The Multinational Firm
Stephen Ross Yeaple
Penn State University and NBER
December 19, 2012
Abstract: This paper documents the recent advances in the international trade literature toward
understanding the role of multinational firms in the conduct of international commerce. Over the
last ten years, we have developed a better understanding of the incentives firms face in where
they locate production, and we know more about the incentives that induce firms to vertically
integrate. Further, the theory literature has progressed from two country models that cannot
capture the richness of multinational firms’ activities to multi-country models that do. The
empirics have advanced as well but at a slower pace. Progress has been slowed by the lack of
comprehensive data and the difficulties of distinguishing between the various mechanisms
proposed by theory.
JEL Codes: F23, F12, L22, L24, L25
Key words: foreign direct investment, horizontal integration, vertical integration, internalization,
offshoring.
1. INTRODUCTION
International trade theory has increasingly focused on the firm as an important unit of analysis.
This trend is a response to the empirical observation that international activity is concentrated in
a small number of very large firms and to the development of theory that has emphasized
increasing returns to scale, imperfect competition, and contracting frictions between agents.
This article reviews the state of the economics literature on the multinational firm.
Multinational firms own production facilities in multiple countries. They obtain these facilities
by engaging in foreign direct investments, where the investments involve either acquiring a
substantial controlling interest in an existing foreign firm (cross border acquisitions) or in
establishing an entirely new facility in a foreign country (greenfield investment). While the
corporate structure of a multinational firm can be complicated, it is useful to define two types of
entities within a multinational firm that are associated with ownership structure, the parent and
the affiliate. Parents are entities that are located in one country that own establishments, the
affiliates, located in other countries.
The study of the multinational firm is centered on several broad and interrelated
questions. First, what induces firms to open production facilities in some countries but not
others? This is a question about what economic activities the firm undertakes and the
attractiveness of certain locations for performing these activities. Second, why is it that so few
firms become multinational and how do the firms that do differ from those that do not? Third,
when firms choose to operate a foreign affiliate, how do they obtain this facility? Do they open a
new establishment, buy an existing facility, or open a joint venture with a local firm? Finally,
1
why do firms own foreign facilities rather than simply contract with local producers or
distributors? This is a question about the boundaries of the firm in an international context.
The Ownership, Location, and Internalization (OLI) framework of Dunning (1977) is
often used to organize ideas regarding the answers to these questions. There must be some firm
specific advantage (ownership), such as technology, that explains why a firm would be able to
compete in an unfamiliar environment, a location advantage associated with various countries to
motivate a desire for international production, and an internalization advantage that explains why
markets are not a good substitute for hierarchical control within the firm. While this
classification scheme is useful, a moment’s reflection suggests it might be excessively tidy. A
firm characteristic might provide an advantage in one location and a disadvantage in another. In
some locations a firm may be able to use arm’s length markets effectively while in others it is
better to vertically integrate. Nevertheless, this framework will prove useful in our discussion of
the literature.
As we are focused on the firm and how it organizes its global production, it is natural to
consider first what types of ownership advantages a firm might have. Much of the literature
focuses on the role of intangible assets that have been either created internally or acquired
externally. These assets, which include proprietary technology or reputation, have the
characteristics of a public good in the sense that they exhibit a degree of non-rivalry within the
firm. The development of these assets often has a fixed or sunk cost nature and the use of these
factors in many different locations simultaneously allows economies of scale to be exploited.
Replicating or horizontal investment are names given to the phenomenon when the same
intangible asset is used to support the same production activity in multiple locations.
2
Another strand of this literature focuses on situations in which the production process for
a particular good is amenable to fragmentation into activities that can be geographically
separated. When different countries might then have a comparative advantage in different
activities, geographic dispersion of production is efficient. We refer to the relocation of
production activities overseas as “offshoring.” When various activities are done within the firm,
we refer to this as vertical integration. When activities are done for the firm by arm’s length
suppliers we refer to this as “outsourcing.”
Both strands of this literature emphasize that multinational firms arise when contracting
frictions make integration of activities within the firm superior to arm’s length transactions on
markets. Coase (1937) made the observation that firms exist when hierarchical control of factors
of production is more efficient than the use of a market mechanism. Extending that logic to an
international context, multinational firms exist when common ownership of productive facilities
across international borders is more efficient than market transactions. For instance, a firm
might prefer to manage multiple plants rather than license the use of its intangible assets to
unrelated parties when it is difficult to prevent an unrelated party from abusing the asset.
Outsourcing may be difficult for many activities due to the nature of their production process,
such as variation in the quality of output or the degree of relationship-specific investments that
must be made by individual agents in order for production to take place.
The review will limited in focus. There will be no effort to be encyclopedic given the
space constraint and the fact that there are a number of very useful surveys of the literature.
More comprehensive treatments include the monographs of Caves (2007), Markusen (2002), and
Navaratti and Venables (2004). While we cannot avoid covering some of the same ground as
3
these earlier surveys, we will focus primarily on the theoretical and empirical work of the last ten
years.
The remainder of this review is organized into four sections. Section two briefly
describes the data available to analyze the global operations of multinational firms and provides
a list of “stylized” facts about the multinational firm. Section three focuses on the integration of
the multinational firms into standard trade models and the relevant empirical literature that both
informs the design of these models and tests these models’ predictions. The papers discussed in
section three have the common feature that they take the need for internalization as given. The
fourth section addresses the literature that is primarily focused on the issue of internalization.
Section five concludes.
2. FACTS ABOUT MULTINATIONAL FIRMS
This section serves two purposes. First, we describe some of the available data that can
be used to infer features of multinational firms’ behavior. Second, we discuss several “stylized
facts” concerning the structure of multinational firms’ operations.
DATA SOURCES
Measuring the global operations of multinational firms is difficult. Most data is collected
by government agencies with narrow mandates and limited resources. Publicly available data are
typically collected at the country level while the multinational firm spans multiple countries. We
4
describe three classes of data that can be accessed with various degrees of difficulty, balance of
payments data, government-collected operations data, and customs data on intra-firm trade. 1
All countries collect data on their balance of payments and one component of this data is
foreign direct investment (FDI). FDI occurs when a firm from one country obtains a controlling
ownership stake (usually 10 percent) in an enterprise in another country or when a financial flow
occurs between parties that are resident in different countries but are related by ownership. 2
These financial flows include equity capital, reinvested earnings, and capital associated with
inter-company debt transactions. As the balance of payments measures financial flows between
countries they may say little about the extent of real economic activity in either the sending or
receiving country. Data on FDI flows are reported by the International Monetary Fund, the
United Nations Center for Trade and Development (UNCTAD), and the Organization for
Economic Cooperation and Development (OECD).
Most governments conduct a census of the firms that operate in their country. Many
surveys require a firm to identify whether it is foreign owned or not, allowing researchers to
assess the differences between domestic firms and local affiliates of foreign firms. Further, some
countries require their resident firms to report whether they own foreign affiliates so that it is
possible to compare parent firms’ characteristics to the population of firms. These data cannot
be used to assess the structure of multinational firms’ global operations.
1
There several private datasets on the global operations of multinationals. Examples are the Amadeus database,
compiled by Bureau van Dijk, and Worldbase, compiled by Dun and Bradstreet. Thompson Financial also compiles
data on cross border mergers and acquisition activities.
2
Where possible, we limit our attention to majority-owned affiliates (foreign ownership exceeds 50 percent)
because for these firms actual foreign control is more likely.
5
Publicly collected data on the global operations of firms is rare. One of the few sources is
the Bureau of Economic Analysis (BEA) of the United States. The BEA conducts extensive and
mandatory surveys of U.S. multinational firms, collecting information on the activities of the
U.S. resident parents and their foreign affiliates. 3 A few other countries, such as Germany and
Japan also conduct surveys of Multinational Firms’ global operations. These data tend to be
proprietary and require special permission to obtain access.
Coverage of the global structure of multinational firms’ operations, although uneven, is
far better recorded than the alternatives to multinational production, such as licensing contracts
and contracts with arm’s length suppliers. Some information can be gleaned by customs data
that distinguishes between related and unrelated party trade. For instance, U.S. customs records
for each transaction whether the transaction is between related parties (defined by ownership
between exporter and importer) and unrelated parties. Transaction level data is confidential, but
industry-level data are available on-line. 4
In the remainder of this section, we sketch a portrait of the operations of multinational
firms bearing in mind that this portrait is unavoidably incomplete.
