Global Sourcing (2004) Pol antras Elhanan Helpman ALEXOPOULOS dimitri Garcia jose Vieira antonY

Plan Introduction The model Equilibrium Organizational forms Prevalence of Organizational Forms Conclusion

I. Introduction How to produce? To keep the production Home (standard vertical integration) Abroad (FDI) To outsource an input (domestic outsourcing) (foreign outsourcing or « arm’s-length trade »)

I. Introduction Intel Corporation has chosen the FDI strategy: It assembles most of its microchips in wholly owned subsidiaries in China, Costa Rica, Malaysia and the Philippines Nike has chosen the arm’s-length import strategy It subcontracts most of its manufacturing to independent producers in Thailand, Indonesia, Cambodia and Vietnam

I. Introduction Growth of international specialization has been a dominant feature of the international economy Feenstra (1998): of the $2 export value for the Barbie dolls when they leave HK for the US, $0.35 = Chinese labor $0.65 = cost of materials $1.00 = transportation WTO (1998): in the production of an American car

I. Introduction Feenstra and Hanson (1996) Bureau of Economic Analysis The share of imported intermediates increased from 5.3% of total US intermediate purchases in 1972 to 11.6% in 1990. Bureau of Economic Analysis The growth of foreign outsourcing by US firms have outpaced the growth of their foreign intrafirm sourcing. Fan and Lang (2000) Decline in vertical integration US manufacturing firms have become more specialized over time

I. Introduction Issues: Melitz (2003) Outsourcing vs. Integration Home vs. Foreign production Conclusion: need of a theoretical framework in which companies make endogenous organizational choices. Melitz (2003) Helpman, Melitz and Yeaple (2004) Low-productivity firms serve only the domestic market High-productivity firms also serve foreign markets Among the high-productivity firms that serve foreign markets, The more productive ones engage in FDI The less productive ones export Affiliate sales relative to exports are larger in sectors with more productivity dispersion PB: their approach emphasizes variations across firms within industries, without addressing the organizational choices of firs that need to acquire intermediate inputs

I. Introduction Grossman and Helpman (2002) Antras (2003) Address the choice between outsourcing and integration in a one-input general equilibrium framework HYP: all firms of a given type are equally productive Their firms face the friction of incomplete contracts in arm’s length relationships, which they weigh against the less efficient production of inputs in integrated companies As a result, some sectors have only vertically integrated firms whereas others have only disintegrated firms. Antras (2003) Approach extended to a trading environment, by introducing two new features: The friction of incomplete contracts also exists within integrated firms Integration provides well-defined property rights There are two inputs: 1 controlled by the final-good producer 1 controlled by another supplier, inside or outside the firm The sector that is relatively intensive in the input controlled by the final-good producer integrates The sector that is relatively intensive in the other input outsources In the former sector there is intrafirm trade in inputs, in the latter sector there is arm’s-length trade

I. Introduction Antras and Helpman Develop a theoretical model that combines: The within-sectoral heterogeneity of Melitz (2003) With the structure of firms in Antras (2003) The final-good producer controls the supply of headquarter services, whereas a supplier of intermediate goods controls the quality and quantity of the intermediates. As a result, they can study the impact of variations in productivity within sectors and of differences in technological and organizational characteristics across sectors on international trade, FDI, and the organizational choices of firms. In this framework, trade, investment and organization are interdependent. The incentives created by different organizations, differences in their fixed costs, and wage differentials across countries shape the equilibrium organizational structure.

I. Introduction In a world of two countries, North and South, in which final-good producers are based in the North, final-good producers that operate in the same sector but differ in productivity sort into integrated companies that produce inputs in the North (do not engage in foreign trade in inputs) Integrated companies that produce inputs in the South (engage in FDI and intrafirm trade) Disintegrated companies that outsource in the North (do not engage in foreign trade in inputs) Disintegrated companies that outsource in the South (import inputs at arm’s-length trade) in sectors with low headquarter intensity, firms do not integrate; low-productivity firms outsource in the North whereas high-productivity firms outsource in the South. In sectors with high headquarter intensity, all four organizational forms may exist in equilibrium, and, as in sectors with low headquarter intensity, high-productivity firms import inputs whereas low-productivity firms acquire them in the North. However, among the firms that acquire inputs in the same country, the low-productivity firms outsource whereas the high-productivity firms insource. This implies that the least productive firms outsource in the North whereas the most productive firms insource in the South via FDI.

