Vertical FDI, outsourcing and
contracts
Lessons 5 and 6
Giorgio Barba Navaretti
Gargnano, June, 11-14 2006
The issue
• Once the decision to produce in a foreign
country has been taken, how is foreign
production carried out?
– Wholly owned subsidiary
– External contractual relationship
• e.g. why McDonald’s franchises and Gap
owns?
The broad trade off
TRADE OFF:
• Costs of setting up own facilities:
–
–
–
–
Fixed costs
Lack of info
Lack of knowledge of the local market
Inefficient scale
• Costs of an external agreement:
– Contractual failures
Summary of the costs of external
transactions
Table 2.5. The costs of external (market) transactions
Type of Transaction
Type of FDI
Problem
Transferring intangible  Horizontal
 Imperfect
assets
appropriability of
 Vertical
knowledge
 Imperfect
appropriability of
reputation
Carrying out one stage
of production
 Vertical
 Hold up with
incomplete contracts
 Agency with
incomplete
information
Consequence
 Dissipation of proprietary
knowledge
 Dissipation of goodwill
 Underinvestment
 Inefficient scale of
production/sales
Types of contractual failures:
hold-up
• Type of action: Carrying out one stage of
production
• Conditions:
• Incomplete contracts: not all contingencies taken into account
• Product specificity: products with specific characteristics
produced on commission for principal
• Problem:
• High risk of re-negotiation
• Supplier underinvests
• Solution:
• Share rents with local agent
• internalise
Types of contractual failures:
Agency
• Type of action: Carrying out one stage of production
• Conditions:
• Incomplete information: the actions of local agents cannot be
observed by the principal
• Incomplete information: conditions of the local market cannot be
observed by the principal
• Problem:
• Agent minimises effort (Moral Hazard)
• Agent withholds information on the state of the market (Adverse
selection)
• Solution:
• Share rents with local agent
• internalise
Types of contractual failures:
Dissipation of intangible assets
• Type of action: Transferring knowledge or
goodwill
• Conditions:
• Asset too difficult to transfer
• Asset too easy to transfer
• Limited protection of intellectual property rights
• Problem:
• Costly transfer of knowledge
• Dissipation of assets: agent acquires knowledge and starts
production on his own
• Solution:
• Share rents with local agent
• internalise
General setting
• Production involves two activities, x and y
• Revenue is given by R(x,y) and it is an increasing
and concave function of x and y
• The MNE (M) has an advantage in x (e.g R&D,
components etc.):
– Unit cost if undertaken by the MNE: c
– Unit cost if undertaken by another firm: gc with g>1
• The local firm (L) has an advantage in y:
– Unit cost if undertaken by L: a
– Unit cost if undertaken by M: aa with a>1
Efficient allocation of resources
No contractual problem: M carries out x and outsources y to L
•Centralised problem: Choose x and y so as to maximize joint
profits:
,
  R( x, y )  ay  cx
.
.
R y ( x, y )  a
F.O.C.: Rx ( x, y)  c,
Decentralised problem: M sells x to L at price q:
 M  ( q  c) x
 L  R( x, y)  ay  qx
Efficient allocation of resources if M and L price takers and q=c
Hold up: setting
• Investments are relation specific:
x and y can be sold outside the relationship at:
rc  c
and
ra  a
•Contracts are not complete:
=>incentive to engage in opportunistic behaviour
Hold up
Internalised solution: wholly owned subsidiary
.,
Max:
 I  Rx, y   aay  cx
FOC:
R x ( x, y)  c,
R y ( x, y )  aa
External solution: outsourcing
Profits of M:
FOC of M:
Profits of L:
FOC of L:
 O   [ R( x, y )  xrc  yra ]  xrc  cx
Rx ( x, y)  c  (1   )rc
 L  (1   )R( x, y )  xrc  yra   yra  ay
(1   ) R y ( x, y )  a  ra
Hold up special case
R(x, y)  x  y  (1 )
with
 1
the optimised value of revenue is: R * (wx , wy )  A[wx w1y ] /( 1) ,
If production is internalised input costs are: wx  c w y  aa
 I  R *  xwx  ywy  (1   ) R *
and profits:
If production is outsourced input costs are:
wx  [c  (1   )rc ] / 
w y  [a  ra ] /(1   )
and profits:  O   [ R *  xwx  yra ]  [1     (1   )ra / w y ]R*,
 L  (1   )[ R *  yw y  xrc ]  [1   (1   )  rc / wx ](1   ) R *
Hold up special case
Parameter values:
 = 0.5, a = c = 1, ra = rc = 0.5, α = 2 and  = 0.8
 O + L
O
L
I
Z
Z
Bargaining share, 
Figure 5.1: Internalisation vs outsourcing
Hold up and industry equilibrium in
outsourcing
• What happens when we move away from bilateral
relations?
• What determines the number of firms in equilibrium
(multinationals and local contractors)?
• Why in reality we do observe both outsourcers and
internalizers?
• What determines the number of ‘outsourcers’ vs. the
number of ‘internalizers’ (multinational are
heterogeneous)?
• How does the hold-up enter into this picture?
• Grossman and Helpman (2002, 2003), Antras (2004) and
Antras and Helpman (2004)
Trade off
• Benefits from outsourcing
– reduces marginal costs and creates competitive
pressure on non outsourcers (and reduces
margins from further outsourcing)
• Costs of outsourcers:
– matching between outsourcers and local firms
– Hold up
Market for multinational products
•Dixit Stiglitz model of monopolistic competition:
•n firms and varieties,
>1 is the elasticity of substitution between varieties
•Pk and Rk respectively price and revenues earned by kth
variety
•G is the price index and E total expenditure:
k
 
R = p
k 1- 
 -1
G
E
,

 
G = k p
k

1 -  
1 / 1 -  
Profits of the MNE under outsourcing and internalization
MNEs can internalize (I) or outsource (O).
  is the share of MNEs that outsource
• Prices have a constant mark up 1/and
profits are a constant fraction of revenues
=> I=(RI/) and o=(Ro/)
• Profits in the two regimes are given by:
O 
E
,
n [   (1   )a 1 ]
 I   Oa 1 .
(5.14)
Matching of multinationals and local component manufacturers
Component
manufacturers
zO
zzOO
Figure 5.3: Component specification space
Features of matching
•Modification costs incurred by component
manufacturers (m) at a distance z away from their
location: z
•Each component manufatcurers can serve 2nz0
multinationals where z0 is the maximum profitable
distance they can cater to
•Proportion of multinationals that outsource:  = 2mz0
Determining z0, m and n
Define maximum distance that can be catered by
component manufacturers without incurring losses:
 z O = (1 - ) O .
Define number of component manufatcurers m:
2nz O [(1   ) O 
zO
 zdz ]  2nz
O
0
Define number of multinationals n
(1   ) I   O  Fn
 
[(1   ) O   z O
2
/ 2]  Fm .
(5.16)
Describing the equilibrium
E (1   ) z O (2  z O )
Fm 
 [   (1   )a 1 ]
z O
Fn 
[   (1   )a 1 ]
(1   )
Zero profits
lines for
component
producers
zO
Fm
Zero profits
line for
manufacturers
Fn
1/2m

Figure 5.4: Equilibrium outsourcing
Summing up
• It is possible that only a fraction of the
multinationals will outsource
• This fraction will depend on exogenous
parameters like fixed entry costs Fm and Fn
and the modification cost 