STYLIZED FACTS
We organize our discussion of robust patterns in the data on Multinational Firms into four
areas. First, we discuss the geographic structure of global production within multinational firms
focusing on the level of development of the countries in which these firms are most active and
3
The BEA also collects data on the U.S. affiliates of foreign companies but this data does not provide information
about the characteristics of the non-U.S. activities of these firms.
4
U.S. related party trade data can be downloaded from http://sasweb.ssd.census.gov/relatedparty/.
6
the physical distance between their facilities. Second, we discuss the industrial characteristics
associated with high levels of multinational activity across industries and the characteristics of
multinational firms relative to non-multinationals within industries. Third, we discuss aspects of
vertical specialization across countries within multinational firms. Finally, we discuss how it is
parent firms come to be associated with their foreign affiliates, concentrating on the tradeoff
between buying existing concerns and opening entirely new establishments.
Multinational firms account for a large share of global production. According to the
estimates of UNCTAD in its World Investment Report 2011, Multinational Firms account for 25
percent of global GDP and a third of international trade. The importance of multinational firms
in economic activity varies considerably across country-pairs within industries and within
country-pairs across industries. For developed countries, sales by foreign affiliates to foreign
customers tend to be a far more important means of serving foreign markets than are exports
from the home country. For instance, according to BEA data, in 2009 the sales of the foreign
affiliates of U.S. firms were nearly $5 trillion while U.S. exports were only slightly greater than
$1 trillion. We begin our discussion of the variation in multinational activity across country with
stark patterns associated with level of economic development.
The most comprehensive data on the relative importance of multinational firms in
economic activity across countries can be gleaned from FDI data. It is well documented that
most multinational activity is confined to developed countries. According to UNCTAD’s World
Investment Report, 2011 developed countries accounted for 82 percent of the outward FDI stock
and 66 percent of the inward stock. The tendency of multinational firm activity to be
concentrated in developed countries is confirmed by the BEA data. In 2009, the share of the
7
value added by the affiliates of U.S. multinationals in developed countries was 73 percent
(Barefoot and Mataloni, 2011). 5 In 2009, the value-added of the affiliates of foreign firms
operating in the United States accounted for $550 billion with seven countries – Canada, France,
Germany, the Netherlands, Switzerland, the United Kingdom, and Japan – accounting for 75
percent of foreign affiliate value-added in the United States (Anderson, 2011). 6
We summarize this information as the following fact.
Fact 1: The parents and affiliates of multinational firms are primarily located in developed
countries. Affiliates are better represented in developing countries than are parents.
We now turn to the geographic patterns concerning the activity of multinational firms.
According to data from the 2009 Benchmark Survey of the BEA, 68 percent of U.S. based
multinational’s employment is at their parent firm while only 32 percent is accounted for by their
majority-owned foreign affiliates. In this sense, the national identity of a firm appears to be
strong. Over time, however, the share of parent firm employment in a U.S. multinationals’ global
employment has fallen from nearly 79 percent in 1989.
Now consider the location of affiliates relative to their parents. Estimates from gravity
equations show that in the aggregate and at the level of the firm, multinational firms’ production
activities drop rapidly in distance between the parent and the foreign location and the pace of this
decline is only modestly lower than the decline in export sales. These gravity results have been
5
The concentration of activity in developed countries has dropped in recent years. In 1999, the value-added of U.S.
owned affiliates in developed countries accounted for 89 percent of the global value-added of U.S. owned affiliates.
6
Multinational firms that originate from developed countries may have a different investment behavior than those
from developed countries. Lipsey and Sjöholm (2011) discuss some evidence that they may be more likely to invest
in other developing countries than are firms from developed countries. See also Fajgelbaum, Grossman, and
Helpman (2012).
8
shown for both multinationals that originate in developed countries (Buch et al 2005, Yeaple
2009, Chen and Moore 2010) and for multinationals that originate in developing countries
(Fajgelbaum, Grossman, and Helpman, 2012). Brainard (1997) and Helpman, Melitz, and
Yeaple (2004), among others, show that the foreign sales of U.S. multinationals’ affiliates are
suppressed less by measures of trade costs than are exports from the United States.
This information is summarized as fact 2.
Fact 2: Most economic activity within multinational firms is concentrated in the parent country,
and the economic activity of affiliates is concentrated in countries that are close to their parents.
Affiliates sales are less geographically concentrated than are exports, however.
We now turn our attention to the cross-industry variation in the importance of
multinational firms in economic activity. According to BEA and OECD data, multinational
activity as measured by the share of an industry’s sales or employment can be predicted by
features of an industry’s technology. Affiliates located in developed countries account for a
larger share of host country value-added and employment in high R&D and capital intensive
industries. U.S. customs data also show that industry R&D and capital intensity play an
important role in predicting the share of international trade that is conducted within multinational
firms rather than at arm’s length (e.g. Bernard, Jensen, Redding, and Schott, 2012).
It is important to note that much of the existing evidence is gleaned from developed
country data. There is some evidence that multinationals that originate from developing countries
may be predominantly in different industries than are those from developed countries. Lipsey
and Sjöholm (2011) provide a meta-analysis of a number of studies and conclude that the
affiliates of developing country multinationals are more concentrated in unskilled labor intensive
9
industries such as Food, Textiles, Apparel, and Wood products than the affiliates of developed
country multinationals. This suggests that the nature of ownership advantages of multinationals
depend in part on their source country.
We summarize this information in the following fact:
Fact 3: Multinational firms account for a larger share of economic activity in capital and R&D
intensive industries, although that pattern is less pronounced among developing country
multinationals.
We now turn to how multinational firms differ from non-multinationals within industries.
There is substantial evidence that both the parents and affiliates of multinational firms are much
larger, more productive, and more export oriented than other firms within the same industries.
For instance, BEA and Census data for 2009 reveal that the 1,079 U.S. parent firms in
manufacturing industries accounted for less than 1 percent of U.S. manufacturing firms but 59
percent of employment, 61 percent of value-added, and 44 percent of exports. Similar patterns
emerge for the affiliates of multinational firms. 7 In France, multinational affiliates accounted for
2 percent of manufacturing enterprises but 26 percent of employment and 32 percent of sales and
40 percent of exports (OECD, 2007). 8
The export participation by affiliates of multinational
firms relative to domestic firms is particularly high for a number of export oriented economies.
According to Manova et al (2011), firms with foreign ownership participation account for 77
7
Using Customs data on related party trade, Bernard, Jensen, and Schott (2009) show that multinational entities,
(U.S. parents and the U.S. affiliates of foreign firms) account for up to 90 percent of U.S. trade.
8
See also Mayer and Ottaviano (2007) for TFP comparisons of multinationals and non-multinational firms for a
number of European countries.
10
percent of Chinese manufacturing exports. OECD data (OECD, 2007) indicate that 92 percent of
Irish manufacturing exports were accounted for by the affiliates of foreign firms.
While much production activity is concentrated within multinational firms, a relatively
small number of multinationals account for a large share of multinational activity. Data from the
BEA benchmark survey of 1999 indicate that top 1 percent of U.S. multinational firms ranked in
terms of the size of their global operations accounted for 38 percent of all affiliate sales while the
bottom 50 percent of firms accounted for less than 2 percent of affiliate sales. This size disparity
is even more striking with respect to intra-firm trade with the top 1 percent of firms ranked in
terms of their global operations accounting for 45 percent of parent exports to affiliates and 53
percent of parent imports from their affiliates. The bottom 50% again accounted for again
roughly 3 percent of sales, respectively. See Ramondo, Rappoport and Ruhl (2012) for further
details on heterogeneity in the distribution of intra-firm trade. 9
Fact 4: The operations of multinational firms are concentrated in a very small number of firms
and both the affiliates and parents of these firms tend to be larger, more productive, and more
export oriented than other firms.
