Chapter 10: Foreign Direct Investment and Intra-Firm Trade An Introduction to International Economics: New Perspectives on the World Economy © Kenneth

Chapter 10: Foreign Direct Investment and Intra-Firm Trade

An Introduction to International Economics: New Perspectives on the World Economy

© Kenneth A. Reinert, Cambridge University Press 2012


Analytical Elements

Countries Sectors Tasks Firms


Value Chains

A value chain is a series of value-added processes involved in the production of any good or service

Consider a semiconductor value chain Research, development and design leading up to details of the

physical circuitry of the chip to be placed on the silicon Fabrication (or just fab in semiconductor jargon) in an advanced

manufacturing process in which circuitry layouts are etched onto silicon wafers containing many die

Assembly and testing in which the die are cut from wafers and mounted or packaged into a functioning device with wire contacts and insulation

Final incorporation in which the semiconductor is incorporated into the final piece of equipment such as a personal computer or mobile phone


Semiconductor Value Chain

The semiconductor value chain is shown in Figure 10.1 An additional task in this figure is that of advanced

equipment and materials crucial to the fabrication process

It is not necessary for a firm to be active across all stages of semiconductor manufacturing

The task scope of a firm in the industry is the result of a firm’s decision-making with regard to what tasks to perform along the value chain

Intel is involved in the first three stages of the value chain: research, development and design; fabrication; and assembly and testing


Figure 10.1: A Value Chain for Semiconductors


Global Production Networks

Value chains are potentially distributed across countries. When these international value chains are linked

together in potential buyer-supplier or ownership relationships, they become known as global production networks or GPNs

An example of this is given in Figure 10.2 The semiconductor production decision is two-fold,

namely the decision as to what part of the value chain to take on and in which countries to do so

There are both task and location decisions to consider


Figure 10.2: A Global Production Network for Semiconductors


Movements along GPNs

There is another way to look at the GPN decision-making process

Movements up and down the value chains of Figure 10.2, whether in the United States or Costa Rica, are vertical movements Movements up a value chain, from subsequent to previous tasks

are backward vertical movements Movements down a value chain from previous to subsequent

tasks are forward vertical movements Movements from one country to another, from the United

States to Costa Rica, for example, are horizontal movements


Firm-Specific Assets

Firms can and do take more than one approach to the semiconductor value chain or GPN

A simplified version of Intel’s semiconductor GPN is presented in Figure 10.3 The dashed lines indicate potential areas where Intel has chosen

not to operate The ability of Intel to operate where it does in its GPN

reflects its competiveness International business researchers explain

competitiveness with reference to firm-specific assets


Figure 10.3: A Global Production Network for Semiconductors


Intel’s Plant in Costa Rica (Source: Wikipedia)


Firm-Specific Assets

Firm-specific assets can be tangible Access to silicon and other advanced materials,

Firm specific assets can also be intangible Specialized knowledge, patented products or processes,

organizational abilities, or brand distinctiveness and loyalty When a firm such as Intel takes on new tasks along the

vertical dimension of a GPN, it can experience an efficiency gain by spreading the costs incurred in acquiring its firm-specific assets (both tangible and intangible) over more value chain stages

These efficiency gains are known as firm-level economies


Firm-Level Economies

The concept of firm-level economies is not, in general, sufficient to explain the integration process along GPNs

Why? Because firms always have the option (discussed in Chapter 9) of licensing its firm-specific assets to other firms

Corporate strategists suggest that a firm’s decision to internalize the firm-specific asset market reflects market failure

That is, for a number of reasons, it has difficulty in selling its firm-specific assets in a contractual arrangement This difficulty is particularly acute for intangible assets


Intra-Firm Trade

We can observe a pattern of intra-firm trade in Figure 10.3

Intel exports fabricated die from its home base to its subsidiary in Costa Rica

This is not an arm’s-length, market-based transaction that takes place at world prices

