Global)Sourcing)of)Complex)ProducGon)Processes:) An)Empirical)Study)of)Spanish)Firms)

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1 2015%02& Morten&Søndergaard& Advisor:&Ina&Charlo;e&Jäkel& MSc&Thesis&for&IEC& Global)Sourcing)of)Complex)ProducGon)Processes:) An)Empirical)Study)of)Spanish)Firms) No.&of&characters:& & Student&no:&301208& Department)of)Economics)and)Business) AARHUS)UNIVERSITY)=)DENMARK)

2 AARHUS UNIVERSITY Global Sourcing of Complex Production Processes: An Empirical Study of Spanish Firms by Morten Søndergaard in the Department of Economics and Business February 2015

3 AARHUS UNIVERSITY Abstract Department of Economics and Business by Morten Søndergaard This paper investigates Whether firms choose to use a hybrid and complex sourcing strategy and if this choice is affected by the firm s productivity and headquarter intensity. In order to investigate this, the main research question is divided into three sub-questions based on which four testable implications are developed. A literature review is performed in order to highlight the chronological development of the theoretical models, explaining which firms find it optimal to integrate its supply chain across the firm s boundary, and which firms choose to expand their sourcing activities across international borders. The theoretical model of Schwarz and Suedekum [2011] is then presented. This model leads to four testable implication related to a firm s choice of 1) complexity 2) outsourcing share and 3) offshoring share. The data set used originates from the Spanish database SEPI. It covers approximately 2000 Spanish companies in the years 2006 to The companies are classified into 20 industry categories based on the three-digit NACE rev. 2 classifications. To analyse the data, two statistical methods are applied, namely those of Tobit and OLS estimations. The results revealed that evidence for a negative relation between a firm s headquarter intensity and its outsourcing share. No evidence for an effect of, neither productivity, nor headquarter intensity on a firm s choice of complexity, was found. Lastly, evidence was found in favour of a positive relation between a firms s level of productivity and a higher offshoring share. Finally, the measurement approach of several key variables and their effect on the obtained results are discussed. Keywords: Global Sourcing, multinational firms, outsourcing, intra-firm trade, offshoring, vertical FDI.

4 Acknowledgements I am first and foremost grateful to my supervisor Ina Charlotte Jäkel for guidance, helpful comments and suggestions. I further thank Isabel Sanchez-Seco from SEPI for assistance in obtaining the data. Further I am grateful to my co students who have provided helpful feedback and suggestions for improvements. ii

5 Contents Abstract i Acknowledgements ii List of Figures List of Tables Abbreviations v vi vii 1 Introduction Motivation Purpose & Research Question Delimitation s Structure Literature Review Development of the Theoretical Literature Related Empirical Studies Evidence of Global Sourcing Choice Some Contradicting Evidence Theoretical background The Environment of a Global Business: An Example Schwarz & Suedekum s Model of Hybrid Sourcing Firm Structure Structure of the Game The Make-or-Buy Decision Choice of Complexity Choice of Global Scale Summary of Theoretical Expectations Methodology & Data Description Data Description Advantages of the Data set Limitations of the Data set Data Cleaning Main Dependent Variables Measure of Complexity iii

6 CONTENTS iv Measure of Outsourcing Share Measure of Offshoring Share Main Independent Variables Measure of Productivity Measure of Headquarter Intensity Other Control Variables Estimation Strategy Complexity Choice Outsourcing Choice Offshoring Choice Empirical Results A First Look at the Data The Main Test of the Analysis Outsourcing Choice Complexity Choice Offshore Choice Practical Implications & Suggestions Critique of Results Policy Implications Suggestions for Further Research Conclusion 51 A Appendix 53 A.1 Creation of Offshore share and Outsource share A.2 Summary statistics Bibliography 57

7 List of Figures 2.1 The Predication of the AH model Histogram of Complexity Histogram of Outsourcing share Histogram of Offshore share Histogram of TFP v

8 List of Tables 4.1 Production Function Estimates Data Description Industry average table ( ) Size average table ( ) Regression table. Dep: Outsourcing share (Tobit model) Regression table. Dep: Complexity (OLS model) Regression table. Dep: Offshore Share (Tobit model) A.1 Cross-correlation table A.2 Summary statistics vi

9 Abbreviations TFP OUT INT DOM FOR RSA AH-Model Total Factor Productivity OUTsourcing INTegration DOMestic supplier FOReign supplier R S A Antras Helpman Model vii