Within multinational firms, parent and affiliates concentrate to some degree in different
activities. The share of parents in the R&D expenditures of multinational firms in 2009 was
nearly 85 percent while their share of employment was only 68 percent. Affiliates tend to be
more focused on serving foreign markets than in providing inputs to their parent firms. In 2009,
on average 61 percent of the sales of the foreign affiliates of U.S. multinationals are made in
9
Among all firms engaged in international trade, the concentration in a handful of firms is even higher. Bernard,
Jensen, and Schott (2007) find that the top 1 percent of U.S. exporters accounted for 90 percent of U.S. trade.
11
their host country market and only 9 percent of these sales are back to the United States.
Interestingly, the affiliates of multinational firms tend to be more export oriented than their
parents. In 2009, parents exported only about 11 percent of their output while 39 percent of sales
of affiliates are outside their host country markets.
Fact 5: Within the multinational firm, parents are relatively specialized in R&D activities while
affiliates are specialized in serving foreign markets rather than exporting to their parent country.
We conclude this section with empirical regularities on the mode of entry of
multinationals into foreign markets. According to UNCTAD (2011), the value of cross-border
mergers and acquisitions relative to FDI flows exceeded 50 percent in 2007. This number
masked empirical regularities across countries, however. Among developed countries, crossborder acquisitions accounted for nearly 70 percent of FDI inflows while for developing
countries the share was less than 20 percent.
At the micro-level, a number of empirical regularities have been documented. A number
of papers have shown that multinational firms are choosy when selecting a local firm to acquire.
For instance, Arnold and Javorik (2009) and Guadalupe et al (2012) show that firms acquired by
foreign multinationals tended to have above average productivity. Nocke and Yeaple (2008)
show that among the U.S. multinationals entering a foreign market, the more productive is the
investing firm, the more likely it is to enter through greenfield investment rather than crossborder acquisition.
Fact 6: Cross Border Acquisitions account for a large portion of global FDI, particularly into
developed countries. More productive firms are more likely to enter through greenfield
12
investment than to acquire an existing local firm, but affiliates acquired through a cross-border
acquisition tend to be more productive than average in the target country.
3.
WHO PRODUCES WHERE?
Geographic frictions define the field of international trade. Political jurisdictions are
defined by borders and policies tend to discriminate against agents from outside the border.
Tariffs discriminate against agents located in other countries, and contracts may be harder to
enforce across borders. Legal restrictions and cultural differences limit factor mobility across
space. Goods are mobile geographically but their movement is subject to physical shipping
costs, tariffs, and legal barriers to trade. Finally, information available at one location may be
costly to obtain elsewhere.
In this section, we address reasons why some firms facing the various types of
geographic frictions choose to own plants in multiple countries. We begin with traditional
approaches and the relevant empirical evidence. We then describe more recent theory and the
extent to which this has improved the fit between theory and data.
TRADITIONAL APPROACHES AND RECENT EXTENSIONS
Historically, the literature on international trade ignored the role played by multinational
firms, treating FDI as faceless capital flows between countries. In 1984, two important papers by
Elhanan Helpman and James Markusen respectively, were published that integrated
multinational firms into traditional trade models. Subsequently, much of literature on the
multinational firm builds on the modeling techniques of these two papers.
13
Helpman (1984) embeds multinational firms into a two-country, two good HeckscherOhlin model that is augmented to include product differentiation, scale economies, and
monopolistic competition in one sector. A firm that enters in the differentiated goods sector
produces a distinct variety over which it is the sole producer (its ownership advantage). The
countries have endowments of capital and labor that are immobile internationally and the
differentiated good industry is relatively capital-intensive, giving capital-abundant countries a
comparative advantage in its production. Trade in goods is frictionless. If the two countries are
sufficiently similar in terms of their relative factor abundances, then factor prices are equalized
by trade in final goods, and the capital-abundant country exports the capital-intensive good. If
the relative factor abundances of the two countries become sufficiently different, then capital
prices rise in the capital scarce country and wages rise in the labor scarce country.
Now suppose that the production of the capital-intensive good can be split into a capitalintensive “headquarter services” (e.g. coordination of production, development of intangible
assets, etc) and a labor-intensive production activity. Firms from the capital-abundant country
now have an incentive to fragment the production of their differentiated good vertically with the
capital-intensive headquarter service in the capital abundant country and the labor intensive
production activity located in the labor abundant country. No factors have moved, but the
services of those factors are embodied in the communication from the headquarters to the plant.
This factor service flow arises only because there is a foreign affiliate. This type of
multinational activity is often called “vertical investment”. 10
10
Helpman (1985) extends the model to include moderately capital intensive intermediate inputs that the parent
(headquarter) provides to its affiliates. The amended model generates a rich array of multinational firm behavior.
Parent firms provide (invisible) headquarter services to their affiliates and export intermediate inputs to their
14
Markusen (1984) follows a different approach, focusing on the public good nature of
knowledge (an ownership advantage) within the firm. Once an intangible asset, such as the
blueprint to produce a particular good, has been developed it is then non-rival within the firm.
Multinational production exploits a particular form of economies of scale whose origin lies in
replicating the same production activities across production locations. That is, once the blueprint
has been developed it can be combined with immobile factors in multiple locations by a single
firm. In the absence of such a firm, redundant development costs would have to be incurred to
make the technology available to geographically dispersed immobile factors. Because this type
of multinational activity involves replicating the same activity in multiple countries, it is referred
to as “horizontal investment”.
Neither Helpman (1984) nor Markusen (1984) consider geographic frictions (other than
international factor immobility). The role of trade frictions in generating multinational
production is prominently featured in Horstmann and Markusen (1992). This paper focuses on a
partial equilibrium model in which up to two firms (one in each of two symmetric countries) may
enter by paying a fixed product development cost. After entering, they can choose which or both
of two countries in which they might produce their good. Each production location requires the
firm to pay a plant-level fixed cost. If the firm exports its good, then it pays a variable trade
cost. 11
affiliates (intra-firm trade). Affiliates sell their product in the host country market (local affiliate sales) and export
their product back to the parent firm (intra-firm trade). He also allows for firms that produce multiple products so
that it is possible a firm exports final goods to the same country in which it owns an affiliate.
11
A related paper is Horstmann and Markusen (1987) who focus on the possibility that a firm might invest in a
given market to pre-empt entry by a local firm.
15
Several implications arise in the analysis of the model. First, firms face a “proximityconcentration” tradeoff in their production decisions that arises because consumers are immobile
and goods are costly to ship. 12 If a firm opens a plant in each country, it foregoes economies of
scale by incurring the plant-level fixed cost twice but avoids the shipping cost. Second, the
number of entrants (duopoly versus monopoly market structures) also depends on these
technological variables. Not surprisingly, multi-plant production is more likely when plant-level
fixed costs are low and trade costs are high. Less obvious is the role of the corporate fixed cost.
When corporate fixed costs are high, only one firm will be active and its sales in each market
will be large, making multiplant operation more profitable. 13
Markusen (2002, Chapter 7) presents a general equilibrium model that encompasses both
vertical and horizontal motives in a two-country setting. This model focuses on the interaction
between comparative advantage, trade costs, and economies of scale. The assumptions are
similar to those of Helpman (1984) but allow for the existence of trade costs. Trade costs
substantially complicate the model analysis, and the predictions of the model, which also hinge
on various factor intensity assumptions, have to be teased out of simulation exercises. 14 An
important prediction is that horizontal or replicating multinationals are pervasive between
similarly sized and endowed countries (for certain factor intensity assumptions they are
consistent with Fact 1). When countries are very asymmetric in terms of size and endowments,
12
The term “proximity-concentration tradeoff” appears to be due to Brainard (1993) which differs from Horstmann
and Markusen by starting with the Krugman (1980) monopolistic competition framework rather than the reciprocal
dumping framework. The idea that affiliate production is motivated by costs of trade goes back many decades.
13
Markusen and Venables (1998, 2000) embed horizontal multinationals in a general equilibrium setting to analyze
the role of country factor abundance and size in a proximity-concentration setting.
14
For an effort to test particular features of these models, see Carr, Markusen, and Maskus (2001).
16
the incentive to export goods becomes strong so that either national exporters or vertically
organized multinationals prevail.
