The Economics of multinationals: Theory of Vertical FDI Lessons 1 and 2 Giorgio Barba Navaretti Gargnano, June,

Objectives and background OBJECTIVES –Investigate different forces affecting the choice of fragmenting production –Investigate effects of production fragmentation BACKGROUND –Simplified version of Helpman (1984) adding VFDI to HO => FPE –Extension in the spirit of Feenstra and Hanson (1996) => Not necessarily FPE

Setting Production is split in two stages: components (c) and assembly (a). Perfect competition Two factors, labour and capital, used in both stages with prices in country i w i and r i Constant returns to scale, so unit cost functions for each stage are c(w i, r i ) and a(w i, r i ). Production of one unit of a uses one unit of c (no substitution between c and primary factors) Trade costs are incurred on shipping final products and components

Cost functions Cost of a unit of output delivered to country k if components are produced in country i and final assembly takes place in j: and for

When do firms fragment production? Countries 1 and 2. 1 is North, has higher wages 1 has advantage in integrated production Assembly is labour intensive (carried out in 2 if production is fragmented) Trade costs same in both directions

Trade costs and production regimes HFDI VFDI export Combined increases in  c and  a

Trade costs and effects on trade

Effects: fragmentation and factor prices in partial equilibrium

Fragmentation in general equilibrium Extension by Helpman and Helpman and Krugman of the H-O model to include FDI 2 countries, 2 goods, 2 factors model Qs: Under what circumstances does FDI occur? What is the effect of FDI on factor prices?  a =1 and  c =1 (free trade in components) or = 4 (no trade in components) Endowments of factors in countries 1 and 2 L 1, K 1, L 2, K 2 One sector is manufacturing (divided in components and assembly) which has fixed factor intensities The rest of the economy is sector Y: employs the entire endowment minus factors employed in M

Fragmentation in general equilibrium, other assumptions Output and mkt clearing factor prices in Y: DEMAND: Incomes in each country are the sum of the returns to the two factors, w i L i + r i K i, i = 1, 2. Consumers have identical homothetic preferences Goods have the same price in both countries => Trade is only driven by international differences on the supply side

Fragmentation and factor price convergence How to explain the Nafta paradox (skill premium rising in Mex and US - Feenstra Hanson)?

Fragmentation and factor prices in general equilibrium

Effects on skill structure when firms are heterogeneous Barba Navaretti, Bertola Sembenelli, 2006

Main issues Vertical investment depend on transport costs and relative factor costs The effects of VFDI on factor prices depends on the relative factor intensities of M’s activities and on the relative factor endowments of countries