1. 1 ECONOMICS 3150M Winter 2014 Professor Lazar Office: N205J, Schulich flazar@yorku.ca 736-5068

2. 2 Lecture 20: March 26 Ch. 8

3. 3 Direct Investment and MNEs In traditional trade model, companies operate only in their home markets With MNEs, same companies operate in both home country and foreign country (home and host countries) Question: Why do MNEs exist? Question: What is their impact on trade patterns and volumes?

4. Employment in Foreign-Controlled Affiliates % of total employmentManufacturing (2007)Services (2006) France26%11% Germany166 Ireland4627 Italy107 Poland3220 Portugal138 Spain168 Sweden3321 UK3013 US115 4

5. 5 Direct Investment and MNEs Distinction between horizontal foreign investment –Geographical diversification; that is, production of same product line in at least one foreign country And vertical foreign investment –Production of intermediate product(s) as inputs(s) into home market production process (backward or upstream vertical integration) Forward or downstream vertical integration also possible with final production in foreign market

6. 6 Direct Investment and MNEs Basic assumptions: –Two countries –Per unit production costs expressed in same currency:  (A),  (B) –Per unit export marketing differential: t Difference between export and domestic marketing costs Export marketing costs include: shipping, insurance, finance (working capital), communications, sales, tariffs, NTMs –Per unit transfer costs:  Extra costs of operating across national boundaries – coordination/control problems with subsidiaries Hierarchical structure of companies and diseconomies of scale Different legal, political, cultural, social environment –Firm specific knowledge assets per unit: 

7. 7 Direct Investment and MNEs t =  =  = 0 –H-O world of domestic firms with no trade barriers t > 0 –H-O world with trade barriers t > 0,  > 0,  > 0 –World of MNEs –Importance of competitive advantage

8. 8 Direct Investment and MNEs AB Parent FirmForeign- owned sub Domestic Firm Production costs  (A)  (A)*  (B) Export marketing t(A)t(A)*t(B) Transfer costs  (A)* Firm specific  (B) Transactions costs  (B)

9. 9 Horizontal Foreign Investment Why do firms choose to enter foreign countries as producers rather than exporters –Foreign investment substitutes for exports from home country Conditions: –Subsidiary in B of parent firm in A has lower costs for serving market in B than domestic firm in B –  (A)* +  (A)* <  (B) +  (B) –Subsidiary in B has lower costs than parent in A –  (A)* +  (A)* <  (A) + t(A)

10. 10 Horizontal Foreign Investment More on firm specific advantages – competitive advantage Firm specific competitive advantage: superior knowledge re. technology (production processes, product innovation), management and organization skills, marketing; reputation  –Lower costs, differentiation advantage Superior knowledge result of past investments, luck and management skills  benefits transferable to subsidiary at low marginal cost –Foreign competitors must overcome advantage by making similar investments

11. 11 Foreign Production vs. Licensing Avoid the costs of  (A)* –Some of the knowledge asset may not be transferable, e.g. capacity to create new technology, skills associated with management, organization and marketing intimately linked to ongoing operations of MNE and its subsidiaries – source of competitive advantage cannot be separated completely for transfer to outsiders –Full economic rent may not be available via transfer because competitive advantage of entire package (including foreign production, distribution, etc.) > sum of the parts –Licensee firm may not appreciate full value of assets because of market ignorance, uncertainty, lack of complementary assets –Limited competition on foreign market for license – monopsony –Possibility of creating future competitors

12. 12 Vertical Foreign Investment Foreign investment does not replace exports; replaces foreign suppliers of inputs or distribution services  changes ownership of company that exports Comparative advantage for foreign country in production of intermediate product/input

13. 13 Vertical Foreign Investment Why do firms choose to enter foreign countries rather than outsource –Foreign investment substitutes exports from foreign company to subsidiary in host country Conditions: –Subsidiary in B of parent firm in A has lower costs for supplying parent in A than domestic firm in B –  (A)* +  (A)* +t(A)* <  (B) +  (B) + t(B) +  (B) –Subsidiary in B has lower costs than parent in A –  (A)* +  (A)* + t(A)* <  (A)

14. 14 Economic Effects of MNEs Intra-firm trade Transfer of rents – quasi-monopoly rents repatriated to home country (future imports of services of capital) –Capital export when foreign investment made; future service imports when profits transferred Subsidiary may use inefficient technology because parent familiar with limited number of technologies –Most appropriate for relative price structure for factors of production in home country – and unwilling to experiment  high production costs, inefficient use of factors of production in foreign country –Subsidiaries export capital-intensive products when relative prices of inputs suggest that exports should be labor-intensive

15. 15 Economic Effects of MNEs Head office employment (skilled labor) and decision- making –R&D, technology development  dynamic productivity gains –Spin-offs for for suppliers – proximity important  development of industrial clusters and economies of scale Technology transfer – improvements in productivity of factors of production in foreign country Increased competition – allocative efficiency Competition for investment by MNEs – tax concessions, exemptions from environmental, labor laws

16. 16 Economic Effects of MNEs Lower value of life  more dangerous work practices, more environmental damages –Reputation effects – sweatshop production Increased specialization in production Support tyrants Integration of production and world markets – exports/imports in each country –Moves closer to H-O world