose production locations for serving foreign market by comparing profits of NonFDI and FDI. • Curvature of FDI

18. Seminar_Chung Cheng Univ Comparing Profits for Exporting and FDI Firms: (g -b) > 0 Appendix 2: g↑or b↓ shifting PFDI leftward Appendix 1: existence and uniqueness of qN

19. Seminar_Chung Cheng Univ Comparing Profits for Exporting and FDI Firms: (g -b) < 0 q+ Appendix 1: sign of DP(q+)is undetermined Appendix 2: g↑or b↓ shifting PFDI upward

20. Seminar_Chung Cheng Univ Model Prediction • A firm’s incentive to undertake FDI depends on relative magnitude of two effects: knowledge spillovers and technology transferring costs. • Gains from knowledge spillovers are larger than losses on technology replication, then more productive firms will undertake FDI. (consistent with Helpman et al. (2004)) • The technology loss is larger than the externalities gain, only firms with intermediate productivity perform FDI. • Least productive firms cannot afford the fixed cost; • Most productive firms confront larger efficiency losses relative to less productive firms, which overcome the gains from saving on variable costs. (consistent with Chang and Lu (2009)).

21. Seminar_Chung Cheng Univ Data and Measures • Two data sources: • Firm data: TEJ, 2001, 2002 • Plant-level data: TSCMO, 2000 • Agglomeration index: Holmes indicators Hmg = jmgLj,mg (sum of all employments of industry m in location g). • Productivity measure: Tornqvist multilateral TFP • TFP index for firmiin year t is calculated as:

22. Seminar_Chung Cheng Univ Summary Statistics

23. TFPi2002= b0+b1TFPi2001+b2Clusteri+b3FDIi+b4R&Di+Zi’g+ei Seminar_Chung Cheng Univ Robust standard errors in parentheses (Bootstrap errors in parentheses of 2SLS) * significant at 10%; ** significant at 5%; *** significant at 1%

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26. Seminar_Chung Cheng Univ Conclusion • This paper examines impacts of industrial agglomeration and foreign direct investment on the total factor productivity of Taiwanese firms. • Main contributions: • “Holmes” indicator of industrial agglomeration • A theoretical model of FDI decisions to identify causal links between global knowledge sourcing and total factor productivity.

27. Seminar_Chung Cheng Univ Conclusion: Our findings • After firms' attributes are controlled, firm productivities are positively affected by local industrial agglomerations. • FDI in China by Taiwanese firms has insignificant effect on next period’s TFP. • More productive Taiwanese firms may suffer from efficiency losses, which outweigh benefits from knowledge spillovers as predicted by our theoretical model. • FDI interacting with TFP in some cases has negative and significant influences on future TFP