International Trade: Multinationals and offshoring Michael Wycherley [email protected] http://sites.google.com/site/wycherlm/ec4100

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Michael Wycherley TCD

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Outsourcing versus Offshoring

Location of production process

Ownership of production process

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Home

Foreign

In-house

Integration

Multinational

Outsource

Domestic outsourcing

Foreign outsourcing

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a. Development of world GDP, FDI, and trade (constant 2000 $; index, 1970 = 100; logarithmic scale) 10,000

FDI

1,000

Trade GDP 100

10 1970 EC 4100

1975

1980

1985

1990

Michael Wycherley TCD

1995

2000

2005 3

a. sales (% GDP)

b. gross product (% GDP)

50

12

40

10 8

30

6

20

4

10

2

0

0

1982

1990

2004

1982

1990

2004

Figure 15.2 Growing importance of multinationals: shares of foreign affiliates. (% of world GDP)

c. assets (% GDP)

d. exports (% GDP)

100

10

80

8

60

6

40

4

20

2

0

0 1982 EC 4100

1990

2004

1982 Michael Wycherley TCD

1990

2004 4

Direction of FDI flows a. FDI inflows, $ bn 450

2002 2003

b. FDI outflows, $ bn

2003

450

2004

2004

400

400

350

350

300

300

250

250

200

200

150

150

100

100

50

50

0

0

European North Union America EC 4100

China

Africa

Latin S-E Eur & America CIS

2002

European North Union America

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China

Africa

Latin S-E Eur & America CIS

5

FDI inflows by region, 1990-2009 (%, 5-year moving average) 100

CIS Southeast Asia

other developing

East Asia

80

Latin

60

America

other

Africa

developed

USA 40

20 EU27 0 1990

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1993

1996

1999

2002

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2005

2008 6

Structure of FDI Foreign Direct Investment 22%

78%

Greenfield investments

Mergers and Acquisitions (M&As) 3%

97%

Mergers

Acquisitions 65%

16% 15%

full acquisition EC 4100

Michael Wycherley TCD

more than 50% acquisition

10-49% acquisition 7

World cross-border Mergers and Acquisitions, by type (% of total, measured in value) 100 80 60 40 20 0 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 horizontal

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vertical

conglomerate

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Features of multinationals Markusen, J.R., 1998. Multinational Firms, Location and Trade. The World Economy, 21(6), pp.733-756.

Multinationals generally: 1. Are associated with high ratios of R&D to sales 2. Employ more skilled workforces 3. Have a high value of intangible assets 4. Are associated with new/technically complex products 5. Associated with product differentiation variables (eg advertising) 6. Are older 7. Do not benefit from plant-level scale economies 8. Tend to be above a threshold size but other than that size doesn’t matter EC 4100

Michael Wycherley TCD

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Headquarter location

Multinationals Markusen & Venables(1998)

Conditions to be satisfied for a firm to become a multinational (Dunning 1977,1981) 1. Ownership advantages

Headquarters in Austria

Headquarters in Bolivia

Firm level fixed costs FwA

Firm level fixed costs FwB

+ Plant level fixed costs GwA

+ Plant level fixed costs GwB

Multi-plant production?

Multi-plant production?

2. Location advantages no

Plant level fixed costs GwB

3. Internalization advantages

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yes

yes

no

Plant level fixed costs GwA

nA; national firm, headquarters in Austria

mA; multinational mB; multinational firm, headquarters firm, headquarters in Bolivia in Austria

MC in A = cwA

MC in A = cwA

MC in A = cwA

MC in A = (c+t)wB

MC inWycherley B = (c+t)wTCD Michael A MC in B = cwB

MC in B = cwB

MC in B = cwB10

nB; national firm, headquarters in Bolivia

Endowment distributions OB

capital

Austria capital abundant Bolivia labor abundant

Austria large Bolivia small

C

Austria small Bolivia large

Austria labor abundant Bolivia capital abundant

OA EC 4100

labor Michael Wycherley TCD

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Multinational firms and the new trade theory Markusen, J., 1998. Journal of International Economics, 46(2), pp.183-203.

