Chapter 10: Foreign Direct Investment and Intra-Firm Trade An Introduction to International Economics: New Perspectives on the World Economy © Kenneth A. Reinert, Cambridge University Press 2012

Analytical Elements Countries Sectors Tasks Firms © Kenneth A. Reinert, Cambridge University Press 2012

Value Chains A value chain is a series of value-added processes involved in the production of any good or service Consider a semiconductor value chain  Research, development and design leading up to details of the physical circuitry of the chip to be placed on the silicon  Fabrication (or just fab in semiconductor jargon) in an advanced manufacturing process in which circuitry layouts are etched onto silicon wafers containing many die  Assembly and testing in which the die are cut from wafers and mounted or packaged into a functioning device with wire contacts and insulation  Final incorporation in which the semiconductor is incorporated into the final piece of equipment such as a personal computer or mobile phone © Kenneth A. Reinert, Cambridge University Press 2012

Semiconductor Value Chain The semiconductor value chain is shown in Figure 10.1 An additional task in this figure is that of advanced equipment and materials crucial to the fabrication process It is not necessary for a firm to be active across all stages of semiconductor manufacturing The task scope of a firm in the industry is the result of a firm’s decision-making with regard to what tasks to perform along the value chain Intel is involved in the first three stages of the value chain: research, development and design; fabrication; and assembly and testing © Kenneth A. Reinert, Cambridge University Press 2012

Figure 10.1: A Value Chain for Semiconductors © Kenneth A. Reinert, Cambridge University Press 2012

Global Production Networks Value chains are potentially distributed across countries. When these international value chains are linked together in potential buyer-supplier or ownership relationships, they become known as global production networks or GPNs An example of this is given in Figure 10.2 The semiconductor production decision is two-fold, namely the decision as to what part of the value chain to take on and in which countries to do so There are both task and location decisions to consider © Kenneth A. Reinert, Cambridge University Press 2012

Figure 10.2: A Global Production Network for Semiconductors © Kenneth A. Reinert, Cambridge University Press 2012

Movements along GPNs There is another way to look at the GPN decision- making process Movements up and down the value chains of Figure 10.2, whether in the United States or Costa Rica, are vertical movements  Movements up a value chain, from subsequent to previous tasks are backward vertical movements  Movements down a value chain from previous to subsequent tasks are forward vertical movements Movements from one country to another, from the United States to Costa Rica, for example, are horizontal movements © Kenneth A. Reinert, Cambridge University Press 2012

Firm-Specific Assets Firms can and do take more than one approach to the semiconductor value chain or GPN A simplified version of Intel’s semiconductor GPN is presented in Figure 10.3  The dashed lines indicate potential areas where Intel has chosen not to operate The ability of Intel to operate where it does in its GPN reflects its competiveness International business researchers explain competitiveness with reference to firm-specific assets © Kenneth A. Reinert, Cambridge University Press 2012

Figure 10.3: A Global Production Network for Semiconductors © Kenneth A. Reinert, Cambridge University Press 2012

Intel’s Plant in Costa Rica (Source: Wikipedia) © Kenneth A. Reinert, Cambridge University Press 2012

Firm-Specific Assets Firm-specific assets can be tangible  Access to silicon and other advanced materials, Firm specific assets can also be intangible  Specialized knowledge, patented products or processes, organizational abilities, or brand distinctiveness and loyalty When a firm such as Intel takes on new tasks along the vertical dimension of a GPN, it can experience an efficiency gain by spreading the costs incurred in acquiring its firm-specific assets (both tangible and intangible) over more value chain stages These efficiency gains are known as firm-level economies © Kenneth A. Reinert, Cambridge University Press 2012

Firm-Level Economies The concept of firm-level economies is not, in general, sufficient to explain the integration process along GPNs Why? Because firms always have the option (discussed in Chapter 9) of licensing its firm-specific assets to other firms Corporate strategists suggest that a firm’s decision to internalize the firm-specific asset market reflects market failure That is, for a number of reasons, it has difficulty in selling its firm-specific assets in a contractual arrangement  This difficulty is particularly acute for intangible assets © Kenneth A. Reinert, Cambridge University Press 2012