I. Introduction We use the model to study the relative prevalence of different organizational forms. We show how prevalence depends on: the wage gap between the North and the South the trading costs of intermediate inputs the degree of productivity dispersion within a sector the distribution of bargaining power the size of the ownership advantage (which may be different in the two countries) the intensity of headquarter services Our model predicts: relatively more final-good producers rely on imported intermediates in sectors with higher productivity dispersion or lower headquarter intensity in sectors with integration and outsourcing, which are the sectors with high headquarter intensity, industries with higher productivity dispersion have relatively more final-good producers that integrate As a result, such sectors have more intrafirm trade relative to arm’s-length trade.

II. The Model Two countries, the North and the South A unique factor of production, labor The world is populated by a unit measure of consumers with identical preferences: x0: consumption of a homogenous good Xj: index of aggregate consumption in secor j μ: parameter Inverse demand function for each variety i in sector j:

II. The Model Producers of differentiated products face a perfectly elastic supply of labor in each country Wage rates are fixed and wN > wS The demand parameters μ and a are the same in every industry This helps focus attention on cross-sectoral differences in technology and organizational costs Our aim: to explore how differences in technology interact with organizational choices in shaping industrial structure, trade flows, and FDI. Only the North knows how to produce final-good varieties. To start producing a variety in sector j, a firm needs to bear a fixed cost of entry consisting of fE units of northern labor. Upon paying this fixed cost, the unique producer of variety i in sector j draws a productivity level θ from a known distribution G(θ). After observing this productivity level, the final-good producer decides whether to exit the market or start producing; in the latter case, an additional fixed cost of organizing production needs to be incurred. This additional fixed cost is a function of the structure of ownership and the location of production.

II. The Model Production of any final-good variety requires a combination of two variety-specific inputs: hj(i): headquarter services Can be produced only in the North, with one unit of labor per unit of output mj(i): manufactured components Can be produced in the North and in the South, with one unit of labor per unit of output in each country Output of every variety is a sector-specific Cobb-Douglas function of the inputs: θ: firm-specific productivty parameter ηj : sector-specific productivity parameter The larger ηj is, the more intensive the sector in headquarter services. Two types of agents engaged in production: H: final-good producers, who supply headquarter services M: operators of manufacturing plants, who supply intermediate inputs Every H needs to contract with an M for the provision of components. We allow international fragmentation of the production process, so that H can choose to trans- act with an M in the North or in the South.

II. The Model It follows from our assumptions that all H locate in the North. Upon paying the fixed cost of entry, wNfE, and observing the productivity level θ, the unique final-good producer H of variety i in sector j seeks out a supplier of components M in the North or in the South. Simultaneously, H chooses whether to insource or outsource intermediate inputs. The joint management costs of final and intermediate goods production, such as supervision, quality control, accounting, and marketing, depend on the organizational form and the location of M. All these costs, the sum of which we term « fixed organizational costs », are denominated in terms of northern labor. We denote them by wNfkl k: index of the ownership structure i: index of the country in which M is located and the manufacturing of components takes place. The ownership structure takes one of two forms: vertical integration V outsourcing O The supplier M is located in one of two sites: in the North N in the South S Therefore, k E􏰖 {V, O} and l E􏰖 {N, S}. An organizational form consists of an ownership structure and a location of M.