Brainard (1997) tests the implications of the “proximity-concentration” framework. 15
Using industry-country level data from the BEA Survey for 1989, Brainard estimates a simple
econometric model in which the dependent variable is the logarithm of the ratio of affiliate sales
by country and by industry made in the host country market to the sum of affiliate sales and
arms-length exports from the source country. This independent variable has the benefit of
describing the degree of substitution between local affiliate sales and exports while controlling
for industry and country characteristics that jointly determine total sales. The explanatory
variables are proxies for key proximity-concentration variables, such as freight and insurance
costs, tariffs, plant-level fixed costs, and corporate-level fixed costs. Also included are controls,
including a crude measure of factor endowment differences. Brainard finds that firms substitute
affiliate sales for exports when trade costs and corporate fixed costs are high and plant-level
fixed costs are low as predicted by the proximity-concentration framework. Moreover, she
shows that differences between host country and source country GDP per capita are associated
with less foreign affiliate sales, which is inconsistent with simple models of vertical
investment. 16
Brainard (1997) has been influential in supporting the horizontal or proximityconcentration approach to multinational firms, but it has limitations. For instance, the measures
15
Examples of earlier studies are Horst (1972), and Swedenborg (1979).
16
Yeaple (2003) using similar data for 1994 argues that this result obscures variation across industries. He shows
that there is a tendency for U.S. multinationals in skill intensive industries to locate in skill abundant countries and
for U.S. multinationals less skill intensive industries to locate in skill scarce countries.
17
of fixed costs are problematic, particularly in light of a growing literature on firm heterogeneity
(discussed below). Plant level fixed costs are measured as the number of non-production
workers at the median sized plant ranked by value-added within an industry, but given the extent
of heterogeneity across firms within industries in terms of their size, it is not clear how to
interpret this measure. More worryingly, in specifications that include both country and industry
fixed effects, the coefficients on tariffs and freight costs go to zero.
The models of horizontal investment described above consider environments in which all
firms are identical so that if some firms export and others engage in multinational production all
firms are indifferent between the two modes. This is at odds with Fact 4, the parents and
affiliates of multinational firms are very different from other firms operating in a given economy.
Helpman, Melitz, and Yeaple (2004) combine the proximity-concentration model of Brainard
(1993) with the firm heterogeneity model of Melitz (2003). Specifically, firms pay a fixed cost to
develop a firm-specific variety and in the process learn their firm-specific productivity
(intangible asset conferring an ownership advantage). Once this productivity is drawn, a firm
may serve its domestic market by paying a fixed cost to open a plant. In addition, a firm may
export to a given foreign market, but doing so requires a firm to incur two types of trade costs, a
fixed cost of marketing their product in the foreign country and a variable iceberg type trade
cost. Finally, a firm may open a plant in the foreign market and transfer its productivity to that
plant by incurring the fixed marketing cost plus the fixed cost of managing an additional plant.
In so doing, the firm avoids trade costs.
Unlike the case of Brainard (1993), both exporters and multinationals appear in
equilibrium and all (but the firms at the cutoff) strictly prefer their organization of international
18
production to all alternatives. Firms with greater productivity sell more in any given country and
so can spread the plant-level fixed costs over a larger number of units sold. By avoiding trade
costs, a firm serves an effectively larger market. In equilibrium, firms sort into modes of serving
world markets, with the least productive firms exiting, the least productive active firms serving
only their domestic market, moderately productive firms exporting to foreign markets, and the
most productive firms opening a foreign affiliate. Using Compustat data, Helpman et al (2004)
show that multinational firms are more productive than exporters who in turn or more productive
than domestically oriented firms. 17 Another implication of Helpman et al (2004) is that the
extent of firm productivity heterogeneity within an industry is a determinant of aggregate
volumes of trade and multinational production. Using data similar to Brainard (1997) and
controlling for standard proximity-concentration variables, Helpman, Melitz and Yeaple (2004)
show that U.S. firms substitute foreign production for exports from the United States in
industries characterized by highly dispersed firm sales, and the effect, as measured by Beta
coefficients, is large relative to other industry characteristics.
Another prediction of the model of Helpman et al (2004) is that more productive firms
are not only more likely to become multinationals but are also more likely to own affiliates in a
larger number of countries. This prediction is explored in depth by Chen and Moore (2010).
Using French firm-level data from the AMADEUS dataset, they calculate firm-level productivity
and investigate the mapping from parent productivity to the production locations chosen by the
17
This hypothesis finds further support in other papers, such as Girma, Gorg, and Strobl (2004). Fillat and Garetto
(2012) show that the shares of multinational firms trade at a discount relative to non-multinationals. This would
seem to contradict their supposed productivity advantage. They show that amending Helpman, Melitz, and Yeaple
(2004) to allow for risk aversion in a dynamic setting eliminates this tension.
19
firm. They find that more productive firms are more likely to be found in any given country,
including those with high labor costs and high barriers to entry. 18
Finally, Baldwin and Ottaviano (2001) extend the proximity-concentration framework to
the case of multiproduct firms. This extension is desirable because large multinational firms
produce a large portfolio of products, because firms are frequently observed to serve customers
in a given country by both exports and affiliate sales, and because these firms may internalize
effects of expanding the production of one product on the profitability of another. Moving
production of a good offshore avoids marginal trade costs which raises profits earned for that
good, but the resulting cannibalization effect lowers the profits earned by the firm’s other
products. When fixed costs are high so that one plant is optimal for each good, a profit
maximizing firm will produce some products in one country and some in the other to minimize
cannibalization effects so generating two -way trade between countries within the same firm.
HYBRID MODELS WITH SIMPLE GEOGRAPHIES
Although the proximity-concentration tradeoff is consistent with the share of sales that is
through local affiliates rather than by exports from the source country, standard proximityconcentration models do not predict correctly the levels that are observed in the data. According
to Fact 2, a source country’s exports and the local sales of its affiliates are decreasing in
measures of trade cost. Yeaple (2009) shows that the decline of aggregate affiliate sales in
distance occurs both because fewer firms locate affiliates in more distant locations and because
18
Yeaple (2009) also explores similar predictions using data for U.S. multinationals but focuses on model-consistent
aggregates. The results are consistent with those of Chen and Moore (2010).
20
the affiliates of those that do sell less the further they are from to the United States. 19 This latter
result suggests that distance is either associated with rising marginal costs at the affiliate level or
lower demand. 20 In this section, we discuss some models that blend vertical and horizontal
elements in essentially a two country setting to account for this fact.
There are several mechanisms that can cause distance to discourage multinational
operations. While simple models of vertical multinational production may have trouble
explaining why most FDI is two-way between similarly endowed countries, integrating features
of vertical FDI models with features of horizontal FDI models to produce a hybrid model can
help explain why distance deters foreign production. We start off with simple adjustments to the
simple geography of a two-country framework.
Suppose that a production technology features a continuum of intermediates that are
costlessly assembled into a final good. Each intermediate differs in its knowledge intensity and
there is an efficiency loss associated with transmitting knowledge across locations. The
efficiency loss is increasing in the knowledge-intensity of the intermediate. Now suppose the
alternative to transmitting the technology is to produce the intermediate near the parent company
and then to ship that intermediate to the foreign location. Goods that require knowledge
intensive intermediates would then involve high levels of intra-firm trade between the parent
country and affiliate (vertical FDI), but as trade costs rise, more value-added is done at the
19
The same pattern is found for German multinationals by Buch et al (2005).
20
Also, multinational production has grown faster than exports during a time period in which trade costs were
falling. This is the time dimension to the cross section puzzle.
21
affiliate (horizontal FDI). 21 This would mean that imported intermediates in total affiliate costs
would fall with distance and affiliate sales would also drop as the firm becomes increasingly
exposed to knowledge transmission costs. Further, the intra-firm trade share would be less
sensitive to trade costs in high knowledge intensive industries while affiliate sales would be more
sensitive to trade costs in high knowledge intensive industries.
Keller and Yeaple (2012) embed this mechanism in the Helpman et al (2004) model, test
these predictions using a panel of U.S. multinational firms from the BEA dataset, and provide a
calculation for how much of the gravity result can be explained by this mechanism. 22 Trade and
technology transfer costs can account for about 30 percent of the effect of gravity with the
remaining effect of gravity due to fixed costs that rise in distance (15 percent) and distancedampening effects on demand for U.S. goods (55 percent).