Intra-Firm Trade We can observe a pattern of intra-firm trade in Figure 10.3 Intel exports fabricated die from its home base to its subsidiary in Costa Rica This is not an arm’s-length, market-based transaction that takes place at world prices It is a trade transaction within Intel itself at a price set by it We now have two distinctions of trade (Table 10.1)  Inter-industry vs. intra-industry  Inter-firm vs. intra-firm © Kenneth A. Reinert, Cambridge University Press 2012

Table 10.1: Industry and Firm Dimensions of Trade Firm Dimension Industry DimensionInter-firmIntra-firm Inter-industryTrade that takes place between two different industries and two different firms Trade that takes place between two different industries and within a single firm Intra-industryType of trade that takes place within a single industry and between two different firms Trade that takes place within a single industry and within a single firm © Kenneth A. Reinert, Cambridge University Press 2012

A Cost View of Internalization Suppose that a home-country firm faces a fixed cost of setting up a production facility in country of FP j Suppose also that the firm faces a smaller fixed cost of establishing a contractual relationship with a firm from country of FC j. There are also variable costs associated with these two options of VP j and VC j The variable costs of international contracting are larger than the variable costs of international production due to the firm-specific assets that give it an advantage over the potential contracting partner. © Kenneth A. Reinert, Cambridge University Press 2012

A Cost View of Internalization In Figure 10.4, the solid FP j +VP j graph begins at the vertical axis intercept equal to the fixed cost of production and increases from there with a slope equal to the variable costs of production. The solid FC j +VC j graph begins at a lower vertical axis intercept equal to the lower fixed cost of contracting and increases from there with a slope equal to the variable costs of contracting The two solid lines intersect at a “breakeven point” that establishes a boundary between quantities where it would be better for the firm to engage in contracting and quantities where it would be better for the firm to engage in production © Kenneth A. Reinert, Cambridge University Press 2012

Figure 10.4: A Cost Analysis of Production and Contracting © Kenneth A. Reinert, Cambridge University Press 2012

The OLI Framework We can tie together some of the considerations of this chapter into what has be come known as the OLI Framework If the home-country MNE is indeed able to successfully engage in business in the foreign country, there must be some other advantages that offset the additional costs of conducting business internationally These advantages are what John Dunning called ownership or O advantages The role of the O advantage is to explain why the MNE engages in the production of a good for the foreign market instead of a foreign firm. © Kenneth A. Reinert, Cambridge University Press 2012

The OLI Framework Location or L advantages are associated with the foreign country The L advantages could include input costs, transportation costs, import restraints, foreign government promotional policies, or access to foreign consumers The role of the L advantage is to explain why the home- country MNE chooses to produce in the foreign country rather than the home country © Kenneth A. Reinert, Cambridge University Press 2012

The OLI Framework Internalization or I advantages explain why the home- country MNE chooses FDI over the contracting option The I advantages are therefore related to all the reasons why contracting might not be a viable option In Dunning’s view, and in the view of other researchers deploying this framework, all three advantages are necessary to explain the presence of FDI The OLI Framework is summarized in Table 10.2 © Kenneth A. Reinert, Cambridge University Press 2012

Table 10.2: The OLI Framework © Kenneth A. Reinert, Cambridge University Press 2012 Source: Dunning (1988) SymbolMeaningContribution OOwnership advantage Explains how a firm’s tangible and intangible assets help it to overcome the extra costs of doing business internationally. Explains why a home country firm, rather than a foreign firm, produces in the foreign country. LLocation advantage Explains why a home-based MNE chooses to produce in a foreign country rather than in its home country. IInternalization advantage Explains why a home-based MNE chooses FDI rather than licensing to achieve production in a foreign country.

Appendix: The Gravity Model Gravity models utilize the gravitational force concept as an analogy to explain the volume of trade or FDI among the countries of the world For example, gravity models establish a baseline for trade or FDI flows as determined by gross domestic product (GDP), population and distance The effect of policies on trade or FDI flows can then be assessed by adding the policy variables to the equation and estimating deviations from the baseline flows © Kenneth A. Reinert, Cambridge University Press 2012

Appendix: The Gravity Model Gravity models are estimated in terms of natural logarithms, denoted “ln” Gravity models explain trade flows or FDI flows from county i to country j (F ij ) in terms of GDP and distance A simple gravity model is given by lnF ij =  +  1 lnGDP i +  2 lnGDP j +  3 lnD ij In this model,  1 and  2 are expected to be positive and  3 is expected to be negative © Kenneth A. Reinert, Cambridge University Press 2012