Strategic Integration and Outsourcing

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1 Strategc Integraton and Outsourcng Baomn Dong and Ruos Wang Abstract. In many ndustres both the nput and fnal good producers are olgopolstc and possess equally effcent technology at each producton stream, yet ther organzatonal forms can dffer substantally. Ths paper reconsders the tradeoffs between vertcal ntegraton and contract outsourcng n an olgopoly setup. Fnal good frms are engaged n a dfferentated product Bertrand competton. Relatonshp specfc nvestment (RSI) and manageral effort exerted by the upstream suppler nfluence the qualty of the ntermedate products and proftablty of all tradng partes. It can be shown that vertcal ntegraton and contract outsourcng can coexst n equlbrum and the results are nvarant to frms productvty levels. Keywords: Vertcal Integraton, Outsourcng, Relatonshp Specfc Investment JEL Classfcaton Number: D0, F, F3. Introducton In recent decades, nternatonal trade of ntermedate nputs has been a dstnct feature of the world economy. A recent report by McKnsey (009) proects that by 0 the sze of global offshorng wll reach US$60 bllon n terms of trade volume. The growth n Asa-Pacfc regon s partcularly rapd: the composte annual growth rate n the regon durng 005 to 0 s 30%. The prmary reason for nput trade growth s n-product trade. The organzatonal forms to realze nput trade can be ether cross-border vertcal ntegraton (FDI) or contract outsourcng, or generc spot market contract. Usng US nput-output table, Feenstra and Hanson (996) fnd that the rato of nput mport aganst total nput procurement rose from 5.3% n 97 to.6% n 990. Hummels, Ish and Y (999, 00) nvent a vertcal specalzaton ndex to measure the degree of vertcal fragmentaton n producton. Ther results reveal that 58% of the global producton fragmentaton occurs among the develop countres, and 36% s between the developed and developng countres, and there s only 8% occurs among the developng countres. The Chnese Mnstry of Commerce, along wth other relevant mnstres, proposed a so-called Thousand-Hundred-Ten Proect 3 n 006 to promote the development of product and servce offshorng. The Chnese government expects to generate over US$0 bllon turnover from offshorng n 00. Although the value of offshorng n Chna ncreased tremendously n recent years, the Correspondng author. Address: Department of Economcs, Unversty of Calforna, Santa Barbara, Santa Barbara, 7, North Hall, UCSB, CA 9306 and Department of Economcs, Unversty of Internatonal Busness and Economcs, Beng, 0009, Chna. Phone: Emal: baomndong@vp.63.com Department of Economcs, Unversty of Internatonal Busness and Economcs, Beng, 0009, Chna The fgure n 007 was only US$60 bllon. The growth rate of offshorng volume by US durng the same perod s %. 3 It refers to develop 000 nternatonally certfed outsourcng suppler natonwde; attract 00 multnatonals to outsource n Chna; and nurture 0 ctes as large outsourcng bases wth nternatonal competence.