10 Chapter 1 Introduction 1.1 Motivation Questions regarding the global supply chain and the slicing of the value chain has attained a considerable amount of attention during the last 3 decades in the ongoing debate about globalization. The level of heterogeneity in terms of the organizational structure and the level of internationalisation among firms, has widely been documented. However, the questions remain: which firms find it optimal to integrate its supply chain across the firm s boundary, and which firms choose to expand their sourcing activities across international borders? The field of International trade literature has worked on answering these questions almost since its origin and it has been through several iterations: from the development of transaction cost theory with Coase [1937] s contribution in The nature of the firm, through the era of models with property rights in focus where Grossman and Hart [1986] are two of the most notable contributors. Latest, Antràs and Helpman [2004] s model of global sourcing has added another dimension to the models. This dimension explains why some firms contract with domestic suppliers while other firms prefer foreign suppliers. Especially, Antràs and Helpman [2004] s model of global sourcing has been a point of departure for many empirical and theoretical papers, within the literature. Antràs and Helpman [2004] s paper was the first to study global sourcing within a property-rights framework assuming incomplete contracts. Several papers have investigated the effects 1

11 Chapter 1 Introduction 2 and predictions of their model and it appears that a broad consensus exist regarding the validity of the model. However, the model has its obvious limitations: it is restricted to a setting where there is only one headquarters and one supplier. This assumption of one supplier providing the intermediate input is not realistic, though, as exemplified by Alfaro and Charlton [2009], who provide the example of the General Motors Corporation having 123 subsidiaries outside the United States of which 42 are vertically integrated subsidiaries. Acemoglu et al. [2007] responds to such conditions by considering a framework where more than one supplier is allowed. The limitation of their model is then, that all suppliers are either integrated or outsourced, meaning that firms who both have integrated and external suppliers cannot co-exist in the model. Schwarz and Suedekum [2011] has created an extension to this model by also allowing for multiple suppliers and allowing for, what they refer to as, hybrid sourcing. In other words, in this model firms can choose to vertically integrate some suppliers, while allowing others to remain independent. In addition, the model allows that some inputs are offshored, while others are produced domestically. This particular aspect is at the core of the motivation behind this paper. 1.2 Purpose & Research Question Using the intuition from Schwarz and Suedekum [2011], the purpose of this paper is to analyse and investigate the sourcing choice of firms who use a hybrid sourcing pattern. Hence, the thesis can be summarised to the following research question: Whether firms choose to use a hybrid and complex sourcing strategy and if this choice is affected by the firm s productivity and headquarter intensity In order to answer the main research question the following three sub-questions have been established: How does headquarter intensity affect the choice of outsourcing share? How does productivity and headquarter intensity affect the choice of complexity? How does productivity affect the choice of offshoring share?

12 Chapter 1 Introduction 3 The data set used originates from the Spanish database SEPI. The data set covers approximately 2000 Spanish companies in the years 2006 to The companies are classified into 20 industry categories based on the three-digit NACE rev. 2 classifications. It comprises firm-level data regarding choice of sourcing strategy (usage of inputs provided by integrated or external suppliers) as well as a broad set of explanatory variables. Within the field of sourcing strategy, the main body of the literature focuses on headquarter intensity and productivity as the main firm characteristics, when explaining heterogeneity among firms. When investigating the characteristics of the firms using the hybrid sourcing mode, this paper will therefore focus primarily on these two variables. This paper contributes to the existing literature by explicitly explaining and testing some of the implications suggested by Schwarz and Suedekum [2011] s model. In this paper, the model is designed so as to allow firms to perform a hybrid sourcing strategy rather than only outsourcing or offshoring, respectively. In addition, this paper contributes to the literature by investigating the dimension of the number of suppliers from which a firm sources its inputs. This aspect is referred to as the complexity of a firm s sourcing strategy. 1.3 Delimitation s There may be multiple reasons for why a firm would choose to outsource of offshore, however, in this paper the focus is solely on explaining the explanatory effect that can be associated with the variables productivity and headquarter intensity. A few limitations exist in the data set used in this paper and as these constrain the analysis, they should be explained in this section. As a result, this paper is delimited by the fact, that only Spanish manufacturers are included. As explained later, this paper will make no distinction between the various countries foreign suppliers may come from. As such, all non-domestic suppliers are simply treated as foreign. This delimitation obviously leads to another delimitation, which regards the differences in the strength of the legal system across countries. This cannot be taken into account either.

