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TAMU ECON 652 - e652ln7

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7 MULTINATIONALSAlternativesSuppose a Þrm located in one country wishes to sell its outputin another country. We ha ve been assuming that a Þrm w ouldserv e a market in another country b y exporting to that country.In fact, suc h a Þrm has three main choices of ho w to serveanother market:11. export,2. license a Þrm there to produce,3. or form a subsidiary there to produce.Now, we consider these t wo additional options, a nd th echoice between them. The Þrm will choose its best alter n ative,the mode t h at maximizes it proÞts. Wha t factors determinethe Þrm’s choice?When a Þrm forms a subsidiary, the Þrm becomes a mu lti-national, as it then has operations in more than one country.The process of multinationalization is also known as foreign di-rect investment (FDI) or direct foreign investment (DFI). Liketrade, FDI is often two-way: Þrms from two countries invest ineach other’s coun tries by forming subsidiaries there.FDI and licensing share the trait that production is shiftedabroad . A key distinction between FDI and licensing is thatwith FD I the subsidiary is part of the m ultinational Þrm, whereaswith licensing the licensee is a separate Þrm. Hence the in-terests of the licensee and licensor can (and often do) clash.Opportunistic behavio r occurs when a licensee takes an actionthat raises its own proÞts but lo wers the proÞts of the licensor.1Even more options such as joint ven tures exist, but these three sufficeto emphasize the key distinctions between the alternatives.MULTINATIONALS 1O L I Fram e wo rkCertain considerations mak e forming a subsidiary more attrac-tiv e than other alternatives. For FDI to be more attractiv e thanlicensing or exporting, a Þrm needs to ha ve three advan tages:• O WN ERSHIP advan tag e exists when the Þrm has paten tor exclusive ability to do something well, so that the Þrmshould sell to m arkets abroad (rather than local Þrmsthere).• LOCATIONAL advan tage exists when tariffs, transporta-tion costs or comparativ e a dvan tag e ma ke exporting unattrac-tive.• INTERNA LIZATION advant age exists when imperfectcontracts make licensing unattractive, so proÞts from pro-ducing and selling in several countries greatest if all activ-ities occur within one Þrm, th u s eliminating opportunisticbehavior.If only o w nersh ip and locational advan tag es are present, aÞrm c hooses to license its tech n ology to a local Þrm. If onlyo wnership and internalization advanta ges are presen t, a Þrmchooses to export.Int e rn a liza tio nTransactions are internalized due to complications of exc h ang-ing information betw e en Þrms. With arms-length use of mar-kets, one Þrm has to tell another Þrm its production secrets.Once the second Þrm has the knowledg e necessary to producethe product, it ma y become a competitor. The licensee mightnot renewing the contract at its conclusion and yet continue tosell, or might sell output in another market not permitted inthe contract.How can a con tract be constructed to extract the full prof-its from selling in the foreign market? Suppose the licensorc harges license fee equal to the proÞts from foreign productionin one period. At the end of the Þrst period, the con tra ct canbe renew ed for the second period. However, the licensee ma y2 MULTINATIONALSrefuse to pay the license fee for the second period, but con tinueto use the kno wledge. If the licensor w ere to license a differ-en t Þrminthesecondperiod,thefeeitcouldchargewouldbereduced due to the competition from the Þrst period’s license e(who produces without a contract in the second period).To avoid the prob lems inherent in renewal, the licensorcould charge license fee equal to present value of the proÞtsfrom foreign production. Howeve r, the potential licensee willlikely be unwilling to pay the fee for fear that the licensor mightimprove product and damage the proÞtability of the licensee.Thus, the licensee wo uld insist on some clause about right ofaccess to product or technological improvements, but the na-ture of R&D means assessing the value of these improvemen tsin advance is very hard. Ne ither Þrm knows how big the im-pro vemen ts will be or when they might arriv e.Firms experience difficulty in writing complete con tractsspecifying actions and payoffs for all states of nature due to thevast number of states of nature (having positive probability).Even if it were possible to write complete contracts, then Þrm sÞnd it especially difficult to enforce contracts in an interna-tional arena. Other countries (especially dev e lop ing countries)often to do not enforce intellectual propert y rights as w ell as theUnited States and other developed coun tries. Even developedcountries are kno w n to favor their own Þrms and thus imper-fectly protect the interests of licensors from other countries. Aninherent conßict between Þrms’ proÞts occurs unless proÞts areall in one Þrm. These informational and enforcement issues arecen tral to modeling the formation of multinational Þrms.Markusen JEP 1995FDI has expanded rapidly recently, so the causes and effectsof FDI is a particularly important issue. Much FDI occurs be-twe en similar countrie s (with similar factor endowments) andisoftentwo-way. Markusenprovidesanexcellentsurveyem-pha sizing these stylize d fact s of FDI.• F D I has grown rapidly, with a large share of world trade(30%) occurring within Þrms.• Most FDI (70%) has developed countries as both the hostMULTINATIONALS 3and the source coun tries, and much of this FDI is t wo-way .• FDI is mostly horizontal, where multinationals create lo-cal production facilities in each country and sell most oftheir output w ithin each country. This structure con-trasts with v e rtical FDI, where m u ltination als allocateproduction processes across countries in accordance withfactor intensity or other sources of comparative advan-tage.• Multinational Þrms tend to arise in industries with largeR&D expenditures relativ e to sales and substan tial prod-uct differentiation. Thus multinational Þrms have sub-stantial intangible assets (including brand recognition/reputation).• Trade barriers and transport costs generate a substitutioneffect toward FDI while decreasing the overall lev el ofboth investment and trade.Prior to Ethier (1986), m ost formal models of FDI werebased on factor endowmen ts (and thus could yield only one-way FD I) and failed to model in tern alization advan tage .Ethier QJE 1986• Tw o coun


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