2 fgures are stll outnumbered by countres such as Inda 4. McKnsey (009) concludes that three reasons attrbute to such relatvely slow progress,.e., lack of large frms, weak IPR protecton, and low domestc demand. An mportant set of research questons then are centered on the nternatonal organzatonal form of the frms, partcularly the vertcal boundary of the frms. These questons nclude: who wll serve the foregn markets? By what means do they serve foregn markets, FDI or export? How do they procure nputs, through outsourcng or vertcal ntegraton? Under what crcumstances, do they prefer offshorng over domestc outsourcng? Exstng lterature s dvded by two legends. One s the frm heterogenety models by Meltz whch explan why some frms export whle others do not. The other s the endogenous frm boundary models by Antràs whch explan what determne the organzatonal forms of the frms n producton. However, the dvdng lne between the two streams of papers s very thn and ndeed dffcult to dstngush snce they all accept the frm heterogenety assumpton n whch the effcency of the frms are asymmetrc ex ante. Antràs (003) fnds that captal ntensve nput s manly mported from the subsdares of multnatonals overseas, and labor ntensve nput s manly procured by outsourcng from ndependent frms. Anecdotal evdence was gathered to support such clam. Antràs and Helpman (004) study a Rcardan model where fnal product can be only manufactured n the North, and conclude that most effcent Northern frms procure the nput from South va ntegraton, and less effcent frms procure nput from the North or the South but through outsourcng.industres wth hgher productvty varaton tend to rely on mportaton of nput, where n headquarter ntensve ndustres, vertcal ntegraton s more prevalent. The results of Antràs and Helpman (004) are mpled by Hart and Moore (990) where fnal product manufacturers who have stronger barganng power gan more from vertcal ntegraton than outsourcng. However, snce ncentve scheme s low powered f producton of nput s done nternally, vertcal ntegraton may not be proftable. Hence, decsons on the choces of the organzatonal forms are based on the tradeoff between upstream-downstream barganng power and ncentve msalgnment. Spencer and Qu (00), Qu and Spencer (00) argue that more productve nvestors produce specalzed components or parts domestcally and mport standard or generc components. Head, Res and Spencer (004) consder the case that fnal product manufacturers produce nput overseas through FDI. Ths lne of lterature compares nput contractual outsourcng va ncomplete contract and purchase from spot market. Because the supplers nvest n specalzng the components, the property rghts approach suggests that fnal-good frms who produce specalzed components n-house to procure generc components at the spot market. Grossman and Helpman (004) study the tradeoff between vertcal ntegraton and nternatonal outsourcng through an ncentve approach. Snce agent provdng ntermedate good s subect to moral hazard, there s a tradeoff between greater montorng under vertcal ntegraton and hgher-powered ncentves for effort under outsourcng. Under the tradtonal assumpton that fnal good can be only produced n the North, the optmal organzatonal forms accordng to productvty rankng are n sharp contrast wth those of Antràs and Helpman (004). Feenstra and Spencer (005) argue that supplers n the North can take advantage of proxmty n 4 Statstcs show that the annual growth rate of offshorng n the man servces supplers was 5-0% n Chna, where t was 30-40% n Inda.

3 undertakng relatonshp-specfc nvestment (RSI), on the other hand, producng at the South through FDI s less expensve margnally. Fnal good can be produced n the South by supplers who make RSI. Accordng to the productvty rankng of RSI, fnal good producer may choose the followng organzatonal forms: for hghest productvty frms, both RSI and producton takes place n the North; at a lower productvty level, Northern supplers shft producton, but not RSI, to the South; as productvty further decreases, Southern supplers undertake both RSI and producton n the South; fnally parts are mported as genercs from a spot market n the South. Therefore the orderng of organzatonal forms s dfferent from ether Antràs and Helpman (004) or Grossman and Helpman (004). Feenstra and Hanson (003) fnd that multnatonal frms engaged n export processng n Chna tend to splt factory ownershp and nput control wth local managers: the most common practce s to have foregn factory ownershp but Chnese control over nput purchases. They argue that ths s n relaton wth market thckness and contractng costs 5. Here control rghts assgnment allevates the moral hazard problem by the manager. Exstng lterature ether models outsourcng versus vertcal ntegraton usng monopolstc competton setup or hghly restrcted partal equlbrum models. However many ndustres are olgopolstc, ncludng both ntermedate nput (such as ron ore, coalmnes, arcraft engnes) as well as fnal good ndustres (e.g., steel, thermal plant, shpbuldng, arcraft manufacture, and numerous consumer products ndustres). In some ndustres, both upstream and downstream are olgopolstc. In such cases, approaches n monopolstc competton models where strategc consderatons are completely gnored are ll-suted snce and the results are questoned. Although there are few olgopoly models n analyzng the relatonshp between nternatonal outsourcng and vertcal ntegraton, the lterature s not completely slent. For nstance, McLauren (000) fnds that market thckness s a determnant of contractual choces. Jones, Kerzkowsk and Chen (005) pont out that as globalzaton deepens and wth lowered entry barrers, competton for frms n the same ndustry becomes fercer, hence weakens the advantages of outsourcng network owned by the multnatonals. Small and medum enterprses (SMEs) may also use nternatonal outsourcng to procure ntermedate nputs. Ths mples that frm productvty may not be an overwhelmng factor n determnng frms nternatonal organzatonal forms. The current paper sets out a framework to study the equlbrum organzatonal choces by olgopolstc frms to serve nternatonal markets. To capture the essence of all strategc aspects of the model, we follow Hart and Trole (990) as a closed economy benchmark. The current paper apples ncomplete approach to study the choce between outsourcng and vertcal ntegraton n a North-South settng. The producton of ntermedate good requres RSI, or dosyncratc nvestment n the termnology of ndustry organzaton. RSI s often uncontractble or unverfable hence the nvestor s subect to holdup 6. Antràs (005) consders that contracts between 5 Grossman and Helpman (005) beleve that market thckness, measured by the number of supplers for nput n the market, s an mportant determnant of transacton costs. A thcker market mples that t s easer for an ndependent fnal good producer to fnd a specalzed nput suppler hence the advantage of vertcal ntegraton s weakened. 6 Hart and Moore (988) argue that even f the nvestment and the payoffs can be observed by the contractng partes, holdup problem stll perssts f they can not be verfed by a thrd party such as a court. 3

4 cross-border frms are more dffcult to enforce than contracts wth partes from the same country. Head, Res and Spencer (004) emphasze the mportance of demand sde nformaton on RSI. In order to allevate the holdup problem, fnal good producer may share the nvestment cost of RSI, however the fnal good frm would then run on the rsk of the opportunsm by the suppler. If the amount of nvestment requred s large enough, ex ante effcency calls for vertcal ntegraton by fnal good frm n order to obtan resdual control rghts. Exstng models then conclude that multnatonals usually vertcally ntegrate upstream supplers through FDI to procure ntermedate goods f they are captal ntensve, and use non-ntegraton organzatonal forms such as contract outsourcng to procure f the ntermedate goods are labor ntensve 7. But usng Brtsh manufacture ndustry data, Acemoglu et al (004) fnd that when supplers are technology-ntensve, contract outsourcng rather than downstream ntated vertcal ntegraton s more lkely. Moreover, ther emprcal result on the relatonshp between vertcal ntegraton and degree of market competton dffers from theoretcal predctons,.e., fercer market competton would result dyng out of large vertcally ntegrated frms. Emprcal evdence also ndcates that RSI and contract ncompleteness does not necessarly result vertcal ntegraton. For nstance, t s common to use smple ncomplete contracts wthout renegotaton mechansms to govern the vertcal relatonshps n Japanese automoble ndustry. Ths mples that vertcal ntegraton does not perform as well as the theory predcts (Asanuma (989)). On the other hand, ncentve problems are emnent when supplers control ntermedate nputs 8. The ntensty of contract nput affects the ncentve provson by the fnal good frm, hence