It is a trade transaction within Intel itself at a price set by it

We now have two distinctions of trade (Table 10.1) Inter-industry vs. intra-industry Inter-firm vs. intra-firm


Table 10.1: Industry and Firm Dimensions of Trade

Firm Dimension

Industry Dimension Inter-firm Intra-firm

Inter-industry Trade that takes place between two different industries and two different firms

Trade that takes place between two different industries and within a single firm

Intra-industry Type of trade that takes place within a single industry and between two different firms

Trade that takes place within a single industry and within a single firm


A Cost View of Internalization

Suppose that a home-country firm faces a fixed cost of setting up a production facility in country of FPj

Suppose also that the firm faces a smaller fixed cost of establishing a contractual relationship with a firm from country of FCj.

There are also variable costs associated with these two options of VPj and VCj

The variable costs of international contracting are larger than the variable costs of international production due to the firm-specific assets that give it an advantage over the potential contracting partner.


A Cost View of Internalization In Figure 10.4, the solid FPj+VPj graph begins at the

vertical axis intercept equal to the fixed cost of production and increases from there with a slope equal to the variable costs of production.

The solid FCj+VCj graph begins at a lower vertical axis intercept equal to the lower fixed cost of contracting and increases from there with a slope equal to the variable costs of contracting

The two solid lines intersect at a “breakeven point” that establishes a boundary between quantities where it would be better for the firm to engage in contracting and quantities where it would be better for the firm to engage in production


Figure 10.4: A Cost Analysis of Production and Contracting


The OLI Framework

We can tie together some of the considerations of this chapter into what has be come known as the OLI Framework

If the home-country MNE is indeed able to successfully engage in business in the foreign country, there must be some other advantages that offset the additional costs of conducting business internationally

These advantages are what John Dunning called ownership or O advantages

The role of the O advantage is to explain why the MNE engages in the production of a good for the foreign market instead of a foreign firm.


The OLI Framework

Location or L advantages are associated with the foreign country

The L advantages could include input costs, transportation costs, import restraints, foreign government promotional policies, or access to foreign consumers

The role of the L advantage is to explain why the home-country MNE chooses to produce in the foreign country rather than the home country


The OLI Framework

Internalization or I advantages explain why the home-country MNE chooses FDI over the contracting option

The I advantages are therefore related to all the reasons why contracting might not be a viable option

In Dunning’s view, and in the view of other researchers deploying this framework, all three advantages are necessary to explain the presence of FDI

The OLI Framework is summarized in Table 10.2


Table 10.2: The OLI Framework

Source: Dunning (1988)

Symbol Meaning Contribution

O Ownership advantage

Explains how a firm’s tangible and intangible assets help it to overcome the extra costs of doing business internationally. Explains why a home country firm, rather than a foreign firm, produces in the foreign country.

L Location advantage

Explains why a home-based MNE chooses to produce in a foreign country rather than in its home country.

I Internalization advantage

Explains why a home-based MNE chooses FDI rather than licensing to achieve production in a foreign country.


Appendix: The Gravity Model

Gravity models utilize the gravitational force concept as an analogy to explain the volume of trade or FDI among the countries of the world

For example, gravity models establish a baseline for trade or FDI flows as determined by gross domestic product (GDP), population and distance

The effect of policies on trade or FDI flows can then be assessed by adding the policy variables to the equation and estimating deviations from the baseline flows


Appendix: The Gravity Model

Gravity models are estimated in terms of natural logarithms, denoted “ln”

Gravity models explain trade flows or FDI flows from county i to country j (Fij) in terms of GDP and distance

A simple gravity model is given by lnFij = + 1lnGDPi + 2lnGDPj + 3lnDij

In this model, 1 and 2 are expected to be positive and 3 is expected to be negative

Documents

Chapter 10: Foreign Direct Investment and Intra-Firm Trade An Introduction to International Economics: New Perspectives on the World Economy © Kenneth