13 Chapter 1 Introduction Structure The remainder of the thesis is structured as follows: In Chapter 2, a review of the literature regarding the questions, which firms find it optimal to integrate its supply chain across the firm s boundary, and which firms choose to expand their sourcing activities across international borders? will be provided. The literature is presented as a chronological development leading up to the paper of Schwarz and Suedekum [2011] s model. Chapter 3 presents the theoretical background, including Schwarz and Suedekum [2011] s model, on which the main analysis of this paper builds. Chapter 4 describes the data and methods used in the paper. In Chapter 5 the main results are reported and interpreted in relation to the testable implications as developed in chapter 3. Chapter 6 critiques the produced results and discusses potential implications for policy-making. In addition, suggestions for future research are given. Finally, Chapter 7 concludes.

14 Chapter 2 Literature Review In this chapter, a review of the theoretical and empirical development, on which Schwarz and Suedekum [2011] model is based upon, is presented. Section 2.1 reviews the development of the theoretical literature. The purpose of this is to place the theoretical framework and the empirical findings of this paper in a historical context and introduce the effects and ideas, on which Schwarz and Suedekum [2011] s model is built. Section 2.2 gives a review of the most central empirical studies within the literature. The purpose of this is to highlight what has already been found and to establish a point of reference for the empirical analysis. Finally, section 2.3 highlights some empirical findings, which contradict the predictions of Antràs and Helpman [2004] s model and point out the need for the extensions made in Schwarz and Suedekum [2011] s model. 2.1 Development of the Theoretical Literature In order to understand, which firms choose to use a hybrid and complex sourcing strategy, the determinants of a sourcing strategy must first be identified. The literature regarding the internationalisation of the firm and the boundaries of the firm has been through several iterations. Through this iterative process, several determinants have been identified. Transaction cost theory is considered to be one of the first theoretical explanations of the firm s choice of sourcing strategy. In his paper: The nature of the firm, Coase [1937] attempts to define the boundaries of a firm and why the firm exists in the first 5

15 Chapter 2 Literature Review 6 place. Coase [1937] explains how the cost and benefits of using the market mechanism versus the cost and benefits of transacting within a firm, determine the size 1 of the firm. The costs of using the market mechanism arise due to a search cost of finding the right supplier and from writing enforceable contracts. For the cost of organising within the boundaries of the firm, Coase [1937] refers to diminishing returns to management, meaning that, as an organisation becomes bigger, it becomes less efficient at coordinating its resources and efforts. Looking at the advantages, using the market mechanism allows for specialisation of the producers, resulting in increased efficiency, while the advantage of transacting within the boundaries of the firm is, accordingtocoase [1937], elimination of uncertainty and the cost of writing contracts. The transaction cost theory was further developed by Williamson [1971]. He changed the focus from transactions and the frictions of using the market, to a more contractoriented view. He argued that transaction costs can arise due to incomplete contracts and relation-specific assets (RSA) that have low or no value outside the relationship. The reason for this is that, when the outside value of the RSA is low, the parties may be tempted to engage in opportunistic behaviour, extorting a larger share of the common profits. Within the literature, this is generally referred to as the holdup problem. He specifies that in a relationship, where both parties have to develop an RSA with low outside value, and when it is impossible, or very costly, to write an enforceable contract, which specifies all contractual obligations, the counter-party should be integrated. As Antràs and Yeaple [2007] underline, the transaction cost theory explains the sources and nature of inefficiencies, that arise, when transacting through the market, very well. But when it comes to transactions within the boundaries of the firm, the theory uses a much more vague notion of governance cost, or, as mentioned above, diminishing returns to management. The property right theories, most notably developed by Grossman and Hart [1986], elaborated on this part of the sourcing choice explanation. As with Williamson [1971] s framework, Grossman and Hart [1986] s theory is also based on a setting, where incomplete contracts and RSA exist. They emphasised that contractual rights can be of two types: Specific rights and residual rights. They argued that buying the residual rights, hence integrating, often is a low-cost alternative to writing a contract that allocates all specific rights of control. This is somewhat similar to what was argued by Williamson [1971]. 1 By size [Coase, 1937] referstothenumberoftransactionsperformed

