Vertical FDI, outsourcing and contracts Lessons 5 and 6

1
Vertical FDI, outsourcing and contractsLessons
5 and 6

• Giorgio Barba Navaretti
• Gargnano, June, 11-14 2006

2
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 McDonalds franchises and Gap owns?

3
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

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Summary of the costs of external transactions
5
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

6
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

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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

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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 RD,
  components etc.)
• Unit cost if undertaken by the MNE c
• Unit cost if undertaken by another firm gc with
  ggt1
• The local firm (L) has an advantage in y
• Unit cost if undertaken by L a
• Unit cost if undertaken by M aa with agt1

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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 qc
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Hold up setting

• Investments are relation specific
• x and y can be sold outside the relationship at

• Contracts are not complete
• gtincentive to engage in opportunistic behaviour

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Hold up
Internalised solution wholly owned subsidiary
Max
FOC
,

.
External solution outsourcing
Profits of M
FOC of M
Profits of L
FOC of L
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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
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Hold up special case
Parameter values ? 0.5, a c 1, ra rc
0.5, a 2 and ? 0.8
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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)

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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

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Market for multinational products

• Dixit Stiglitz model of monopolistic competition
• n firms and varieties,
• sgt1 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

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Profits of the MNE under outsourcing and
internalization

• MNEs can internalize (I) or outsource (O).
• r is the share of MNEs that outsource
• Prices have a constant mark up (s-1)/s and
  profits are a constant fraction of revenues
• gt PI(RI/s) and Po(Ro/s)
• Profits in the two regimes are given by

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Matching of multinationals and local component
manufacturers
 
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Features of matching

• Modification costs incurred by component
  manufacturers (m) at a distance z away from their
  location mz
• Each component manufatcurers can serve 2nz0
  multinationals where z0 is the maximum profitable
  distance they can cater to
• Proportion of multinationals that outsource r
  2mz0

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Determining z0, 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
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Describing the equilibrium
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Zero profits lines for component producers
Zero profits line for manufacturers
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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 m