Copyright © 2012 Pearson Addison-Wesley. All rights reserved.Chapter 8Firms in the Global Economy: Export Decisions, Outsourcing, and Multinational EnterprisesCopyright © 2012 Pearson Addison-Wesley. All rights reserved.8-2Trade Costs and Export Decisions• Most U.S. firms do not report any exporting activity at all — sell only to U.S. customers.– In 2002, only 18% of U.S. manufacturing firms reported any sales abroad.• Even in industries that export much of what they produce, such as chemicals, machinery, electronics, and transportation, fewer than 40 percent of firms export.Copyright © 2012 Pearson Addison-Wesley. All rights reserved.8-3Trade Costs and Export Decisions• Trade costs help explain why only a subset of firms export, and why exporters are relatively larger and more productive (lower marginal costs). • In the United States, an exporting firm in a typical manufacturing industry is on average more than twice as large as a firm that does not export.Copyright © 2012 Pearson Addison-Wesley. All rights reserved.8-4Table 8-3: Proportion of U.S. Firms Reporting Export Sales by Industry, 2002Copyright © 2012 Pearson Addison-Wesley. All rights reserved.8-5Multinationals and Outsourcing• Foreign direct investment refers to investment in which a firm in one country directly controls or owns a subsidiary in another country.• If a foreign company invests in at least 10% of the stock in a subsidiary, the two firms are typically classified as a multinational corporation. 10% or more of ownership in stock is deemed to be sufficient for direct control of business operations.Copyright © 2012 Pearson Addison-Wesley. All rights reserved.8-6Multinationals and Outsourcing• Greenfield FDI is when a company builds a new production facility abroad.• Brownfield FDI (or cross-border mergers and acquisitions) is when a domestic firm buys a controlling stake in a foreign firm.• Greenfield FDI has tended to be more stable, while cross-border mergers and acquisitions tend to occur in surges.Copyright © 2012 Pearson Addison-Wesley. All rights reserved.8-7Multinationals and Outsourcing• Developed countries have been the biggest recipients of inward FDI.– much more volatile than FDI going to developing and transition economies. • Steady expansion in the share of FDI flowing to developing and transition countries. – Accounted for half of worldwide FDI flows in 2009.• Sales of FDI affiliates are often used as a measure of multinational activity.Copyright © 2012 Pearson Addison-Wesley. All rights reserved.8-8Fig. 8-9: Inflows of Foreign Direct Investment, 1980-2009Copyright © 2012 Pearson Addison-Wesley. All rights reserved.8-9Multinationals and Outsourcing• Horizontal FDI when the affiliate replicates the same production process elsewhere in the world.• Vertical FDI when the production chain is broken up, and parts of the production processes are transferred to the affiliate location.Copyright © 2012 Pearson Addison-Wesley. All rights reserved.8-10Multinationals and Outsourcing• Vertical FDI is mainly driven by production cost differences between countries (for those parts of the production process that can be performed in another location).• Vertical FDI is growing fast and is behind the large increase in FDI inflows to developing countries.Copyright © 2012 Pearson Addison-Wesley. All rights reserved.8-11Multinationals and Outsourcing• Horizontal FDI is dominated by flows between developed countries.– Both the multinational parent and the affiliates are usually located in developed countries. • Locate production near large customer bases. – Hence, trade and transport costs play a much more important role than production cost differences for these FDI decisions.Copyright © 2012 Pearson Addison-Wesley. All rights reserved.8-12Fig. 8-10: Outward Foreign Direct Investment for Top Countries, 2007-2009Source: UNCTAD, World Investment Report, 2010.Copyright © 2012 Pearson Addison-Wesley. All rights reserved.8-13The Firm’s Decision Regarding Foreign Direct Investment• Proximity-concentration trade-off: – High trade costs associated with exporting create an incentive to locate production near customers. – Increasing returns to scale in production create an incentive to concentrate production in fewer locations.Copyright © 2012 Pearson Addison-Wesley. All rights reserved.8-14The Firm’s Decision Regarding Foreign Direct Investment• FDI activity concentrated in sectors with high trade costs.– When increasing returns to scale are important and average plant sizes are large, we observe higher export volumes relative to FDI.• Multinationals tend to be much larger and more productive than other firms (even exporters) in the same country.Copyright © 2012 Pearson Addison-Wesley. All rights reserved.8-15The Firm’s Decision Regarding Foreign Direct Investment• The horizontal FDI decision involves a trade-off between the per-unit export cost t and the fixed cost F of setting up an additional production facility.•If t(Q) > F, costs more to pay trade costs t on Q units sold abroad than to pay fixed cost F to build a plant abroad.– When foreign sales large Q > F/t, exporting is more expensive and FDI is the profit-maximizing choice.– Low costs make more apt to choose FDI due to larger sales.Copyright © 2012 Pearson Addison-Wesley. All rights reserved.8-16The Firm’s Decision Regarding Foreign Direct Investment• The vertical FDI decision also involves a trade-off between cost savings and the fixed cost F of setting up an additional production facility.– Cost savings related to comparative advantage make some stages of production cheaper in other countries.Copyright © 2012 Pearson Addison-Wesley. All rights reserved.8-17The Firm’s Decision Regarding Foreign Direct Investment•Foreign outsourcing or offshoring occurs when a firm contracts with an independent firm to produce in the foreign location. • In addition to deciding the location of where to produce, firms also face aninternalization decision: whether to keep production done by one firm or by separate firms.Copyright © 2012 Pearson Addison-Wesley. All rights reserved.8-18The Firm’s Decision Regarding Foreign Direct Investment• Internalization occurs when it is more profitable to conduct transactions and production within a single organization. Reasons for this include:1. Technology transfers: transfer of knowledge or another form of technology may be easier within