determnes the fnal good frm s choce on outsourcng versus vertcal ntegraton. One of the man weaknesses of most exstng theoretcal models s the lack of consderatons on frms strategc behavor. Ths s because most papers use monopolstc competton model. Suppose that there are multple upstream supplers for ntermedate components. In equlbrum, only one suppler who maxmzes the gan wll match one downstream fnal good producer, hence the ntroducton of multple upstream supplers may not be mportant. Moreover, snce the fnal good frm wll only choose one suppler n equlbrum, there wll not be so many supplers to emerge at the frst hand. When contract s ncomplete, dosyncratc nvestment results n holdup by the non-nvestng party and vertcal ntegraton s the tool to mtgate such holdup whch can nduce effcent upfront dosyncratc nvestment. Ths s llustrated by early lterature such as Wllamson (975, 985), Klen, Crawford and Alchan (978), Grossman and Hart (986), Hart and Moore (990). There are three organzatonal form choces between an upstream suppler and a downstream fnal good frm,.e., backward vertcal ntegraton, forward vertcal ntegraton, and non-ntegraton 9. Generally speakng, forward vertcal ntegraton gves more power to the suppler, hence nduces more effcent upstream dosyncratc nvestment. Backward vertcal ntegraton yelds more power to the fnal good producer hence nduces effcent downstream dosyncratc nvestment and lowers 7 Spencer and Qu(00), Qu and Spencer (00), and Head, Res and Spencer (004) clam that buyers external choce s to purchase standard or generc components and parts from the target (country s) market. Head, Res and Spencer (004) consder that multnatonals may also contract wth supplers from home country. 8 Grossman and Helpman (004) fnd that domestc workers are easer to montor. 9 Backward vertcal ntegraton refers to the case where downstream frm acqures the upstream suppler and obtans fall resdual control rghts. Forward vertcal ntegraton refers to the opposte. Non-ntegraton refers 4

5 the suppler s barganng power 0. Although vertcal ntegraton can elmnate holdup problem, but there ncurs a cost of lower-powered ncentves snce the management can not commt to not nterference the upstream dvson. On the other hand, the beneft of effort by the manager of an upstream dvson wthn a vertcal ntegrated frm s dluted compared wth an unafflated upstream suppler s. Therefore the moral hazard problem by the dvson manager becomes more severe hence requres a hgh powered ncentve scheme. The lterature on vertcal ntegraton n an olgopoly envronment s rch, e.g., Ordover,Saloner and Salop (990), and Bolton and Whnston (993) etc. However the results are very senstve to the assumptons of market structure hence consensus was hard to reach untl Hart and Trole (990) (henceforth HT) who propose a unfed analytcal framework. Vertcal ntegraton s of vtal mportance n regulatory and ant-trust economcs. Although vertcal ntegraton can mprove effcency n a compettve settng, t may be used to foreclose rvals hence dsplays ant-compettve nature. HT s a framework that elaborates market mperfecton and savngs n transacton costs and accommodates many assumptons. The current paper extends HT to the case of nternatonal trade and nvestment. The paper attempts to answer the followng questons: when complete outsourcng occurs? When asymmetrc equlbrum arses? When complete vertcal ntegraton happens? In partcular, we explore the ncentve and proftablty of outsourcng and vertcal ntegraton n asymmetrc equlbra. In complete vertcal ntegraton case, when eager bandwagon occurs and under what condtons reluctant bandwagon arses. To the best of our knowledge, ths s the frst paper to study endogenous nternatonal frm boundary n an olgopoly settng. The rest of the paper s as follows. Secton lays out the basc model. Secton 3 dscusses two mportant varants of the basc model. Secton 4 concludes the paper.. The Model Wthout loss of generalty, assume that there are two downstream frms who produce fnal goods, two upstream supplers who produce specalzed components. The cost of wrtng (and enforcng) long term ex ante contract between an upstream frm and a downstream frm s so hgh that complete contract nput procurement s mpossble. Therefore the only way to nfluence ex post behavor s to rearrange the resdual control rghts over the assets. Nevertheless, when the resdual control rghts of one stream, partcularly the upstream s, s obtaned by a frm n another stream, the ncentve scheme for the manager of the vertcally merged frm now dffers from that of the spot market or contract outsourcng competton. The decson to vertcally ntegrate the upstream suppler s the tradeoff between allevaton of undernvestment resulted by holdup, and ncreased agency costs n the upstream dvson. We assume that agency cost s hghest for cross border management. In the scarce demand varant, the vertcally ntegrated frm has the ncentve to supply ntermedate goods for the downstream compettor. Because n such a case, the RSI level s effcent hence the ntegrated frm can offset the moral hazard costs by scale economes n ntermedate good producton. 