ANU Trevor Swan Distinguished Lectures in Economics

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ANU Trevor Swan Distinguished Lectures in Economics

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Major Contributions to Economics

• 1943 - circulated the first econometric model of the Australian economy– Only previous macroeconomic model was Tinbergen (1936).

• 1953 - policy instruments and targets – published 1960– foreshadowed Mundell (1999 -Nobel prize).

• 1955 - “the Swan diagram” – published in 1963– concerned with achieving both internal and external balance

• 1956 – published “Economic Growth and Capital Accumulation” – Known as the “Solow - Swan” growth model. Solow (1956)

independently published a similar model (1987- Nobel prize)

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Trevor: Reserve Bank Board 1975 - 1985

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Trevor and Pat Swan – early 1940’s

Understanding International Outsourcing: New Theories of Trade and

Organizational Form

Barbara J. SpencerUniversity of British Columbia and the NBER

March 8, 2007

ANU Trevor Swan Distinguished ANU Trevor Swan Distinguished Lectures in EconomicsLectures in Economics

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Objective• Provide a perspective on international

outsourcing based on the new literature that combines the choice of organizational form with international trade.

– partly based on my survey article “International Outsourcing and Incomplete Contracts” CJE, 2005.

• Main question: What explains international outsourcing versus other options for procurement?

– What explains the decision by firms to outsource rather than vertically integrate?

– What explains the decision to outsource abroad?

IntroductionIntroduction, IO Theory, International Outsourcing, Conclusion, IO Theory, International Outsourcing, Conclusion

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Outline of Talk1. Introduction

– The firm’s choice set: make or buy and location

2. Domestic outsourcing – Insights from the theory of Industrial Organization• Central concept - Incomplete contracts and the

hold-up problem • Three different theoretical approaches

3. International Outsourcing: • general equilibrium models• partial equilibrium – empirical work on outsourcing

to China

4. Conclusion - Summary and future directions

Introduction, IO Theory, International Outsourcing, Conclusion , IO Theory, International Outsourcing, Conclusion

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Add location (domestic or foreign) to the firm’s make or buy decision

Make or Buy

Location

Internal to firm - make

Outsource - buy

Domestic Domestic Vertical Integration

Domestic Outsourcing

Foreign Foreign Direct Investment - FDI

International Outsourcing

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Distinguish between outsourcing of specialized and generic inputs

Make or

Buy

Location

Internal

- make

Outsource - buy

Generic

Input

Specialized

Input

Domestic

Vertical Integration

- Domestic

Buy from domestic spot market

Contract with domestic supplier

Foreign Foreign direct investment (FDI)

International

-buy from foreign spot market

International-Contract with foreign supplier

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What is meant by organizational form?

The different options for procurement correspond to different organizational forms.

Organizational forms– Vertical integration

• produce the input at home • Become a multinational firm by undertaking FDI so

as to produce the input abroad

– Outsource a specialized input • Contract with a domestic supplier• Contract with a foreign supplier

– Outsource a generic input – buy it on the market1212

Introduction, IO Theory, International Outsourcing, Conclusion, IO Theory, International Outsourcing, Conclusion

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2. Theory – Domestic Outsourcing

Central concept - Incomplete contracts and the hold-up problem– If contracts are complete (cover every

contingency) and are enforceable, vertical structure does not matter

Three theoretical approaches– Property Rights

– Transaction Costs

– Principal-agent models/ design of incentive systems

Introduction, Introduction, IO TheoryIO Theory, International Outsourcing, Conclusion, International Outsourcing, Conclusion

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Incomplete Contracts & Hold-up Problem• Relationship-specific investment : investment designed

for a particular firm - NO value to other firms.

– Since there is no outside market for products arising from the specific investment, the investment is rewarded only through contracts with the particular firm.

• Contract is incomplete: not possible to write contracts conditional on the level of the specific investment.

– Return that suppliers receive for investment is determined by bargaining between the parties after investment is sunk.

• Hold-up problem: investment not fully rewarded

→ too little investment or effort

Introduction, Introduction, IO TheoryIO Theory, International outsourcing, Conclusion, International outsourcing, Conclusion

Darth Vader & the Holdup Problem

• IMPERIAL OFFICER: Skywalker has just landed, my Lord

• VADER: Good. See to it that he finds his way here. Lando, take the princess to my ship.

• LANDO: You said that the princess would be left in the city under my supervision.

• VADER: I am altering the deal. Pray I don’t alter it any further.

Star Wars – The Empire Strikes BackStar Wars – The Empire Strikes Back

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Property Rights Theory (Grossman & Hart, 1986; Hart & Moore, 1990)

• Contracts are incomplete– for both an outside supplier or a manager within the firm

• Outsourcing can reduce the hold-up problem – Property rights theory defines a firm by the ownership of assets.– Since a firm can withhold assets if bargaining breaks down, but a

manager cannot, the firm has a better bargaining position. independent suppliers have more incentive to invest

• Who should invest?– If specific investment in an input is best done by those directly

responsible for its production, then production should be outsourced to encourage investment.

– If investment in an input at the head-quarter’s level by the owner of the firm would be more productive than investment by a supplier, then

• vertical integration is more efficient

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Transaction Costs Lower transaction costs inside the firm make

vertical integration more efficient than outsourcing

– Coase (1937); Williamson (1975, 85) Outsourcing involves costs of search and

matching (McLaren 2000)• Thickness of the market

– markets are thicker if there are more firms to match with.

More outsourcing in thicker markets

• Outsourcing may also involve inefficiencies due to incomplete contracts


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Principal and agent models

• The principal is typically the owner of the firm and the agent is the manager

• The principal designs optimal contracts to induce effort by the agent under imperfect monitoring.

The greater ease of monitoring within the firm favours vertical integration


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General equilibrium models• Vertical integration vs. contractual outsourcing of

specialized inputsA. Antràs (2003)- Property rights

Antràs & Helpman (2004) – Property Rights

Grossman and Helpman (2004) – Principal & Agent

B. McLaren (2000), Grossman & Helpman (2002, 2005) - Thickness of market – transaction costs

– Simplifying assumptions for general equilibrium

Partial equilibrium• Contractual vs. generic outsourcing

– Feenstra and Spencer (2006) – Outsourcing to China

Introduction, IO Theory, Introduction, IO Theory, International Outsourcing, Conclusion, Conclusion

3. International Outsourcing

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What is new about the theory?• Traditional general equilibrium trade theory assumes

perfect competition– atomistic firms: firm size and vertical structure is not relevant

• Monopolistic competition has been widely adopted– Fixed costs determine the size of firms under free entry.– Products are differentiated– But, vertical structure and trade in intermediate goods are not

considered.

• Theories of trade and organizational form require a theory of the firm in which vertical structure matters. A major achievement has been to embed contracting models

into general equilibrium models of monopolistic competition.

Introduction, IO theory, Introduction, IO theory, International Outsourcing, Conclusion, Conclusion

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Embeds a property rights model of the firm into a general equilibrium model of monopolistic competition and trade.• differences in factor endowments across countries

explains the choice of organizational form Prediction: Capital intensive intermediate goods are

likely to be produced by vertically integrated firms rather than outsourced

What drives the model?• Hold-up problem: alleviated if final-good firms

contribute capital to suppliers so as to share in the cost of production of specialized inputs.

• If the capital contributed is sufficiently large: property rights theory ⇨ vertical integration


Antràs (2003*) – Property rights

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Share of intra-firm US imports and relative factor endowments (Antras, 2003)

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Property rights vs principal & agent

• Antràs & Helpman (2004) - Property Rights

• Grossman and Helpman (2004) – Principal & agent

• Both papers incorporate monopolistic competition models of trade involving differences in productivity across firms that determine organizational form– Melitz (2003) introduced firm-specific differences in

productivity into general equilibrium trade models.

• But the Property Rights and Principal and Agent approaches give very different predictions as to the choice of organizational form.


Outsource

VerticallyIntegrate

SouthSouth

SouthSouth

NorthernNorthernFirmFirm

NorthNorth

NorthNorth

N firm -Productivity RankN firm -Productivity Rank

AH(2004)FDIFDI

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33

44

22

25

Outsource

VerticallyIntegrate

SouthSouth

SouthSouth

NorthernNorthernFirmFirm

NorthNorth

NorthNorth

N firm -Productivity RankN firm -Productivity Rank

AH(2004)FDIFDIGH(2004)

22

33

1, 41, 4

11

33

44

22

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B. Thickness of the Market Transaction cost approach: hold-up problem solved

by vertical integration• Outsourcing due to a fixed cost of vertical integration

Multiple equilibria possible (McLaren, 2000): • a thicker market increases outsourcing, which in turn

makes the market thicker

Grossman &Helpman (2002)• Combines thickness of market with general equilibrium

monopolistic competition

• Outsourcing based on incomplete contracts.

