MGRECON 401 Economics of International Business and Multinationals

MGRECON 401 Economics of International Business and Multinationals LECTURE 4 Multinational Investments, Outsourcing, and Ethics

4 -2 Lecture Focus What are the trends in FDI? What determines the choice between FDI, exporting, and licensing? What are the benefits of a multinational? Why is there often resistance to a multinational in a developing country?

4 -3 Multinationals and Foreign Direct Investment (FDI) MNC = a firm with significant operations in more than one country. FDI = when a firm invests directly in facilities to produce and/or market a product in a foreign country. Once a firm undertakes FDI it becomes a multinational corporation (MNC).

4 -4 Foreign Direct Investment (FDI) FDI takes two forms: Green-field investment: establishing a wholly new operation in a foreign country. M&A: acquiring or merging with an existing firm in the foreign country. Investing in foreign financial instruments (Foreign Portfolio Investment) IS NOT FDI.

4 -5 Forms of FDI Horizontal FDI = FDI in the same industry as the firm operates at home. Vertical FDI = FDI in either an industry that is backward (e. g. , provides an input) or forward (sales and distribution) of a production/sales process.

4 -6 Flow and Stock of FDI Flow: The amount of FDI undertaken over a given period of time (usually one year). Stock: Total accumulated value of foreign-owned assets at a given time.

4 -7 World exports, GDP, and FDI World GDP and FDI 1990 -2001 (index = 100 in 1990)

4 -8 Inward FDI flows by region

4 -9 Inward FDI Flows as a Percentage of Gross Fixed Capital Formation, 2000

4 -10 FDI Flows by Region

4 -11 US: FDI Inflow as a Percent of Gross Fixed Capital Formation

4 -12 US: Inward FDI Stock as a Percent GDP

4 -13 Obtaining Data on FDI United Nations Conference on Trade and Development (UNCTAD): www. unctad. org.

4 -14 Country Characteristics of FDI has grown rapidly. 2001 and 2002 saw a dramatic drop. Developed countries account for overwhelming portion of outward and inward FDI.

4 -15 Country Characteristics of FDI Two-way FDI flows are common between pairs of developed countries, even at the industry level. Most FDI is horizontal: most of output of foreign country is sold in foreign country.

4 -16 Country Characteristics of FDI Political risk and instability seems to be an important deterrent to inward FDI.

4 -17 Firm and Industry Characteristics of FDI Large differences exist across industries in the degree to which production and sales are accounted for by MNCs tend to be important in industries and firms that: Have high levels of R&D to sales, Employ large numbers of professional and technical workers as a percentage of their total workforces, Produce new and/or technically complex products, and Have high levels of product differentiation and advertising.

4 -18 Firm and Industry Characteristics of FDI MNCs tend to be firms in which the value of the firms’ intangible assets is large relative to its market value. FDI is positively related to the existence of trade barriers that differ across industries.

Characterization of MNCs in Developing Countries 4 -19 Prevalent in labor-intensive stage of production in Developing Countries MNC pay higher wages than local firms MNCs offer significant training MNC create demand for related and supported industries MNC enhances productivity in developing countries.

4 -20 Characterization of MNCs in Developing Countries Developing countries historically resisted MNCs Political uncertainly leads to high expropriation risk (Latin America, Iran, …) Thought they could go it alone; underestimated the importance of human capital and technology Developing countries now frequently offer substantial inducement to MNC Tax holiday, infrastructure, tariff protection Flow of FDI to developing countries is also consequence of lower expropriation risk (increasing recognition of importance of MNC).

4 -21 Characterization of MNCs in Developing Countries No clear evidence that MNC alter conditions of local competition Some tendency to buy out local competition But MNC tend to locate in concentrated industries Elimination of local competition may be due to a change in optimal allocation of resources. Sometimes MNC will spread out R&D, but mostly not Little evidence on technology transfer

4 -22 Alternatives to FDI Exporting and licensing are the two main alternatives to FDI. Licensing = when a domestic firm (licensor) awards a foreign firm the right to use its product, production processes, brand name or trademark. In return, the licensor receives fees and royalties.

