The Economics of multinationals: Theory of Vertical fdi lessons 1 and 2 Giorgio Barba Navaretti


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The Economics of multinationals: Theory of Vertical FDI Lessons 1 and 2


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 wi and ri

  • Constant returns to scale, so unit cost functions for each stage are c(wi, ri) and a(wi, ri).

  • 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



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



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 L1, K1, L2, K2

  • 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





Fragmentation and factor price convergence



Fragmentation and factor prices in general equilibrium



Effects on skill structure when firms are heterogeneous



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



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