Economics 560 Suggested Answers Case Study 2 Shifting Gears: Ford Motor Company in Mexico 1. Consider the Mexican government’s Auto Decrees between 1962 and 1982. Does the government appear to be motivated by (a) the theory that factor mobility replaces trade or (b) the theory that factor mobility augments trade (or (c) both)? Explain, using evidence from the case. In a Heckscher-Ohlin model the ability of factors to cross national borders in response to factor-price differentials leads to the replacement of trade in goods and the attainment of the same welfare gains as with free trade. When the production process can be divided into parts, foreign investment can lead to increased welfare and augmented trade. The 1962 Auto Decree eliminated imports of cars. This seems to rely upon trade replacement: capital investment in Mexico will yield the same gains as would be available through trade. The 1972 and 1977 Auto Decrees limited imports of car parts by requiring that any import be offset by an export of the same value. This also reflects a belief that limiting imports will encourage foreign investment (and domestic investment) to produce the car parts locally. (So also did the domestic content requirement in the 1983 Auto Decree.) There is also evidence of the trade-augmenting role of foreign investment. The 1977 Auto Decree allows firms to meet their export requirements through the activities of maquiladoras they own: these rely upon dividing the production process into parts and siting some activities in maquiladoras. In these plants, US investments lead to an augmenting of trade. 2. Ford’s decision in 1984 was to invest to make high-quality Fords in Mexico for sale throughout the world. Which of the O,L,I explanations for foreign investment motivated that choice? Explain your reasoning, using evidence from the case. Ownership, location and internalization are three justifications given for foreign direct investment. There is evidence for all in the 1984 decision. First, there is a continuing excess return to investment in Mexico, as indicated by low labor costs. Second, trade barriers remain to importing cars – and in the US, there is a quota on imports of Japanese cars into the US. Also, the Mexican government has insisted upon increased exports (Auto Decrees 1972 and 1977) if local production is to continue. Third,there is evidence that foreign investment will be better than licensing: the company can combine its assets in a way that yields higher profits than simply outsourcing production to others. Ford’s assets -- Mazda technology, experience in Mexican production, marketing and distribution networks in the US – can be combined to yield greater profits. The alternative of outsourcing runs the risk of low-quality production as evidenced by the text’s discussion on quality and defects of current Mexican Ford models. 3. Does the relationship between Ford and the government of Mexico as described in the case resemble an obsolescing bargain? Explain why or why not based on evidence from the case. In an obsolescing bargain, two actors follow individually rational strategies. One actor’s (i.e., the government’s) incentive to punish the other (i.e., the investor) once the investment is in place leads the investor to pass on the investing – and yields strictly worse payoffs than could be achieved by cooperative strategies. In this case, there is evidence of changing government incentives for Ford – from the positive support through ban on imported cars in 1962 through the more punitive balance-of-payments requirements of the 1972 and 1977 Auto Decrees. It is possible that this pattern would have discouraged the Ford investment in 1984, except that the Mexican government was cooperative in its support at that time: it relaxed balance-of-payments and domestic-content requirements for the new operation. Is this the beginning of a second round of initial looseness followed by tightening?Grade Distribution 96 – 100 0 91 – 95 1 86 – 90 5 81 – 85 2 Mean: 82 76 – 80 5 Median: 82.5 71 – 75 3 61 – 70 0 0 – 60 0 Total