Vertical FDI, outsourcing and contracts Lessons 5 and 6 Giorgio Barba Navaretti Gargnano, June,

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?

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

Summary of the costs of external transactions

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

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

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

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:  c with  >1 The local firm (L) has an advantage in y: –Unit cost if undertaken by L: a –Unit cost if undertaken by M:  a with 

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

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

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

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:

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

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)

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

Market for multinational products Dixit Stiglitz model of monopolistic competition: n firms and varieties,  is the elasticity of substitution between varieties P k and R k respectively price and revenues earned by kth variety G is the price index and E total expenditure:

Profits of the MNE under outsourcing and internalization MNEs can internalize (I) or outsource (O).  is the share of MNEs that outsource Prices have a constant mark up  and profits are a constant fraction of revenues =>  I =(R I /  ) and  o =(R o /  ) Profits in the two regimes are given by:

Matching of multinationals and local component manufacturers

Modification costs incurred by component manufacturers (m) at a distance z away from their location:  z Each component manufatcurers can serve 2nz 0 multinationals where z 0 is the maximum profitable distance they can cater to Proportion of multinationals that outsource:  = 2mz 0 Features of matching

Determining z 0, 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

Describing the equilibrium

Zero profits lines for component producers Zero profits line for manufacturers

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 