0 But may also reduce the ncentve to nvest on upstream RSI f nvestment decsons are not perfectly effcent wthn the boundary of the frm. 5

6 U U U U D D D D Fgure. Vertcal and Horzontal Structure of the Model Fnal good frms engage n dfferentated product Bertrand competton. Consumers prefer hgh qualty product. The qualty of the fnal product s publcly observable. The market for ntermedate goods s blateral olgopoly. There are two upstream frms U and U, and two downstream frms D and D. Frms n the same producton stream are homogeneous ex ante. We do not make ad hoc assumptons on productvty dfference to avod trval results. The demand functon for vertcally dfferentated product Bertrand competton can be wrtten as: where ( ) q = a p I, e + θ k p I, e,,,,, = k refers to the qualty of frm s product, and t s a functon of upstream RSI e,or k k ( I, e ) () I and the effort of the manager of upstream suppler. Assume that the margnal qualty mprovement by effort or RSI decreases or qualty s a convex functon of ts arguments,.e., k > 0, I k I < 0; k > 0, e k e < 0; k I e < 0; where I I, I, e e, e. To focus on the equlbrum dosyncratc nvestment levels and the changes of the boundary of the frms, assume that downstream producton s constant return to scale technology and qualty of the ntermedate nput k completely transmtted to the fnal good. Qualty dfference results dfferent substtutablty of the two fnal goods. Denote θ k the mpact of the qualty of frm s goods on frm s product substtutablty. Assume that the two fnal products are substtutes,.e., θ k < 0 and assume the wllngness to pay for hgher qualty s The dashed curve represents the boundary of an ntegrated frm. 6

7 θ < decreasng at the margn, or k 0. The cost of producng fnal goods wth qualty k s (, ) C C C I e and < 0, I C I > 0; C e < 0, C e > 0; C I e < 0. Downstream frms compete non-cooperatvely. At a gven qualty level, equlbrum prce (nverse demand) can be wrtten as, ( ) a+ C + θ k a C + p = 4 θ k θ ( k ). Varant : Scarce Demand To make the analyss more nterestng, gnore the ex post monopoly case n orgnal HT model. In scarce demand varant, we have, q U + U U arg max q q = π m m (3) where subscrpt m represents monopoly level. () In non-ntegraton or full outsourcng equlbrum, each downstream frm D obtans a fracton β of ntermedate nput from upstream frms U and U. The two symmetrc frms realze the same proft level, or D NI = βπ = β p q p, p C,,,; = U NI = U NI = β π + π (5) ( )( ) (4) In partal ntegraton case, assume wthout loss of generalty, frm U and frm D vertcally ntegrate, whch can be denoted by V : U D. Frms U and D stll keep unafflated. The undernvestment n V s then resolved, however the moral hazard problem by the upstream dvson manager becomes severe. Therefore, there are 3 choces for U. Frst, sell all ntermedate goods produced through contract outsourcng to D and share profts wth D. Second, sell all nput to V hence V monopolze fnal good market. Thrd, supply nput to both D and V where a proporton of α 7

8 s suppled to the ntegrated frm V. In the frst scenaro, D and V conduct dfferentated product Bertrand competton and we have, V = π E (6) (, ) D = βπ = β p q p p C U = ( β ) π (8) where E s the sunk cost for vertcal ntegraton. Because undernvestment s resolved n ths case for the ntegrated frm, the qualty of nput n V may be hgher than that of U. (7) If U chooses the second choce, then V becomes a monopolst for fnal goods, therefore, + β V = π E m (9) U = ( β) π m (0) U U U U D D D D Fgure. Domestc Full Integraton and Cross-Border Partal Integraton The thrd choce s a combnaton of the frst and second choces. For a gven ranges of demand and cost parameters the frst scenaro may arse n equlbrum snce supplyng nput to V would result n downstream monopoly hence lowers U s barganng power. In the frst scenaro, the qualty of nput suppled to D may not be necessarly lower than those produced by V. Ths s because even though U s now an unafflated upstream frm, V may supply the nput wth correct qualty to D hence U wll have to make effcent RSI n order to survve n the market. D 8

