1 ECONOMICS 3150C Lecture 9 December 2. 2 Vertical Foreign Investment Internalization: based on costs for using external market –More relevant for manufacturing

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ECONOMICS 3150CLecture 9

December 2

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Vertical Foreign Investment

• Internalization: based on costs for using external market– More relevant for manufacturing sector than service or resource sectors– Service sector: follow customers – proximity, transportation costs

• External market or contract costs:– Price, supply, quality uncertainties – long-term vs. recurring short-term

contracts (negotiating, monitoring, enforcement – arbitration, legal fights over breach of contract)

• Coordination costs– Cost advantages through technical improvements in coordination of

production and transfer of products between different stages of production (in different divisions of same company) as compared to coordination of independent producers through price system

– Technological improvements in communications, transportation reduce coordination costs over time

– Foreign direct investment more attractive over time

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Vertical Foreign Investment

• Conditions:– Subsidiary in B of parent firm in A has lower costs for

serving market in A than parent firm in A (A)* + (A)* + t(A)* < (A)

– Subsidiary in B has lower costs than foreign competitor in B in serving market in A

(A)* + (A)* + t(A)* < (B) + (B) + t(B)

– t(A)* does not have to equal t(B) : incremental per unit cost of using external market

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Existence of Firms

• New ways of organizing corporation and principal activities – virtual companies

– Outsourcing vs. vertical integration– Internal transfer pricing – use of accounting rules or

external market prices as proxies? tax considerations (ability to shift profits from high corporate tax country to low corporate tax country)

– Implications for efficiency, motivation of different rules for establishing internal transfer prices – consider compensation (bonuses) for managers, employees of two divisions within same organization where one division supplies the other (transfer pricing and measure of profitability of two divisions)

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Existence of Firms

• Specialization/outsourcing: virtual corporations, core competencies: airlines, drug companies, IBM, Nike, Apple, banks, Wal-mart, auto companies

– Drug companies: distribution networks, deep pockets to navigate through drug testing procedures (buy research companies, specialize in marketing and distribution)

– NIKE: marketing (outsource production, distribution)– FedEx: logistics– Disney: creating family entertainment (vertical integration –

create ideas/stories and multiple distribution channels: theme parks, television, cable channels, movies, books, etc.)

– Wal-mart: distribution and logistics– Auto companies: design, engineering and marketing

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Economic Effects of MNEs

• Intra-firm trade• Transfer of rents – quasi-monopoly rents repatriated to home country

(future imports of services of capital)– Capital export when foreign investment made; future service imports

when profits transferred

• Subsidiary may use inefficient technology because parent familiar with limited number of technologies – Most appropriate for relative price structure for factors of production in

home country – and unwilling to experiment high production costs, inefficient use of factors of production in foreign country

– Subsidiaries export capital-intensive products when relative prices of inputs suggest that exports should be labor-intensive

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• Head office employment (skilled labor) and decision-making– R&D, technology development dynamic productivity gains– Spin-offs for for suppliers – proximity important development

of industrial clusters and economies of scale

• Technology transfer – improvements in productivity of factors of production in foreign country

• Increased competition – allocative efficiency

• Competition for investment by MNEs – tax concessions, exemptions from environmental, labor laws

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• Lower value of life more dangerous work practices, more environmental damages – Reputation effects – sweatshop production

• Increased specialization in production

• Integration of production and world markets – exports/imports in each country– Moves closer to H-O world

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Trade Barriers

• Tariffs

• Export subsidies

• Quotas

• Local content requirements

• Preferential procurement

• Red tape barriers

• Foreign investment restrictions

• Contingency protection– Countervail

– Anti-dumping

– Safeguards

– Unfair trade

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Trade Barriers

• Tariffs– Import vs. export– Ad valorem vs. specific– Commodity classification– Base price for applying tariff

