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

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

• Giorgio Barba Navaretti

• Gargnano, June, 11-14 2006

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