a. Base scenario

OB

.95 .90 .85

National firms only

.80 .75

Endowment of capital

.70

Mixed regimes

.65 .60

Multinational firms only

.55 .50 .45 .40 .35 .30 .25 .20 .15 .10 .05

OA .05 .10 .15 .20 .25 .30 .35 .40 .45 .50 .55 .60 .65 .70 .75 .80 .85 .90 .95 Endowment of labor EC 4100

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Proximity-concentration trade off (update of Brainard 1997, from Handbook of International Economics, Vol 4, chapter 2, 2014) • Dep. variable is exports by the US in industry j to country i divided by the sum of these exports and sales by US affiliates in industry j located in country i. • Freight and tariff costs are country-industry specific • PlanSc and Corp are measures of economies of scale • GDP is difference in GDP between US and j EC 4100

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Firm Heterogeneity • Can extend the Melitz model to look at FDI, • Add a plant level fixed cost and variable transport costs • An active firm can then •

• • EC 4100

Produce for the domestic market Produce at home for home and abroad Produce abroad Michael Wycherley TCD

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Does Foreign Direct Investment Increase the Productivity of Domestic Firms? Javorcik, Beata Smarzynska. 2004. American Economic Review 94 (3): 605–27.

Suggests 1. Foreign owned firms are more productive (but, interestingly, full foreign ownership doesn’t produce spillovers) 2. FDI increases productivity in competitors (but not robust to relaxing assumptions) 3. FDI increases productivity of suppliers to the multinationals 4. FDI doesn’t affect productivity of customers of the multinationals EC 4100

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Quantifying Productivity Gains from Foreign Investment Fons-Rosen et al. 2013. National Bureau of Economic Research.

• Similar results to Javorcik • Except can divide into Country type • Developing countries see –ve spillovers from FDI amongst competitors and customers of foreign firms • Effect on aggregate productivity small. With doubling foreign ownership, productivity in developed countries goes up by 0.01% and down in developed countries by 0.004% EC 4100

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APPLICATION

Service Exports

Trade Surplus in Business Services This figure shows the combined trade surplus in computer and information services, other business services, and financial services for the United States, the United Kingdom, and India from 1980 to 2008.

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APPLICATION Change in Relative Wages in the United States Relative Wage of Nonproduction Workers

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APPLICATION Change in Relative Wages in the United States Relative Employment of Nonproduction Workers

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APPLICATION Change in Relative Wages in the United States Relative Employment of Nonproduction Workers

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1 A Model of Offshoring

Value Chain of Activities

The Value Chain of a Product Any product has many different activities involved in its manufacture. Panel (a) lists some of these activities for a given product in the order in which they occur. The value chain in (b) lists these same activities in order of the amount of skilled labour used in each. In panel (b), the assembly activity, on the left, uses the least skilled labour, and R&D, on the right, uses the most skilled labour. Because we assume that the relative wage of skilled labour is higher at Home and that trade and capital costs are uniform across activities, there is a point on the value chain, shown by line A, below which all activities are offshored to Foreign and above which all activities are performed at Home. EC 4100

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1 A Model of Offshoring

Value Chain of Activities Relative Wage of Skilled Workers •Our first assumption is that Foreign wages are less than those at Home, so • W *L < WL and W *H < WH. • Also, that the relative wage of low-skilled labour is lower in Foreign than at Home, so • W *L/W *H < WL/WH. •Although labour costs are lower in Foreign, the firm must also take into account extra costs of doing business there. •We assume that these extra costs apply uniformly across all the activities in the value chain—a somewhat unrealistic assumption. EC 4100

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1 A Model of Offshoring Relative Demand and Supply for Skilled Labour