Irarrazabal, Moxnes, and Opromolla (2010) structurally estimate a version of Helpman,
Melitz, and Yeaple (2004) that has been extended to include parent-affiliate trade in
intermediates. As in Keller and Yeaple (2012) this trade exposes affiliates to trade costs. The
key object to estimate is the share of intermediate inputs in affiliate costs that are necessary to
rationalize gravity in the firm-level data. 23 Their answer is 90 percent. This whopping number
obtains after having accounted for distance-related variation in fixed costs of entry. One way to
interpret this result is that the proximity-concentration framework is only marginally relevant
21
Blonigen (2001) documents such a mixture of activities at work in data on the operations of Japanese automobiles
in the United States.
22
Earlier theory in this literature includes Zhang and Markusen (1999). Earlier empirical work on the intra-firm
trade of U.S. multinationals is Hanson, Mataloni, and Slaughter (2005).
23
The authors using an interesting dataset for Norwegian firms that contains both export and affiliate sales
information but does not break out intra-firm trade.
22
because to make it fit requires the marginal costs of affiliates to rise in distance from the parent
at nearly the same rate as trade costs.
The interaction between vertical and horizontal motives for multinational production can
also be analyzed by observing the structure of multinational firms’ operations before and after a
trade liberalization for a single country pair. This is the strategy of Feinberg and Keane (2006)
who structurally estimate a dynamic hybrid model using firm-level BEA data that spans the
Canadian-U.S. Free Trade Agreement. Such a hybrid model is important in the Canada-U.S.
context as the value of intermediate inputs imported by affiliates are more than one-third of
aggregate affiliate value added and two-thirds of Canadian affiliates import intermediates, export
intermediates, and sell their product locally. Over a ten-year period that spans the free trade
agreement, Canadian affiliates of U.S. multinational became much more integrated with their
parents, selling a substantially smaller portion of their output in the Canadian market. The
authors find that their model attributes a one-third increase in the volume of arm’s length
multinational firm trade and a 5-10 percent increase in intra-firm trade to the tariff reduction.
These changes, while large, are much less than the actuals, leading the model to attribute much
of the change in multinationals’ organization to technological change, such as the rise of just-intime delivery. 24
HYBRID MODELS WITH COMPLEX GEOGRAPHIES
24
Feinberg and Keane (2001) consider a reduced form approach to the same experience. One notable result from
that paper is the extent of parameter heterogeneity across firms within the same industry: within industry responses
to trade liberalization show greater variance than across industry responses. This result raises the question as to how
useful industry classifications are.
23
Until recently, the literature has been confined to two-country models that cannot capture
the full complexity of actual multinational operations. As noted earlier, about a third of sales of
the affiliates of U.S. MNE are to countries other than affiliate’s host country or the United States.
Some portion of these sales undoubtedly is consistent with a “proximity-concentration”
framework in which an affiliate in a continent sells to multiple countries, but the primary motive
is to avoid shipping costs from the source (or parent) country. However, for at least an important
subset of firms, the structure of their global operations involves fragmenting the production of
some inputs to low cost locations where factor prices encourage concentration, while other
activities, such as assembly, might be replicated in many locations. We refer to firms that
replicate some activities in many countries while concentrating other activities in a few countries
as firms that follow complex strategies.
Complex strategies are modeled explicitly in Yeaple (2003) who considers an
environment in which there are three production activities that differ in their relative factor
intensities and three countries, of which two are identical and skill abundant (the north) and one
is abundant in unskilled labor (the south). The differences in factor abundances mean that entry
will be done in the north while one of the intermediate inputs is least costly to produce in the
south. Trade costs between countries motivate replication of production activities while
discouraging fragmentation. Any kind of multinational production incurs a fixed cost. In the
model, both types of multinational production lower marginal cost in a complementary manner.
Replicating production abroad lowers marginal cost by avoiding transport costs while
fragmenting production processes lower marginal cost by accessing low cost southern labor. A
24
firm that avoids trade costs by replicating one stage of production increases its sales and so gains
even more from fragmenting production and vice versa.
This mechanism has many implications. For instance, while high trade costs encourage
replication and discourage fragmentation, complementarity means that for intermediate levels of
trade cost both activities must be undertaken for multinational production to be viable. As a
result, a reduction in trade costs can induce replication by increasing the return to
complementary fragmentation and an increase in trade costs can induce fragmentation by
increasing the return to complementary replication. Finally, policy changes in one country (e.g.
the Czech Republic) could make multinational production in another location (e.g. Germany)
more desirable. Additional issues concerning various complementarities and the role of firm
heterogeneity are taken up in Grossman, Helpman, and Szeidl (2006) and Yeaple (2008).
While Yeaple (2003) provides some guidance on how to think about the geographic
complexities facing multinationals in their location decisions, the geographic and production
structure considered is special. 25 For instance, there is no sense of asymmetric access to the
export platform of the south and there is no particular sequence in which production must occur.
Some of these issues are addressed in Ekholm, Forslid, and Markusen (2007) who also consider
a three-country model in which intermediates must be provided by the multinational firm’s home
25
We have assumed throughout that intermediate inputs are gathered worldwide and then assembled into final goods
at a single location. Baldwin and Venables (2010) refer to as a “spider”: intermediates are drawn to a central
location. An alternative production structure is the “snake” in which a sequence of activities needs to be done on the
good as it progresses toward its final stage. Baldwin and Venables show that location activity can be very different
depending on the production structure.
25
country. They explicitly allow one of two northern countries to have favored access to a
southern export platform, which leads to very different cross-country dependencies. 26
Models of export-platform FDI or complex strategies suggest that empirical work needs
to account for the fact that changes in the characteristics of a country’s neighbors can change the
attractiveness of that country as a production location. Both Head and Mayer (2004) and Yeaple
(2008) show that affiliates cluster in centrally located production sites as measured by the foreign
market potential of the region. Alfaro and Charlton (2009) go further in integrating vertical
linkages by integrating input-output relationships into the analysis of affiliate clustering. They
show that there is a tendency of vertically linked affiliates to cluster geographically but cannot
provide direct evidence of trade links between affiliates. This may be problematic. Ramondo,
Rapoport and Ruhl (2012) provide evidence that input trade between affiliates and affiliates and
parents may not be important for a large set of firms so that input-output relationships may be
poor proxies for trade linkages.
Empirical work accounting for these interdependencies is scarce as the spatial
econometric techniques are difficult to use. Blonigen et al (2007) is representative of such
research. Using a spatial lag and measures of the market potential of a particular location, they
show that a country’s neighborhood predicts the volume of U.S. multinational affiliate activity in
a particular location. More importantly, they show that including these measures do not
dramatically alter the coefficient estimates on other variables. Less encouraging is their result
that the coefficient estimates are not robust across subsamples in their data. This latter result
26
For further analysis of export platform models see Neary and Mrázová (2011).
26
may reflect the limitations of existing spatial econometric techniques that require à priore
knowledge of the exact nature of cross-country interactions.
Differences in relative demand for goods across space add another layer of complexity to
geography. The role of non-homothetic preferences in understanding the structure of global
multinational operations is taken up in Fajgelbaum, Grossman, and Helpman (2011) who
consider a four-country, north-south model. They show empirically that multinational firms that
originate in developing countries are more likely to invest in other developing countries and that
firms originating in developed countries invest primarily in other developed countries. They
consider a non-homothetic preference system in which goods differ in their quality and are
horizontally differentiated as well. Fixed costs to entry and geographic frictions interact to
create a home market effect: firms producing high quality goods are more likely to enter in
developed countries and then invest (due to proximity benefits) in other developed countries
while the opposite is true for firms producing lower quality goods. In terms of the OLI
framework, developed country firms have ownership advantages that are more valuable in
developed countries while developing country firms have ownership advantages that are more
valuable in developing countries.
QUANTIFIABLE MODELS WITH COMPLEX GEOGRAPHIES
We now turn our attention to a new branch of the literature that develops quantifiable
models that incorporate many of the mechanisms described above and that allow for
counterfactuals that fully incorporate general equilibrium feedback effects in a multi-country
setting.
27
Arkolakis, Ramondo, Rodriguez-Clare, and Yeaple (2012) introduce a model in which
countries are distinguished by their size, by their comparative advantage in introducing new
technologies, and by their location. Firms pay a fixed cost to invent a new product and receive a
vector of productivities where each element of this vector corresponds to a particular country. In
this way, comparative advantage is introduced into the model without the complex issues
regarding the factor intensities of goods and the factor abundances of countries. Having paid a
fixed marketing cost in a given country, the firm minimizes its cost of serving that country by
choosing the lowest cost location where local costs depend on the constellation of trade costs,
technology transfer costs, the local wage, and comparative advantage. In this way, the model
captures a “proximity versus comparative advantage” tradeoff in an environment that allows
firms the full set of locational opportunities, including export platform investment.
Arkolakis et al (2012) focus on how geography, increasing returns, and comparative
advantage determine the location of innovation versus production. With both technology and
output costly to move internationally, fixed costs of entry make market size a key determinant of
the location of innovation versus production. This “home market effect” coexists with
comparative advantage of entry (quality of productivity draws on average by country) in
determining the structure of global innovation and production by multinational firms. The
authors fit the model to aggregate bilateral trade and multinational production data. While the
home market and the comparative advantage effects are not separately identified by the available
data, comparative static exercises are readily implemented because changes in trade and
technology transfer cost frictions between countries can be considered independently of other
country characteristics. They find that the gains from openness are large, particularly for small
28
countries located in densely populated areas. The counterfactual exercises suggest, however,
that around the calibrated values of trade and information costs, small reductions in these costs
can lower the welfare of individual countries.
Arkolakis et al (2012) achieve tractability in their framework by abstracting from fixed
costs of production in order to focus on the location of global entry versus production. But, as
noted earlier fixed costs of production are thought to play an important role in the structure of
multinational firms’ operations. In the presence of fixed costs at the plant level and the
possibility of export platform FDI, a firm’s decision to establish foreign plants is inter-dependent
across countries leading to a potentially very difficult discrete choice problem at the firm level.
Tintelnot (2012) quantifies the size and importance of these fixed costs in a general
equilibrium model that allows for export platform FDI. Tintelnot achieves tractability in his
model by making the problem of the firm “smooth” through several assumptions. First, in each
country there is a fixed set of potential parent firms and each firm is endowed with the ability to
produce a continuum of goods that it will sell in every country. Second, the firm is also endowed
with a “core” productivity over its goods and a vector of idiosyncratic fixed costs of opening a
plant in each foreign country. Third, if a firm incurs the fixed cost in a foreign country, it then
obtains a country-specific draw for each of its goods (comparative advantage). Fourth, given the
productivity draws made available from its plant location choices, the firm minimizes its cost of
serving global markets taking into account technology transfer costs, shipping costs, and wages.
Each additional location that a firm opens a plant raises a firm’s variable profits (adding an
entirely new set of productivity draws for each product) but at a decreasing rate as new locations
cannibalize sales from other locations. In a sense, the mechanism of Eaton and Kortum (2002)
29
has been subsumed inside the firm in order to create smoothness in the payoffs of the firm’s
options.
Tintelnot uses his model to two ends. First, he structurally estimates the model on firmlevel data for German multinationals. He finds that the fixed costs of production, which lie
between 4 and 6 million euros on average for those firms that established a plant in the
respective country, account for a significant amount of the home bias in production that exists at
the firm-level. Tintelnot then calibrates his model to bilateral trade and multinational production
data. The model fits the data well: although he does not fit the model to affiliate exports, the
model generates artificial export platform data that are remarkably consistent with the data.
Model counterfactuals demonstrate the importance of allowing for export platform investment.
FINANCIAL MARKETS AND THE MULTINATIONAL FIRM
We conclude this section with a brief discussion of how financial frictions across
countries may shape the operations of multinational firms. Multinational firms tend to be large
and highly diversified firms that can access credit markets in multiple jurisdictions. As such,
they may be in a favored position vis-à-vis local firms in countries with dysfunctional financial
systems as they can shift financing needs from local credit markets to their internal credit
markets. There is a substantial body of empirical evidence that this is so. For instance, Desai,
Foley, and Hines (2004) show that in countries with poor creditor rights, U.S. multinational firms
shift their borrowing away from external markets and toward their parent firms. Another
example is Manova, Wei, and Zhang (2011) who show that the foreign affiliates of multinational
firms in China are better represented in China’s exports in industries in which external financial
needs are high and opportunities for collateralization is low.
30
One way to establish the importance of credit to multinational expansion is to see what
happens during a financial crisis. Klein, Peek and Rosengren (2002) demonstrate that the foreign
investments of Japanese multinationals that had strong ties with the Japanese banks that were
most affected by the collapse of Japanese assets prices in the early 1990s were highly curtailed.
Alternatively, during a financial crisis credit constrained local firms are often sold to
multinationals with deep pockets (e.g. Acharya et al, 2011).
4. CROSS BORDER ACQUISITIONS VERSUS GREENFIELD INVESTMENT
According to Fact 6, many firms obtain ownership of foreign production facilities by
acquiring an existing facility rather than by opening a new affiliate, but there is little agreement
as to how to interpret this fact. On the one hand, the models presented in the previous section
may need to be amended only modestly if the acquired firms are simply a bundle of primary
factors, such as a real estate or capital. On the other hand, it may be that foreign firms acquire
domestic firms because they want to obtain access to intangible assets that they have difficulty
creating themselves. If this is the case, then a new question arises, why do foreign firms value
these assets more than domestic firms? Another possibility is that cross-border acquisitions
involve an attempt to reduce competition in a given market. If this is the case, then we might
think very differently about the facts. If the goal of a merger is to blunt product market
competition then it may make sense that firms acquire other firms in countries in which their
competitors are located (a possible explanation for Fact 1).
We consider first the possibility that cross border acquisitions are driven by the desire to
acquire intangible assets. Suppose that firms are bundles of intangible assets and that these
31
assets are complementary in generating profits with the firm. In the context of an international
environment, we might think of some types of firm-specific assets as internationally mobile,
such as high quality management techniques or access to proprietary technology, and other types
of firm-specific assets are location specific, such as reputation, knowledge of local conditions, or
integration in to local production networks. This is the environment analyzed by Nocke and
Yeaple (2007) who add synergy driven cross-border acquisitions to the model of Helpman et al
(2004). Their focus is on what types of firms engage in cross border acquisitions relative to what
types of firm engage in other modes of foreign operations. The authors show that firm
heterogeneity matters. When firm heterogeneity is primarily in the quality of mobile assets, the
firms that engage in cross border acquisitions tend to the most productive firms. When firm
heterogeneity is primarily in the quality of immobile assets, the least productive firms engage in
cross border acquisitions.
Nocke and Yeaple (2008) consider a different twist on synergy driven mergers in a world
in which countries differ in their cost of production but trade between countries is frictionless.
They show that greenfield FDI will tend to be one-way from high cost to low cost locations as
firms are willing to pay a lot to move highly productive assets to a low cost production location.
Two-way cross-border acquisitions arise between countries in which there are small differences
in the cost of production in order to exploit small differences in the distribution of intangible
assets across countries. Hence, the model captures Fact 6: most multinational entry between
similar developed countries takes the form of cross border acquisition while most multinational
32
entry into developing countries tends to be greenfield FDI. 27 It also shows how large two-way
volumes of FDI can be generated between similar developed countries (Fact 1) even in the
absence of trade costs.
Guadalupe et al (2012) consider a large panel of Spanish firms for which some firms
came to be acquired by a foreign multinational. Using matching techniques to address selection
issues, the authors show that foreign firms tend to acquire relatively more productive Spanish
firms which subsequently tend to become even more productive through process innovation.
Acquired firms are also likely to become exporters after acquisition often through exporting to
the acquiring multinational. The results are consistent with the view that cross border
acquisitions involves synergies between foreign parents (access to foreign markets and ability in
process innovation) and target firm characteristics (high productivity in the target country).