9 s wllng to gve a (weakly) favorable terms to U for contract outsourcng snce f otherwse V may foreclose D gven U s out of the market. Proposton. When demand s scarce and homogeneous frms, asymmetrc equlbrum or partal ntegraton may arse. Remark.. Varant : Scarce Supply In scarce supply case, both D and V wll compete for the procurement of the nput produced by U. Because V s vertcally ntegrated hence does not have an ncentve to supply ntermedate goods to ts downstream rval when supply s scarce. U wll choose frst best dosyncratc nvestment level even as an unafflated frm. Hence, partal ntegraton may arse n equlbrum n scarce supply case as well. Proposton. (to be added) 3. Concluson To be detaled. Reference: Acemoglu, D., Aghon, P., Grffth, R. and Zlbott, F. (004) Vertcal Integraton and Technology: Theory and Evdence, Workng Paper. Antràs, Pol Frms, Contracts, and Trade Structure Quarterly Journal of Economcs, 8(4): and Helpman, E. 004, Global Sourcng, Journal of Poltcal Economy, (3): and Stager, R. 008, Offshorng and the role of trade agreements, NBER workng paper. Bernard, Eaton, Jensen and Kortum (003) Plants and Productvty n Internatonal trade, Amercan Economc Revew. 93(4), Feenstra, R. C, 998, Integraton of Trade and Dsntegraton of Producton n the Global Economy, Journal of Economc Perspectves, (4): 3-50 and Hanson, G., 996, Foregn Investment,Outsourcng and Relatve Wages The Poltcal Economy of Trade Polcy: Papers n Honor of Jagdsh Bhagwat, MIT Press. and, 003, Ownershp and Control n Outsourcng to Chna: Estmatng the Property- Rghts Theory of the Frm, NBER workng paper no

10 and B. J. Spencer, 005. Contractual versus Generc Outsourcng: the Role of Proxmty, NBER Workng Paper No. 885 Grossman, G., and Elhanan Helpman, 00, Integraton vs. Outsourcng n Industry Equlbrum Quarterly Journal of Economcs, 7(): and, 004, Manageral Incentves and Internatonal Organzatonal of Producton Journal of Internatonal Economcs, 63: and, 005, Outsourcng n a Global Economy Renew of Economc Studes, 7(): Grossman, Gene M., Helpman, Elhanan and Szedl, Adam (006), Optmal ntegraton strateges for the multnatonal frm, Journal of Internatonal Economcs, 70(): 6-38, Grossman, Sanford, and Hart, Olver (986) The Costs and Benefts of Ownershp: A Theory of Vertcal and Lateral Integraton, Journal of Poltcal Economy, 94(4): Hart, Olver, and Jean Trole Vertcal Integraton and Market Foreclosure. Brookngs Papers on Economc Actvty: Mcroeconomcs, Helpman, E., 006. "Trade, FDI, and the Organzaton of Frms," Journal of Economc Lterature, 44(3): , Meltz and Yeaple, (004) Exports vs FDI wth Heterogeneous Fms Amercan Economc Revew. 94(): Hummel, D., Ish, J., and Y, Ke-Mu (00), The Nature and Growth of Vertcal Specalzaton n World Trade Journal of Internatonal Economcs, 54: Jones, Ronald, Henryk Kerzkowsk, and Lurong Chen 005. What Does Evdence Tell Us about Fragmentaton and Outsourcng? Internatonal Revew of Economcs and Fnance, 4: and Kerzkowsk, H., 998, Globalzaton and the Consequences of Internatonal Fragmentaton, n Gullermo Calvo and Maurce Obsfeld, eds,. Money, Factor Moblty and Trade, Cambrdge, MA: MIT Press. and 00, Horzontal Aspects of Vertcal Fragmentaton n Leonard K. Cheng and Henryk Kerzkowsk, eds., Global Producton and Trade n East Asa. Boston, MA: Kluwer Academc McLaren, John 000. Globalzaton and Vertcal Structure Amercan Economc Revew, 90(5): Meltz (003), The Impact of Trade on Intra-Industry Reallocatons and Aggregate Industry Productvty, Econometrca, 7: Ordover, Saloner and Salop, 990, Equlbrum Vertcal Foreclosure, Amercan Economc Revew, 7-4. Qu, Larry D. and Spencer, Barbara J., 00. "Keretsu and relatonshp-specfc nvestment: mplcatons for market-openng trade polcy," Journal of Internatonal Economcs, 58(), 49-79, Rey, P. and Trole, J., 007 "A Prmer on Foreclosure", Handbook of Industral Organzaton, vol. III, Mark Armstrong and Rob Porter eds, North Holland, Spencer, Barbara J and Qu, Larry D, 00. "Keretsu and Relatonshp-Specfc Investment: A Barrer to Trade?" Internatonal Economc Revew, 4(4), Swenson, Deborah L. 005, Overseas Assembly and Country Sourcng Choces Journal of Internatonal Economcs, 66: