MGRECON401 Economics of International Business and Multinationals LECTURE 2 Global Sourcing Decisions

4-2 The optimal sourcing and shipping decision of a multinational is similar to the optimal production and trade decision of the world’s resources.

4-3 Lecture Focus Explain the pattern of international trade observed in the world economy. Understand the source of comparative and competitive advantage around the world.

4-4 Unit Labor Cost Labor Only Example Production Technology Y = A*N Y = Output A = Labor Productivity N = Labor Production Cost = w*N w = Wage Rate Production Cost = w*N = w*(Y/A) = c*Y c = w/A = wN/Y = unit labor cost c = marginal cost of production

4-5 Unit Labor Cost Labor Only Example Profit = (p – c)Y Lower Unit Labor Cost leads to higher profit per unit of production

4-6 Unit Labor Cost Definition: Unit Labor Cost = Wage divided by the marginal productivity of labor = w/MPL Unit labor cost equals the cost required to produce one more unit of output with labor. Inputs are at an optimal mix when the cost of producing one more unit of output with each input is equalized. Unit labor cost = marginal cost of production.

4-7 Unit Labor Cost Technical Appendix Production Function (H1): Y = F(K,N) Cost Function: Cost = rK + wN Unit Labor Cost: ULC = w/F N (K,N) Cost Minimization: F N (K,N)/w = F K (K,N)/r Derivation: KF K (K,N)+ NF N (K,N) = (rK+wN)/ULC Note for H1 functions: Y = KF K (K,N)+ NF N (K,N) Derivation: Cost = ULC*Y = c*Y Profit: (p-c)Y

4-8 Computing Unit Labor Cost Value of output (sales) (Y) = payment to capital (rK) + payment to labor (wN) + payment for intermediate inputs (M). Value-added (Y-M) = payment to capital (rK) + payment to labor (wN).

4-9 Computing Unit Labor Cost Labor Productivity = Value-added per worker = (Y-M)/N Unit labor cost (ULC) = Wage divided by labor productivity = wN/(Y-M)

4-10 Unit Labor Cost and Competitive Advantage A country has a competitive advantage in producing a good if it is the low cost producer of that good. A country is a low cost producer of a good if wages are low relative to the productivity of producing that good. Competitive advantage = low unit labor cost.

4-11 Unit Labor Cost and Comparative Advantage Country A has a comparative advantage over Country B in producing Good X over Good Y if the productivity of Country A in producing Good X relative to the productivity of producing Good Y is higher than that ratio in Country B. Countries specialize in the production of goods for which they have a comparative advantage. Wage = marginal productivity of labor of goods that are produced (roughly, wage is determined by the marginal productivity of labor averaged over all goods) Comparative advantage leads to specialization in the production of goods with low unit labor cost (other goods have a higher unit labor cost).

4-12 Example of Comparative Advantage Country A: Producing one less unit of Y saves up resources to produce two units of X. Country B: Producing one less unit of Y saves up resources to produce one unit of X. Country A has a comparative advantage in producing Good X. If both countries produced X and Y, Country B could take one unit of Y, ship it to A, sell it for resources to produce two units of X, and ship two units of X back to Country B. This trade works independent of how efficiently X and Y are produced with resources in either country.

4-13 Unit Labor Cost in Japanese Manufacturing

4-14 Obtaining Data on Unit Labor Cost Groningen Growth and Development Center: International Comparisons of Output and Productivity by Industry: Bureau of Labor and Statistics (BLS):

4-15 Theory of National Competitive Advantage The theory attempts to analyze the reasons for a nation’s success in a particular industry Porter studied 100 industries in 10 nations Postulated that the determinants of competitive advantage of a nation were based on four major attributes Factor endowments Demand conditions Related and supporting industries Firm strategy, structure and rivalry

4-16 Factor endowments Factor endowments: A nation’s position in factors of production such as skilled labor or infrastructure necessary to compete in a given industry Basic factor endowments Advanced factor endowments

4-17 Basic factor endowments Basic factors: Factors present in a country Natural resources Climate Geographic location The first oil well

4-18 Advanced factor endowments Advanced factors: the result of investment by people, companies, government.

4-19 Advanced factor endowments communications skilled labor research technology education

4-20 Demand conditions Demand: creates capabilities creates sophisticated and demanding consumers Demand impacts quality and innovation

4-21 Related and supporting industries Creates clusters of supporting industries that are internationally competitive Must also meet requirements of other parts of the Diamond

4-22 Firm Strategy, Structure and Rivalry Long term corporate vision is a determinant of success Management ‘ideology’ and structure of the firm can either help or hurt you Presence of domestic rivalry improves a company’s competitiveness

4-23 Determinants of Competitive Advantage in nations Government Company Strategy, Structure, and Rivalry Demand Conditions Related and Supporting Industries Factor Conditions Chance Two external factors that influence the four determinants. Fig 4.8

4-24 Caterpillar Tractor What are key features of the EME industry? What was CAT’s strategy that firmly established it as the #1 EME company? How well did CAT’s strategy fit with its organizational design and external environment? How is the EME industry changing? What are CAT’s vulnerabilities? Do you have any suggestions for how CAT should change?