MGRECON401

Economics of International Business and Multinationals

LECTURE 4 Multinational Investments,

Outsourcing, and Ethics

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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?

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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).

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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.

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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.

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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.

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World exports, GDP, and FDI

World GDP and FDI 1990-2001 (index = 100 in 1990)

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Inward FDI flows by region

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

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FDI Flows by Region

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US: FDI Inflow as a Percent ofGross Fixed Capital Formation

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US: Inward FDI Stock as a Percent GDP

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Obtaining Data on FDI

United Nations Conference on Trade and Development (UNCTAD):

www.unctad.org.

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Country Characteristics of FDI

FDI has grown rapidly. 2001 and 2002 saw a dramatic drop.

Developed countries account for overwhelming portion of outward and inward FDI.

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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.

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Country Characteristics of FDI

Political risk and instability seems to be an important deterrent to inward FDI.

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Firm and Industry Characteristics of FDI

Large differences exist across industries in the degree to which production and sales are accounted for by MNCs.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, andHave high levels of product differentiation and advertising.

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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.

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Characterization of MNCs in Developing Countries

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.

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Characterization of MNCs in Developing CountriesDeveloping 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).

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Characterization of MNCs in Developing CountriesNo clear evidence that MNC alter conditions of local competition

Some tendency to buy out local competitionBut MNC tend to locate in concentrated industriesElimination 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

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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.

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Export or FDI

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:cforeignY+ G < (chome + t)Y

orG/Y < t + chome - cforeign

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Video Clips

Open for Business: How India Has Opened Its Economy to Foreign Markets

McDonald’s Everywhere

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License or FDIInternalization: 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 Fordsteel millGlass factoryRubber tree plantation in BrazilIron mine in MinnesotaRailroads and ships for transport

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Market ImperfectionsRelationship-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.

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Market ImperfectionsDownstream Incentive Problem:

Double marginalizationSuppose mc = mc1 + mc2

Optimal for combined firm to set mr = mcFirm 1 (upstream) charges p > mc1 to downstream firm (due to monopoly power)Then Firm 2 perceives mc = p + mc2, which will lead Firm 2 to overprice the final product.

Example: Coke and Pernod-Ricard (distributor) in France.

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Market Imperfections

Transfer of knowledge.Difficult to sellCreates future competitors

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Market Imperfections

Loss of control and difference in incentives can create a conflict.

Attitudes towards risk may differIncentive to abuse reputation of parent company

Unforseen contingencies: cost of haggling.

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Cost of Internalization

Spanning Costs and core competence.

Optimal risk sharing and incentives.

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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.

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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!

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StarbucksSales 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

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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 and Korea.

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Video Clip

Starbucks: Building Relationships with Coffee Growers

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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?

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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?

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Nike

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

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Video Clip

Nike CEO Phil Knight