II. The Model We assume that the fixed organizational costs are higher when M is located in the South regardless of ownership structure, because the fixed costs of search, monitoring, and communication are significantly higher in the foreign country: fkS > fVN and fkS > fON for k =V, O Given the location of M, the fixed organizational costs of a V firm are higher than the fixed organizational costs of an O firm: fVl > fOl for l = N, S As a result of these assumptions, the fixed organizational costs are ranked as follows: We adopt this ordering in order to avoid a taxonomy of cases. There exists a tension between two considerations that affect the ranking of fVl and fOl: the need to supervise the production of intermediate inputs in addition to other managerial tasks raises man- agerial overload and the fixed organizational costs of a V firm relative to an O firm. economies of scope in the management of diverse activities reduce the fixed organizational costs of a V firm relative to an O firm. Our ordering amounts to assuming that managerial overload is more important than managerial economies of scope. Al- though we believe this assumption to be appropriate in many instances, and we therefore maintain it in the main analysis, we shall point out how some of the results change when fVl < fOl

II. The Model The setting is one of incomplete contracts. Final-good producers and manufacturing plant operators cannot sign ex ante enforceable contracts specifying the purchase of specialized intermediate inputs for a certain price. The parties cannot write enforceable contracts contingent on the amount of labor hired or on the volume of sales revenues obtained when the final good is sold. Hart and Moore (1999) and Segal (1999) The parties cannot commit not to renegotiate an initial contract and that the precise nature of the required input is revealed only ex post and is not verifiable by a third party. To simplify the analysis, we just impose these constraints on the contracting environment. Because no enforceable contract can be signed ex ante, final-good producers and manufacturing plant operators bargain over the surplus from the relationship after the inputs have been produced. We model this ex post bargaining as a generalized Nash bargaining game in which the final-good producer obtains a fraction β􏰖E (0, 1) of the ex post gains from the relationship.

II. The Model Following the property rights approach to the theory of the firm, we assume that ex post bargaining takes place both under outsourcing and under integration. The distribution of surplus is sensitive, however, to the mode of organization. More specifically, the outside option of H is assumed to be different when it owns the manufacturing plant than when it does not. In the latter case, a failure to reach an agreement on the distribution of the surplus leaves both parties with no income, because the inputs are tailored specifically to the other party in the transaction. However, by vertically integrating the production of components, H is effectively buying the right to fire M and seize the inputs mj(i). If there were no costs associated with firing the operator of the manufacturing plant, the final-good producer would always have an incentive to seize the inputs mj(i) ex post, and M wouldhave an incentive to choose mj(i) = 0 ex ante (which of course would imply xj(i) = 0). In this case, integration would never be chosen. We therefore assume that firing M results in a loss of a fraction 1 􏰑- δ of final-good production, because H cannot use the intermediate inputs without M as effectively as it can with the cooperation of M. We also assume that δN ≥ δS. This captures the notion that a contractual breach is likely to be more costly to H when M is in the South. More figuratively, we think of this assumption as reflecting less corruption and better legal protection in the North. As is clear from the weak inequality, however, our results still hold when δN = δS. The location of M and the mode of ownership are chosen ex ante by H to maximize its profits. There is an infinitely elastic supply of M agents in each one of the countries. Each final-good producer H offers a contract that seeks to attract a plant operator M. The contract includes an up-front fee for participation in the relationship that has to be paid by M. This fee can be positive or negative; that is, the operator can make a payment to the final-good producer or vice versa. The purpose of the fee is to secure the participation of M in the relationship at minimum cost to H. When the supply of M is infinitely elastic, M’s profits from the relationship net of the participation fee are equal in equilibrium to its ex ante outside option. For simplicity, we set M’s ex ante outside option equal to zero in both countries. It is, however, easy to extend the analysis to cases in which these outside options are positive and different in the North and in the South.

III. equilibrium The organizational structure equilibrium will be determined by: Incentives created by different organizations Differences in their fixed costs Wage differentials across countries. Being in an incomplete contract framework, it means that the contract will be renegotiated at some point in time. Therefore, a bargaining game specification is needed. If the parties agree in the bargaining, the potential revenue from the sale of the final good is given by: (4) The resulting payoffs implies that the final-good producer (henceforth H) appropriate higher fraction of the revenue under integration than under outsourcing, with this fraction being higher when integration takes place in the North. The payoffs ordering are the following: (5)