Arnold and Javorcik (2009) use similar econometric techniques to Guadalupe et al (2012) to
study the impact of foreign acquisitions in the developing country context of Indonesia. Foreign
firms acquire relatively well-performing Indonesian firms, and the subsequent TFP and wage
growth of foreign acquired firms relative to matched domestic firms is faster. They also show
that foreign acquisition is associated with increased international trade. 28
Head and Ries (2008) address the multilateral structure of cross-border mergers and
acquisitions. In their framework, each country has a set of management teams and a set of firms
27
Blonigen (1997) explains the acquisition wave in the United States by Japanese firms as exchange rate driven.
Japanese firms have an ownership advantage serving their home market and the appreciation of the Yen makes U.S.
intangible assets that could be used to serve the Japanese market cheaper. This is a synergy story.
28
These results contrast with a number of models such as Gordon and Van Bovenberg (1996) who hypothesized that
adverse selection would result in acquisitions be concentrated in poorly performing firms.
33
that may be proportional to country size. Managers have different abilities monitoring production
in different plants. Cross border mergers occur when the optimal manager for a given firm is
located in a foreign country. Pushing against foreign control are monitoring costs that are a
function of geography and this gives rise to a gravity equation that rationalizes Fact 2.
Other research treats cross-border acquisition as a mechanism for reducing the degree of
competition in an industry. For example, Neary (2007) models cross-border acquisitions in an
oligopolistic environment in which firms from low cost locations acquire firms from high cost
locations in order to reduce competition. Here the cost asymmetry across countries that is due to
comparative advantage is fundamental in driving international mergers. A central result in the
paper is that a reduction in trade costs between countries can then spur consolidation through a
cross-border merger wave. This is one possible explanation for how trade liberalization within
Europe may have led to an increase in cross-border ownership. 29 It is not clear that this
mechanism would be associated with increased size of affiliate operations over the same period,
however.
5.
THE BOUNDARIES OF THE FIRM
We have covered papers that assume that all production activities must be conducted within the
firm and so ignore alternatives, such as outsourcing the production activities to an independent
firm. In practice, there is huge variation, even within the same industry, in the way that firms set
their boundaries. For instance, while Apple Computer contracts out much of the value-added for
29
Horn and Persson (2002) also consider cross-border acquisitions in the context of a coalition formation game.
34
its products, Lenovo keeps most of its operations in-house. We now briefly discuss some of the
recent literature on the internalization problem. 30
In structuring their global operations, firms face difficulties associated with contracting
with outside contractors on the one hand and with firms’ own employees on the other hand. The
nature and the severity of imperfect contracting will have implications that vary across industries
and across firms within an industry depending on the nature of technology. For instance, in
some industries firms earn rents from intangible assets and those rents could be diminished by
contract failure (asset dissipation). An arm’s length contractor might damage a firm’s reputation
for quality or steal proprietary secrets. In other industries, relationship specific investments
might be necessary, giving rise to the potential for hold-up problems. Having produced an input
for a firm, an outside contractor may find that it is denied full payment, while the purchaser may
find courts unlikely to support a claim of shoddy manufacturing.
An important paper in asset dissipation literature is Ethier and Markusen (1996) who
construct a model in which firms compete to invent a new product that can generate rents for a
fixed amount of time before becoming obsolete. 31 The firm then chooses between exporting the
product, licensing the technology to a foreign producer, or opening a multinational affiliate to
serve a foreign market. Exporting forces the firm to incur trade costs but prevents the
technology from becoming available to local producers prematurely, while both licensing and
multinational production require the firm to teach a foreign management team the technology
30
Antras and Rossi-Hansberg (2009) and Antras (2011) also provide a discussion of much of the recent literature.
See also Spencer (2005).
31
Horstmann and Markusen (1986) is another important early work. There, a firm may internalize production when
a local supplier may lower product quality and so damage the firm’s reputation.
35
and to incur a fixed cost. Asset dissipation occurs when a foreign management team forms a
separate firm to compete with the inventor thereby adversely affecting the inventor’s rents. 32
To prevent the dissipation of its technology, the firm can export early in the technology’s
life cycle and then later license the technology to a local producer as the technology is becoming
generally available. If a local producer is involved early in the technology’s life cycle, the
contract that is arranged, whether the local producer is an owned affiliate or is an arm’s length
contractor, must be such that neither the inventor nor the local producer will defect from the
agreement. The inventor may always export the product to the market to compete with a local
firm that has defected and this creates both a punishment to the defector as well as a temptation
to defect for the inventor. The model gives rise to interesting interactions between locational
characteristics and the internalization problem. For instance, if trade costs rise, this makes the
desire to transfer technology stronger but also limits the ability of the innovator to punish the
defector. High trade costs may even induce a firm to export early in the technology’s life cycle.
Recent empirical work by Bilir (2011) supports the hypothesis that asset dissipation may
be an important factor in the location decisions of U.S. multinational firms. Bilir presents a
model in which products are developed in the north and may be imitated in the south. Industries
differ in their technological life cycle, the length of time that a technology avoids becoming
obsolete. Imitation is costly and limited to some extent by the patent protection provided by the
south. Bilar shows that multinational firms will not open an affiliate in the south until the
expected time to obsolescence hits a critical level, which will be early in fast life-cycle industries
32
Examples of such behavior are common in the popular business press, particularly in developing countries with
poor legal institutions. The possibility of such technology spillovers has led to a large literature that asks whether
multinational production results in increased productivity of local firms. See Keller (2010) for a review.
36
and late in long life-cycle industries. Patent protection intuitively plays a more important role in
attracting multinational firms in long-life cycle industries.
Bilir tests this (and other related) predictions of this model on panel data for U.S.
multinationals. By constructing a measure of the product life cycle from the average lag of
patent citations and interacting this measure with (time-varying) measures of intellectual
property rights protection, she makes a convincing case that multinational activity is more likely
to be proscribed in long life cycle industries where patent protections are weak. While the
analysis has nothing to say about arm’s-length transactions per se, it provides strong support to
the idea that asset dissipation is a serious concern for multinational firms. 33
Much of the recent work, both in terms of theory and empirics, has been motivated by the
work of Antràs (2003). Antràs (2003) adapts the Grossman and Hart (1986) property rights
approach to the firm to the case of international sourcing of intermediate inputs in a simple and
intuitive way. To produce a final good, intermediates must first be produced. These
intermediates require two agents, a final-good producing firm F and a supplier of the
intermediate S, to make relationship specific investments. These investments are aggregated via
a Cobb-Douglas production function where the cost share on F’s investment represents the
relative importance of the firm’s contribution to joint output while the remaining cost share is the
contribution of the manager. The two agents cannot contract over the level of investment made.
Instead, after the investments have been made by F and S, the two agents engage in Nash
bargaining to split the surplus. Critically the outside option of the two agents depends on the
33
This result is consistent with survey evidence of Mansfield (1993), who found that firms were reluctant to transfer
their newer technologies to affiliates in countries in which intellectual property rights were poor.
37
organizational form. If the two agents were not part of the same firm, then both have an outside
option of zero while if S were an employee of F, F may fire S, seize the inputs and assemble the
final good with some loss of productivity.
Given the ex post Nash bargaining, there will always be underinvestment by both agents
but the extent of the underinvestment of a given agent depends upon the organizational form. 34
When intermediate input production is outsourced, S gets more of the surplus in the Nash
bargaining and so has an incentive to make a larger investment while the opposite is true when
intermediate input production is done within the firm. Hence, we should be more likely to see
vertical integration in industries in which the technology dictates that F makes the relatively
more important investment.
An important feature of the Antràs framework is that it can make direct contact with the
data. To the extent that intermediate input trade occurs across borders, firms’ integration
decisions are reflected in the share of international trade that is conducted between parties related
by ownership. This data is readily available while firm level data on contracting is not.
The Antràs mechanism has been applied in a number of interesting contexts. Antràs
(2003) embeds this mechanism in a Heckscher-Ohlin setting. The model predicts that related
party trade will predominate between similar countries that are abundant in the resource used
most intensively in industries whose technologies favor vertical integration (and so can explain
Fact 1). Antràs and Helpman (2004, 2008) derive predictions over the share of trade that is intrafirm in a north-south partial equilibrium setting that integrates firm heterogeneity and variation
34
Note that Antràs does not allow partial ownership of the intermediate producer plant such as might be the case in a
joint venture. This can be justified by the fact that partial ownership is uncommon among developed country
affiliates. Desai, Hines, and Foley (2004) provide an analysis of why joint ventures are rare and becoming rarer.