• Import Tariffs – protect domestic suppliers

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Trade Barriers

• Export tariffs– Government extracts rents rather than domestic

producers when domestic price < world price oil & gas under NEP in Canada

– Canada receives revenues rather than US Treasury – case of lumber

– China – tariffs on exports of steel• Produces 1/3 of world’s total supply of steel

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Trade Barriers

• Who pays tariff?– Terms of trade effects, incidence

• Small country– No market power – no terms of trade effects– Domestic consumers pay entire tariff– Revenues collected by government – costs of

administration of tariff system and collection of revenues

– Income distribution effects, employment effects

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Trade Barriers

• Large country– Market power – terms of trade effects– Foreign suppliers pay tariff because world price

lowered by full extent of tariff– Decrease in value of imports, but no change in

volume of imports – no change in domestic production of goods

– No income distribution effects other than as a result of use of tariff revenues; no employment effects other than as a result of use of tariff revenues

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Non-Tariff Measures (NTMs)

• Export subsidies and auto bail-outs– Terms of trade effects

– Production subsidies

– Income tax holidays

– Capital grants

– Labor subsidies ($X per hour) – difference between labor and direct production subsidies

– Below market rate export financing (export credit subsidy) – low interest rate loans for foreign customers

– Government guarantees for receivables – enhances ability of domestic suppliers to borrow from banks at lower rates of interest to finance working capital

– Government needs to raise revenues to pay for subsidy – incentive effects, administration and collection costs

– Income distribution effects; employment effects

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• Import quotas– Small country – price taker in world markets– Tariff rate can be estimated to produce same outcomes as quota

that is auctioned– Income distribution effects– Increase in domestic price economic rents created– Who gets the rents?

• If licenses for quotas given away, recipients of licenses (domestic – distributors; or foreign recipients – exporters) obtain rents

• If licenses auctioned – government receives rents similar to tariff

– WTO decision against China• China violated international free trade rules by limiting imports of

books and movies• Implications for control of information?

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P1

Y1

S(A)

S(World)

D(A)

0P1

0Y1 1Y1

Imports = 1Y1 – 0Y1

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P1

Y1

S(A)

S(World)

D(A)

0P1

0Y1 1Y1

Quota = 2Y1 – 0Y1

2Y1

TS(A)

2P1

3Y1

3Y1 + Quota

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• Voluntary export restraints (VERs)– Quotas on exports imposed by exporting country effectively a quota

given away to foreign suppliers

– Favoured by exporting country as compared to tariffs or quotas that are auctioned economic rents/revenues accrue to exporting firms rather than to treasury of importing country

– More costly to importing country but politically appears that exporting country admits to “unfair trade” practice and voluntarily agrees to rectify practice importing country does not appear to act as bully

– Example of Japanese autos in 1970s and 1980s – more expensive models with higher profit margins exported to US enabled Japanese auto producers to gain foothold in this segment of market

– China (January 2008): 10-15% tariff on exports of stainless steel sheets, 15% on steel tubes, 15% on cold-rolled sheets

• Reduce trade surplus – under pressure from EU and US (both threatening to impose tariffs

• Cut energy consumption and pollution

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• Local Content Requirements– Specified fraction of final good to be produced domestically – X% of

sales price; Y% of total units sold domestically (case of autos under the Auto Pact; Canadian content provisions for broadcasting)

– Under NAFTA: what constitutes domestically produced good (Mexico, US, Canada) exempt for tariffs within North American market – most goods include some value added from foreign (ex. NA) suppliers

– Comparable to import quota with license given to foreign producers of intermediate inputs

– Employment guarantees

– Domestic suppliers may have competitive advantage but face market obstacles: overcoming reputation advantage of long-established foreign suppliers; late entrant needing to overcome learning curve advantage of first mover – foreign suppliers

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• Procurement Preferences– Preferential price advantage given to domestic suppliers – government

will buy from domestic supplier as long as price is no more than X% greater than that of foreign supplier similar to tariff

– Similar to restrictive quota or tariff when foreign suppliers prevented from bidding

• Red Tape Barriers– Health and safety standards – infected cattle, SARs

– Customs classifications

– Harassment potential

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• Contingency Protection– Security of access issue related to FTA

– Countervailing duties – in case of subsidies; definition of subsidies

– Anti-dumping – predatory, sporadic, persistent (price discrimination)

– Balance of payments, employment safeguards

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• Countervailing duties– Definition of subsidies – health care system, education, etc.