4 -23 Export or FDI or Domestic Firm wishes to sell Y in a Foreign country. Fixed cost G to set up a plant in the Foreign country. Per unit transportation cost t to ship the good. Unit labor costs: chome and cforeign FDI if: cforeign. Y+ G < (chome + t)Y G/Y < t + chome - cforeign

4 -24 Video Clips Open for Business: How India Has Opened Its Economy to Foreign Markets Mc. Donald’s Everywhere

4 -25 License or FDI Internalization: Ownership and Control What is the optimal span of ownership of a company? When should it license to a foreign producer v. create a foreign subsidiary? When should it purchase v. produce intermediate goods? Example: Henry Ford steel mill Glass factory Rubber tree plantation in Brazil Iron mine in Minnesota Railroads and ships for transport

4 -26 Market Imperfections Relationship-specific Investment (Hold-up problem): an investment is specific to a relationship if it is of less value to parties outside the relationship. Leads to ex-post monopoly power Example: auto supply parts company. Solution: long-term contracting, reputation, or ownership. Hold-up problem leads to vertical integration. Examples without vertical integration: IKEA, Benetton, and Nike.

4 -27 Market Imperfections Downstream Incentive Problem: Double marginalization Suppose mc = mc 1 + mc 2 Optimal for combined firm to set mr = mc Firm 1 (upstream) charges p > mc 1 to downstream firm (due to monopoly power) Then Firm 2 perceives mc = p + mc 2, which will lead Firm 2 to overprice the final product. Example: Coke and Pernod-Ricard (distributor) in France.

4 -28 Market Imperfections Transfer of knowledge. Difficult to sell Creates future competitors

4 -29 Market Imperfections Loss of control and difference in incentives can create a conflict. Attitudes towards risk may differ Incentive to abuse reputation of parent company Unforseen contingencies: cost of haggling.

4 -30 Cost of Internalization Spanning Costs and core competence. Optimal risk sharing and incentives.

4 -31 Strategic Aspects of FDI Prevent competitors from achieving a first mover advantage. More costly to enter later once a competitor is established. Option of waiting is also valuable.

4 -32 Starbucks Corporate icon known the world over. Has evolved from Seattle-based coffee house to global food & retailing powerhouse. Has changed the way Americans think about coffee – no longer a 50 cent drink!

4 -33 Starbucks Sales of $3. 3 billion in 2002. Sales growing by more than 20% annually!! Stock has soared more than 2, 200% over past 10 yrs – better than Wal-Mart!!! Today, there are 6, 000 Starbucks worldwide and company is gunning for 10, 000 outlets by 2005. Howard Schultz

4 -34 Starbucks in Asia Began overseas expansion in ‘ 95 with licensing deals in Japan. Switched to JVs after it was disappointed with licensing. Invested $10 million and transferred employees from North America. Followed same strategy in Thailand Korea.

4 -35 Video Clip Starbucks: Building Relationships with Coffee Growers

4 -36 Nike § § § Describe the sense in which the monopolistic competition model captures the interaction of firms in the athletic shoe industry. How does the monopolistic competition model explain the rise in the variety of athletic shoes that we have seen over the last decade or so? Why do we not see intra-industry trade between the US and the rest of the world in the athletic shoe industry?

4 -37 Nike § How has Nike used its foreign production of shoes as a source of competitive advantage? § As Nike and other athletic shoe companies produce their shoes in other countries, why have they chosen to outsource their production instead of relying on foreign subsidiaries?

4 -38 Nike § Should the WTO allow countries to impose a tariff on imports from countries that do not abide by “fair labor practices? ”

4 -39 Video Clip Nike CEO Phil Knight