Relative Demand and Supply for Skilled/Unskilled Labour In panel (a), we show the relative demand In panel (b), we show the relative demand and supply for skilled labour at Home, H/L, and supply for skilled labour in Foreign, depending on the relative wage, WH/WL. H*/L*, depending on the relative wage, W*H/W*L. The equilibrium relative wage at Home is determined at A. The Foreign equilibrium is at point A*. EC 4100

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1 A Model of Offshoring

Changing the Costs of Trade Change in Home Labour Demand and Relative Wage

Offshoring on the Value Chain As the costs of capital or trade fall in the Foreign country, a Home firm will find it profitable to offshore more activities. Offshoring shifts the dividing line between Home and Foreign production from A to B. The activities between A and B, which formerly were done at Home, are now done in Foreign. Notice that these activities are more skill-intensive than the activities formerly done in Foreign (to the left of A) but less skill-intensive than the activities now done at Home (to the right of B). EC 4100

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1 A Model of Offshoring Change in Foreign Labour Demand and Relative Wage Change in the Relative Demand for High-skilled/Low-skilled Labour With greater offshoring from Home to Foreign, some of the activities requiring less skill that were formerly done at Home are now done abroad. It follows that the relative demand for skilled labour at Home increases, and the relative wage rises from point A to point B.

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1 A Model of Offshoring Change in Foreign Labour Demand and Relative Wage Change in the Relative Demand for High-skilled/Low-skilled Labour (continued) The relative demand for skilled labour in Foreign also increases because the activities shifted to Foreign are more skill intensive than those formerly done there. It follows that the relative wage for skilled labour in Foreign also rises, from point A* to point B*.

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APPLICATION Change in Relative Wages in the United States Relative Wage of Nonproduction Workers

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APPLICATION Change in Relative Wages in Mexico

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APPLICATION Change in Relative Wages in the United States Explanations Increase in the Relative Wage of Nonproduction Labour in U.S. Manufacturing, 1979– 1990 This table shows the estimated effects of offshoring and the use of hightechnology equipment on the wages earned by nonproduction (or skilled) workers. Part A focuses on how these two variables affect the share of wage payments going to nonproduction workers. Part B shows how these two variables affect the relative wage of nonproduction workers.

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2 The Gains from Offshoring Simplified Offshoring Model FIGURE 7-9

No-Trade Equilibrium for the Home Firm The line tangent to the isoquant through point A measures the value that the firm puts on components relative to R&D, or their relative price, (PC/PR)A. Amount Y1 of the final good cannot be produced in the absence of offshoring because it lies outside the PPF for the firm.

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2 The Gains from Offshoring Fall in the Price of Components FIGURE 7-11

Fall in the Price of Components If the relative price of components falls from (PC/PR)W1 to (PC/PR)W2, then the Home firm will do even more R&D and less components production, at point B rather than B. The increase in the terms of trade allows the Home firm to produce output Y2 at point C, and the gains from trade are higher than in the initial offshoring equilibrium (points B and C). EC 4100

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2 The Gains from Offshoring Fall in the Price of R&D A Fall in the Price of R&D A fall in the relative price of R&D makes the world price line steeper (PC/PR)W3. As a result, the Home firm reduces its R&D activities and increases its components activities, moving from B to B along the PPF.

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2 The Gains from Offshoring Fall in the Price of R&D A Fall in the Price of R&D (continued) At the new world relative price, the Home firm faces a terms-of-trade loss and can no longer export each unit of R&D for as many components as it could in the initial offshoring equilibrium. The final good output is reduced from Y1 to Y3 at point C. Notice that the final good output Y3 is still higher than output without trade, Y0.

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2 The Gains from Offshoring Fall in the Price of R&D A Fall in the Price of R&D (continued) After the fall in the relative price of R&D, there are still gains from trade relative to no-trade (point A) but losses relative to the initial offshoring equilibrium (points B and C).

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