III. equilibrium As we are in an incomplete contract framework both H and M will choose their quantities noncooperatively. Each one will produce the quantity that maximises their individual profits. Total operating profits are given by: (6) where, (7) As H has to attract an M agent, whose outside option (i.e. if they fail to agree) is zero, and the contract includes a participation fee (t) which can be positive or negative, the final-good production (H) will be the one who decides the organizational form because he will have the incentive to increase t as much as he can (as long as the payoff of M is not negative). As a result:

III. equilibrium Thus, upon observing its productivity level, H will decide the ownership structure and the location of manufacturing that maximizes (6). The productivity threshold will determine whether H exits the industry or not. This productivity threshold depends on the sector’s aggregate consumption index X and implies that (9) In fact, to solve this optimization program, the final-good producer will have to choose the triplet that maximizes (6) Equation (6) puts in evidence that profits are decreasing both with and . Hence, from a cost saving point of view H faces a trade-off as fixed costs are higher in the South and variable costs are lower there ( ). Next, the final good producer cannot freely choose its fraction of revenue . Although a higher gives H a larger fraction of revenue, it also induces M to produce fewer components. Therefore H trades the choice of a larger fraction of the revenue for a smaller revenue level. In fact, this fraction of revenue will be determined as follows: (10)

III. equilibrium Each party’s severity of underinvestment is inversely related to the fraction of the surplus that it appropriates. Therefore, ex ante efficiency requires giving a larger share of revenue to the party undertaking the relatively more important investment.

Iv. Organizational forms Firms face two types of tensions when choosing the organizational form. Regarding the location decision, variable costs are lower in the South but fixed costs are lower in the North. For the ownership decision, the firm has to take into account the fact that insourcing entails higher fixed costs and gives H a larger fraction of the revenue. However, if the effect of M’s incentives are strong enough, H’s profits may be lower under integration (because if H appropriates a large fraction of revenue, M will have no incentive to produce the components). In component-intensive sectors, firms don’t integrate; high-productivity firms outsource in the South, low-productivity firms outsource in the North, and least productive firms exit the industry. In headquarter-intensive sectors we can find the four different organizational forms. The most productive firms integrate in the South and somewhat less productive firms outsource in the South. Firms with even lower productivity acquire components in the North, and among them the more productive integrate and the less productive outsource. Finally, the least productive firms exit.

Iv. Organizational forms Low headquarter intensity sector A low headquarter intensity is depicted when . As indicated by the arrows, profits decrease with increases in . In this situation H prefers outsourcing to insourcing, regardless the manufacturing location because outsourcing has lower fixed costs and it gives H a lower fraction of revenue. Depending on whether the cross-county difference in the wage rate is small or large relative to the cross-country difference in the fixed organizational costs, the resulting equilibrium can have: outsourcing in both countries outsourcing in the South only.

Iv. Organizational forms Low headquarter intensity sector When wage differential is small relative to to the fixed cost differential firms with a productivity higher than the productivity threshold will outsource in the North and firms with even higher productivity will outsource in the South. When wage differential is large relative to the fixed costs all firms with a productivity higher than the threshold will outsource in the South. With this threshold level being the intersection between the red line and the horizontal axis. (6)

Iv. Organizational forms High headquarter intensity sector A high headquarter intensity is depicted when . As indicated by the arrows, profits increase with increases in . The figure 4 shows us that is steeper than for . When wage differential is small relative to the fixed cost differential and when the sector is relatively more intensive in headquarter services, the marginal return of headquarter services is high, making underinvestment significantly costly for H. Therefore, in such a situation, it’s always profitable for H to insource, regardless the manufacturing location because . Integration gives H a larger share of revenue. However, variable costs are lower in the South. For that reason can be steeper or flatter than . This is to say that can be larger or smaller than . Depending on whether the cross-county difference in the wage rate is small or large relative to the difference between and , the resulting equilibrium can have: The four organizational forms; Outsourcing in the North, insourcing in the North and insourcing in the South; Outsourcing in the North and insourcing in the North (6)

Iv. Organizational forms First case: It follows that: (14) Given the orderings in (3) and (14) figure 4 shows us that all four organizational forms exist in equilibrium High headquarter intensity sector (6)