38
across countries in contract enforcement. Integrating firm heterogeneity allows the analysis of
firm-level decisions and allows smooth aggregation to the industry level as in Helpman, Melitz,
and Yeaple (2004). 35
The intra-firm trade share implications of Antràs and Helpman model have motivated
much empirical work. Given space constraints we discuss only three of the most recent and the
most comprehensive. Nunn and Trefler (2012) work with a highly disaggregated sample (H.S.
six digit) of U.S. import data which distinguishes between related party trade and arm’s length
trade. They construct measures of industry characteristics that are plausibly correlated with the
relative importance of relationship-specific investments and then regress the intra-firm trade
share on these variables, letting “the data speak.” The authors find that an industry’s skill,
capital, and R&D intensity predict intra-firm trade shares as one might expect. Going further,
they show that the type of capital intensity matters: industries that use a lot of capital that is not
firm-specific (i.e. autos or computers) do not tend to display high levels of intra-industry trade.
The authors extend their analysis to address the specific predictions of Antràs and Helpman
(2004, 2008) regarding firm heterogeneity and find that the data is consistent with these
predictions. 36
35
As in Helpman, Melitz, and Yeaple (2004), Antràs and Helpman (2004) have strong sorting implications: the most
productive firms in an industry in which vertical integration arises source their intermediates from an owned affiliate
while less productive firms buy inputs from arm’s length suppliers. Direct evidence supporting this implication is
provided by Kohler and Smolka (2012).
36
Yeaple (2006) uses BEA data to explore related questions. The advantage of BEA data relative to the Customs
data is that it allows the researcher the opportunity to treat U.S. affiliates exports to their U.S. parents separately
from trade between foreign affiliates operating in the U.S. and their foreign parents.
39
Bernard, Jensen, Redding, and Schott (2012) use even more disaggregated U.S. import
data. Observing trade patterns at the level of the firm and product, the authors provide finer
detail on the structure of intra-firm versus arm’s length trade. In particular, they create an index
of a product’s contractability based on the importance of wholesale activity of the firms that
import the product. Goods associated with within-firm distribution presumably are those for
which contracting problems are most severe. The authors show that an improvement in an
exporting country’s governance raises the probability of related party trade but lowers the share
of imports that is intra-firm while goods with lower contractibility are associated with more
intra-firm trade. Finally, lower contractability is associated with a greater reduction in the intrafirm trade share as an exporting country’s governance improves. 37
Costinot, Oldenski, and Rauch (2011) consider a variant of intra-firm trade share
regression. The authors hypothesize that production technologies across goods differ in the
extent to which unexpected problems arise in production. When problems are unlikely to arise,
outsourcing to an arm’s length producer is efficient while vertical integration is preferred when
agents are likely to need to adapt to unforeseen circumstances. The authors test this hypothesis
by constructing from occupational data an index of how “routine” an industry’s production
technology is. They find that “routineness” strongly predicts lower intra-firm trade shares and
that including this variable causes other industry characteristics (such as skill intensity and
intermediation indexes) to become statistically insignificant.
37
Other important studies of the property rights approach are Carluccio and Fally (2010), who use French firm-level
data, and Feenstra and Hanson (2005) who investigate the organization of Chinese processing firms in the context of
a government imposed sourcing rules.
40
The models so far discussed are highly stylized in that only two agents contribute value
to a final product. Modern value chains may involve hundreds of inputs produced by many
distinct firms or divisions of a firm. Antràs and Chor (2012) tackle the question of how vertical
integration versus outsourcing decisions are made when stages of production occur sequentially.
They show how the prevalence of vertical integration along the value chain depends critically on
the degree of substitutability of final goods relative to the substitutability of investments made by
individual agents along the value-chain. In deciding whether to vertically integrate or outsource
a particular activity, firms must take into account the share of value-added that they obtain, the
incentives that this creates for the individual undertaking that activity, and the manner in which
the decision affects the incentives of other agents producing inputs further down the value-added
chain. The authors show that when demand for the final output is very inelastic, firms should
integrate only the final stages of production and outsource those upstream while the opposite
occurs when demand for the final good is relatively elastic. The authors then test these
implications using intra-firm trade data where a good’s relative “downstreamness” (measured
using input-output techniques) interact with the elasticity of substitution of final goods producing
industries. 38
Finally, there are a number of papers that consider other features of moral hazard. We
focus on the work of Antràs, Desai, and Foley (2009) because it combines theory and empirics. 39
38
Garetto (2012) develops a very different model in which the elasticity of substitution between intermediates
predicts the extent of related party trade in total trade. In her model input sourcing firms vertically integrate in
response to market power on the part of unaffiliated suppliers. Her paper is unique in providing a calibration of the
gains from foreign input sourcing.
39
Grossman and Helpman (2004) is an example of a pure theory paper in this literature. They investigate agency
problems within the firm and when it is better to avoid these problems by outsourcing production.
41
These authors expand the scope of the analysis to link these issues to the financial structure of
the multinational firm. The authors consider an application of Holmstrom and Tirole (1997) in
which there are three types of agents. There is an innovator who had developed a technology, a
local entrepreneur who can implement the project, and a continuum of potential local investors
with low opportunity cost of funds who can contribute to the funding of the project. The project
requires funding that is conditional on the scale of the project and this funding can be contributed
in part or in full by any of the agents. Two related agency problems arise. First, the local
entrepreneur can misbehave in ways that lower the expected earns of the project. Second, the
innovator, who can monitor the manager and reduce the benefits of shirking, can only do so at a
cost and so needs incentives to monitor. In general, contracts cannot restrain opportunistic
behavior of either the local entrepreneur or the innovator but local “investor protections” can
partially restrain opportunistic local entrepreneurs. In countries with weak investor protections,
arm’s length contracts will be discouraged, multinational affiliates will rely more heavily on their
parent firms for funding, parent firms will take larger equity stakes in their affiliates, and
affiliates size will be stunted relative to that of countries with stronger investor protections. The
authors find empirical support for these implications using U.S. data on licensing and royalty
income and multinational production data.
6. CONCLUSION
There is now a large catalogue of models of the multinational firm that have been
cleverly designed to explain various stylized facts. The list of factors relevant toward
understanding multinational production is long: increasing returns, contracting frictions,
42
comparative advantage, trade and communications costs, et cetera. Distinguishing empirically
between these factors is difficult because models are rarely nested, data is largely inadequate,
and identification even in an ideal setting is tricky.
Even interpreting stylized facts is still difficult. Why is it that most multinational
production is north-north rather than north-south? Is this because multinational firms can find
many existing facilities to acquire in developed countries through a cross border acquisition, or is
it because developing countries have a comparative advantage in production activities that do not
require ownership? If there is little multinational production in a given location is this because it
is an unattractive production location or because it is easy to write contracts in that country so
that ownership is unnecessary?
One area in which there has been notable progress in the literature in the last ten years is
the trend toward developing multi-country models in which geography can play a central role.
For these models to be tractable, strong simplifying assumptions must be made, and it is not clear
how much violence these assumptions do to reality. A particularly nagging question is the role
of cross-country dependencies driven by the nature of vertical production chains. We have every
reason to believe that the nature of production chains is important but there is little guidance
from the empirical literature as how to treat them in aggregative models.
A further complicating factor is the lack of data on arm’s length contracting. The scope
of a firm’s global operations is limited by the foreign affiliates that it reports, but firms may be
highly integrated with and dependent on unaffiliated contractors. To date, most of the empirical
literature on the boundaries of the multinational firm has been limited to documenting
correlations between industry characteristics and the scale of multinational production. This is
43
fine as far as it goes, but it does little to help us to understand how substitutable arm’s length
contracts and vertical integration are. 40 Integrating these mechanisms into quantifiable multicountry general equilibrium models would be a valuable dimension for further research.
40
See Garetto (2012) for an example of early work in this dimension.
44
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