• Closed economy

Introduction, IO Theory, International Outsourcing, Conclusion

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B. Thickness of the market: Domestic vs. International Outsourcing

Grossman & Helpman (2005)• No vertical integration

• Countries with more labour attract outsourcing – due to thicker markets.

• Complex results due to general equilibrium interactions:

- an expansion in Southern labour actually reduces the wage gap between the North and the South.

Introduction, IO Theory, International Outsourcing, Conclusion

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Simplifying assumptions: general equilibrium

Requires a simplified model of contracting

• The parties share in profit through lump-sum transfers.

– May better capture profit-sharing joint ventures than contractual purchase of inputs from independent firms.

• If suppliers commit to a quantity up-front, the price of an input is zero. Otherwise inputs are priced at marginal cost.

– Realism? Customs officials could view as suspicious.

Introduction, IO Theory,Introduction, IO Theory, International Outsourcing, Conclusion, Conclusion

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Implications for Boeing 787?

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Problems: Airbus A380

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Feenstra & Spencer (2006), “Contractual versus Generic Outsourcing”

Variety in intermediate goods – A final good producer, such as an automaker, requires a continuum of parts.

– parts are ordered on the continuum in terms of increasing productivity of specific investment by suppliers.

– Property Rights approach - all parts are outsourced Free entry of suppliers, but one final-good producer More structure in the model of contracts.

– Trade-off between specialized and generic parts is built into the Nash bargaining process.


3. International Outsourcing: partial equilibrium

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1

4

3

2

1

Multinational

RSI Productivity

North

Assembler

Contractual Outsourcing

Generic Generic OutsourcingOutsourcing

South Supplier

Ranking

Plant in South

South Market

NorthSupplier

Feenstra and Spencer (2006)

Manufacturing Exports from China (bn $)

0

50

100

150

200

250

300

350

400

450

88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03

year

bn

$

FIE Processing Export Other Processing Export Ordinary Export3333

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Variety or Volume?• Feenstra and Spencer (2006) explore the

effect of distance on the variety of exports covered by each organizational form.

• Data: manufacturing exports from each province in China to all destination countries (1988 – 2003) – Enormous literature of the effect of distance on the

volume of international trade (gravity equations), but consideration of variety is relatively recent.

Introduction; IOIntroduction; IO Theory; Theory; International Outsourcing; Conclusion; Conclusion

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Empirical Results• Two measures of distance

– Internal distance from the province to the nearest port– External distance from the port to the destination country

• As predicted, greater internal distance reduces the proportion of exported varieties from China that

– are contractual (processing exports) rather than generic (ordinary manufactures)

– involve contracts with multinationals

• External distance from the port to the destination county has essentially no effect.

– As in standard gravity equations, the value of exports to more distant countries are reduced.


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4. Summary and Concluding Remarks Why contract with foreign firms rather than produce

at home?1. Lower costs of foreign production- lower wages

• Greater physical distance reduces the variety of goods that are outsourced abroad rather than at home (Feenstra and Spencer, 2006).

2. Industries with a low capital intensity of production outsource to countries where capital is scarce (Antràs, 2003)

3. Reduced costs of international transactions• Lower costs of international search and matching

(Grossman & Helpman, 2005)

• Thicker markets due to the combining of economies with the formation of free trade areas (McLaren, 2000)

• Improvements in communications (internet)

Introduction, IO Theory,Introduction, IO Theory, International Outsourcing, International Outsourcing, Conclusion

Why contract with foreign firms rather than produce through FDI

1. High fixed costs of FDI2. Shifting of costs to component suppliers

(Grossman & Helpman, 2004)

3. Nature of differences across firms– Moderate productivity level (Antràs & Helpman, 2004)

– Very high or very low productivity (Grossman & Helpman, 2004)

– Relatively low productivity of investment (Feenstra and Spencer)

4. Low capital intensity of production (Antràs, 2003)

5. Greater geographic distance (Feensta & Spencer)

Introduction, IO Theory,Introduction, IO Theory, International OutsourcingInternational Outsourcing, , Conclusion

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Future Directions More partial equilibrium modeling so as to

focus on the effects of policy on organizational form

Explore the strategic motives that affect outsourcing by large oligopolistic firms

Empirical research:1) distinguish between role of thicker markets and better

institutions for the enforcement of contracts

2) on the factors (distance, quality of institutions, worker skill) that link the variety of exports with organizational form.

Introduction, IO Theory,Introduction, IO Theory, International Outsourcing, International Outsourcing, Conclusion

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ANU Trevor Swan Distinguished Lectures in Economics