Iv. Organizational forms High headquarter intensity sector Second case: In this event, (14) doesn’t hold anymore because , and there are only two equilibrium possibilities: Either Integration in the North dominates. Consequently, only 3 organizational forms can exist in equilibrium, at best: Outsourcing in the North Insourcing in the North Insourcing in the South (6)

Iv. Organizational forms High headquarter intensity sector Second case: In this event, (14) doesn’t hold anymore because , and there are only two equilibrium possibilities: Or Integration in the North dominates outsourcing and insourcing in the South. Consequently, only two organizational forms can exist in equilibrium, at most: Outsourcing in the North Insourcing in the North Hence, there is no international trade in inputs. (6)

V. Prevalence of Organizational Forms Measure of prevalence: the fraction of firms and market share.

Component-Intensive Sector No firm integrates, low η The fraction of firms that outsource in the South. Lower wage in the south: Raises the profit of outsourcing in the South. Raises 𝜎 𝑀𝑂 𝑆 . The minimal productivity to be active in the sector rises

Component-Intensive Sector The fraction of firms that outsource in the South. Increase in the dispersion of productivity : Raises 𝜎 𝑀𝑂 𝑆 . Higher headquarter intensity: 𝜎 𝑀𝑂 𝑆 is less prevalent Smaller fraction of the surplus from outsourcing in the south (β): Raises the profitability of outsourcing in the South. 𝜎 𝑀𝑂 𝑆 is more prevalent

Headquarter-Intensive Sector Organizational forms

Headquarter-Intensive Sector Lower wage in the South: 𝜎 𝐻𝑂 𝑁 𝑑𝑒𝑠𝑛′𝑡 𝑐ℎ𝑎𝑛𝑔𝑒, 𝜎 𝐻𝑉 𝑁 𝑑𝑒𝑐𝑙𝑖𝑛𝑒𝑠, 𝜎 𝐻𝑂 𝑆 𝑟𝑖𝑠𝑒𝑠 𝑎𝑛𝑑 𝜎 𝐻𝑉 𝑆 𝑟𝑖𝑠𝑒𝑠. Increase of productivity dispersion: Decline 𝜎 𝐻𝑂 𝑁 , Increase 𝜎 𝐻𝑉 𝑆 and ambiguous effect in the others. Higher headquarter intensity (η): Domestic outsourcing is favored relative to foreign outsourcing Integration is favored relative to outsourcing The effects of η on the fraction of firms that insource in the south is ambiguous

Headquarter-Intensive Sector Increase in the revenue shares Increase in 𝛽 𝑉 𝑆 (rises slope of the profit line 𝜋 𝑉 𝑆 ) The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises

Headquarter-Intensive Sector Increase in the revenue shares Increase in 𝛽 𝑉 𝑁 (rises slope of the profit line 𝜋 𝑉 𝑁 ) The fraction of firms that outsource in the north declines and these that insource in the north rises. The fraction of firms that outsource in the south declines and these that insource in the south does not change

Headquarter-Intensive Sector Increase in the primitive bargaining power parameter (β): Shifts the bargaining power in favor of H. Outsourcing becomes more attractive. 𝜎 𝐻𝑂 𝑁 and 𝜎 𝐻𝑂 𝑆 rise, 𝜎 𝐻𝑉 𝑁 𝑎𝑛𝑑 𝜎 𝐻𝑉 𝑆 𝑑𝑒𝑐𝑙𝑖𝑛𝑒𝑠 The fraction of firms that import components rises.

VI. Concluding Comments The high-productivity firms -> South In the same country: high-productivity firms insource. In sectors with very low intensity of headquarter services, no firm integrates. Low-productivity firms outsource at home High-productivity firms outsource abroad.

VI. Concluding Comments The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms. Sectors with more productivity dispersion (lower z), more imported inputs. Within the headquarter-intensive sectors, integration is more prevalent. Higher headquarter intensity, less imported inputs. Lower wages in the south raises the fraction of firms that import intermediate inputs. It raises the fraction of firms that outsource in each country. Arm’s length trade rises relative to intrafirm trade