Vertical FDI, outsourcing and contracts Lessons 5 and 6 Giorgio Barba Navaretti Gargnano, June, 11-14 2006.

Vertical FDI, outsourcing and contracts

Lessons 5 and 6

Giorgio Barba Navaretti

Gargnano, June, 11-14 2006

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

Table 2.5. The costs of external (market) transactions Type of Transaction Type of FDI Problem Consequence

Transferring intangible assets

Horizontal Vertical

Imperfect appropriability of knowledge

Imperfect appropriability of reputation

Dissipation of proprietary knowledge

Dissipation of goodwill

Carrying out one stage of production

Vertical Hold up with incomplete contracts

Agency with incomplete information

Underinvestment Inefficient scale of

production/sales

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

cxayyxR ),( .

,),( cyxRx ayxRy ),(

, .

xcqM )( qxayyxRL ),(

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:

arandcr ac

•Contracts are not complete:

=>incentive to engage in opportunistic behaviour

Hold up

,

cxyayxRI ,

,),( cyxRx

.

cxxryrxryxR cacO ]),([

cx rcyxR )1(),( ayyryrxryxR aac

L ),()1(

ay rayxR ),()1(

Internalised solution: wholly owned subsidiary

Max:

FOC:

External solution: outsourcing

Profits of M:

FOC of M:

Profits of L:

FOC of L:

ayxRy ),(

Hold up special case

)1( yxy) R(x, 1with

,][),(* )1/(1 yxyx wwAwwR

the optimised value of revenue is:

cwx awy If production is internalised input costs are:

*)1(* RywxwR yxI and profits:

If production is outsourced input costs are: /])1([ cx rcw )1/(][ ay raw

and profits: *,]/)1(1[]*[ RwryrxwR yaaxO

*)1](/)1(1[]*)[1( RwrxrywR xccyL

Hold up special case

O

I

O+ L

L

Bargaining share,

Figure 5.1: Internalisation vs outsourcing

Z Z

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

EGp = R - k - k 11 ,

p = G k -

k

- / 1 11

•Dixit Stiglitz model of monopolistic competition:

•n firms and varieties,

is the elasticity of substitution between varieties

•Pk and Rk 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

])1([ 1 n

E O , 1OI . (5.14)

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=(RI/) and o=(Ro/)

• Profits in the two regimes are given by:

Figure 5.3: Component specification space

zO

zO

zO

Componentmanufacturers

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 2nz0 multinationals where z0 is the maximum profitable distance they can cater to

•Proportion of multinationals that outsource: = 2mz0

Features of matching

Determining z0, m and n

Oz = (1 - )O.

mOOO

zOO F znzzdz nz

O

]2/)1[(2])1[(2 2

0

. (5.16)

Define maximum distance that can be catered by component manufacturers without incurring losses:

Define number of component manufatcurers m:

nOI F )1(

Define number of multinationals n

Describing the equilibrium

])1([

)2()1(1

OO

m

zzEF

])1([)1(

1

O

n

zF

zO

Figure 5.4: Equilibrium outsourcing

Fm

Fn

1/2m

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