– Value of subsidies

– Terms of trade

– Costs to domestic industry – distinct from economic shocks, competition

– Magnitude of tariff to level playing field

– Duration of protection

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• Anti-dumping– Distinguish among predatory, sporadic, persistent

– Does nature of dumping matter?

– Degree of dumping – price differential

– Costs to domestic industry – distinct from economic shocks, competition

– Magnitude of tariff to level playing field


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• Safeguards– Flexible exchange rates as shock absorber

– Global shock or country-specific shock

– Herd effect – pace of outsourcing accelerates

– Costs to domestic industry – labor adjustment policies, unemployment insurance, training programs

– Magnitude of tariff


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• Unfair Trade (S. 301)– 3rd country and home country effects

– Definition of unfair trade – wide ranging and ambiguous

– Harassment – who pays for investigation and legal proceedings (asymmetric costs of fighting complaints)

– Ambiguous interpretation of law – susceptibility to political pressures

• Definition of injury (threshold for injury for retaliation), causation (links between cause and effect, external variables)

– US domestic laws including trade remedy laws supersede international obligations of US

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• Foreign investment restrictions– Rights of establishment – limits on foreign investment and control

(airlines, telecommunications, broadcasting, cable, banks)

– Performance requirements

– National treatment

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Developing Countries

• Africa– Scarcity of capital, skilled labor– Political instability, insecure property rights, corruption

• Strong positive correlation between GDP per capita and inverse index of corruption

– Debt • Bono’s recommendation: debt forgiveness by rich countries• What was the debt used for? Will forgiveness contribute to

correcting underlying structural problems?

– Resource wealth – oil, minerals• Squandered through theft and military spending• Compare to Emirates – long-term visions even with limited

democracy

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• Russia– Collapse of Communist state followed by anarchy – no

rules, no enforcement

– Cannot graft Western market onto country with no history with such markets

– Markets defined by rules

– Putin:• Introduced rules and enforcement

• Benefited from high oil and gas prices

• Long-term plan to turn around the economy

• Importance of democracy?

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• Dependence on external sources of capital– Herd effects, contagion effects

– Instability of short-term capital flows

– Asian crisis in 1997; Russia crisis throughout most of 1990s; Argentina in 1980s and 1990s

– China: more than US$2 trillion in reserves

– Sovereign funds and ability to avoid most of fallout from sub-prime mortgage fiasco in US

• Germany considering law to restrict takeovers by sovereign funds (particularly from China, Russia and Middle East) that may jeopardize Germany’s “public order and safety”

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• Doha Round– Rich vs. poor countries– Importance of eliminating trade barriers for agricultural

products• Rich countries spend US$ 260 B in support of agriculture and

farmers• Agriculture accounts for 2% or less of economies of rich

countries; 5.5% in Brazil, 11.3% in China, 17.6% in India and Nigeria, 32% in Sudan

– Tradeoff: reduction of tariffs on manufactured products by poor countries

• Tariffs an important source of revenues for governments in many poor countries

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• Doha Round– No deal at this time because of conflicts between US

and China and India, and internal disagreements within the EU

– No re-start of negotiations until late 2010 – US politics

– Little interest by business

– Increased complexity• 152 countries participating

• Consensus building difficult

• India, Brazil and China more important participants

Documents

1 ECONOMICS 3150C Lecture 9 December 2. 2 Vertical Foreign Investment Internalization: based on costs for using external market –More relevant for manufacturing