16 Chapter 2 Literature Review 7 But, while Williamson [1971] argued that integration (meaning buying the residual rights) eliminates the incentives for opportunistic and distortionary behaviour, Grossman and Hart [1986] argued that integration merely shifts this behaviour from one party to the other. Since the integrated supplier is simply hired, he can be fired if he doesn t obey. This means that he no longer has any bargaining power, and the firm can now extort the supplier. This leaves the integrated supplier with low incentives to invest in the relationship. According to Grossman and Hart [1986], the fear of a holdup situation within the boundaries of the firm has two implications. Firstly, under any ownership structure there will be underinvestment in the RSA s. This is eitherduetonoincentives (integrated supplier) or due to of the fear of being cheated (outsourced supplier). Secondly, a firm will prefer to integrate if its own investment decision is particularly important relative to the supplier investment decision. In this case the incentive of the supplier, is less important. Antràs [2003] took Grossman and Hart [1986] s property-right approach and elaborated even further upon it. He specified a framework, where a final product is composed of two types of inputs: A final-good input, provided by the headquarters, and an intermediate input, which could either be controlled by the headquarters or be provided by an external supplier. Antràs [2003] showed that the key determinant, when deciding on integration or outsourcing, is the elasticity of the final good with respect to the two inputs; if the final product is intensively depended on the intermediate input, the production should be outsourced, while, if the final-good input is the most important component, the intermediate input should be integrated. This elasticity of the final-good input will be referred to as headquarter intensity throughout this paper. Antràs and Helpman [2004] developed even further on the Antras mechanism and combined it with within-industry heterogeneity in terms of productivity, and a North- South model, where the firm could choose between two locations for the supplier. The resulting model is from now referred to as the AH-model. Besides the previously introduced choice of make or buy, the firm could now also choose between sourcing from a domestic supplier or from a foreignly located supplier, thereby introducing the international trade dimension into the model. The model heavily relied on the assumption that producing abroad is associated with higher fixed cost but a lower variable cost, than if production had taken place

17 Chapter 2 Literature Review 8 domestically. The implication of this was that the most productive firms would also have the largest benefits from offshoring. This two-dimensional model allowed the firm to choose among four different sourcing strategies: Foreign integration (FI), foreign outsourcing (FO), domestic outsourcing (DO) and domestic integration (DI) Given this Cost assumption and the incomplete contract environment, Antràs and Helpman [2004] argued that a firm s productivity level and headquarter intensity determine the choice of sourcing strategy: Firms from headquarter intensive industries and with high productivity will prefer FI. Firms with a high to medium productivity level will use FO. Firms with medium to low productivity level will prefer DI while the firms with the lowest productivity will source through DO. Firms from industries with low headquarter intensity will choose among two sourcing options; the most productive will choose FI while the least productive will choose FO. The prediction can be seen in the following figure taken from Antràs and Helpman [2004] Figure 2.1: The Predication of the AH model Summing up, the literature has focused on transaction costs, headquarter intensity and the level of productivity, as the main determinants of firms sourcing strategy. Especially in settings with incomplete contracts and with RSA. It is worth highlighting that none of these theories, explicitly, allow for more than one supplier nor hybrid sourcing. As will be elaborated on in chapter 3, the Schwarz and Suedekum [2011] modeluseselements of all the theoretical frameworks, presented above, in order to develop a model, that allows for hybrid and complex sourcing strategies. 2.2 Related Empirical Studies Having presented the underlying theoretical explanations of sourcing presented by the existing literature, this section will first investigated the empirics that confirm the prediction made by the AH-model and then the empirics that contradict.

18 Chapter 2 Literature Review Evidence of Global Sourcing Choice The global sourcing model of Antràs and Helpman [2004] has been subject to several empirical studies since its publication. The prediction that productivity and headquarter intensity are determining factors has been tested in a wide array of papers, using different estimation strategies and different data sets. For instance, Defever and Toubal [2007], Defever and Toubal [2013] use a cross sectional of French manufactures to investigate the role of a firm s Total Factor Productivity (TFP) in its decision to import from its affiliates (FI), rather than from an independent supplier (FO). In their slightly modified version of the AH-model, where outsourcing has a higher fixed cost than integrating abroad, and where headquarter intensity is firm-specific, rather than industry-determined, they find strong empirical support for the theoretical predictions of their model. In particular, they find evidence for highproductivity firms having a larger probability of using FO, especially when the production has low headquarter intensity. Further, Defever and Toubal [2007] note that a non-trivial fraction of the French firms in their data set are using some type of hybrid sourcing strategy. Interestingly, these are excluded from their study. Stefano Federico also tests both the headquarter intensity and the productivity aspect of the AH-model by looking at Italian manufacturing firms. In Federico [2012] the relationship between headquarter intensity and its determining effect on the choice between outsourcing or integration is investigated. Federico [2012] confirms that integration is preferred to outsourcing in headquarter intensive industries. He uses a wide set of indicators of headquarter intensity and finds that especially capital intensive industries prefer integration to outsourcing [Federico, 2012]. In [Federico, 2010] the productivity sorting pattern suggested in the AH-model isin- vestigated. He finds evidence of statistically significant productivity differentials among firms with different sourcing strategies, when controlling for industry, area and export status. He concludes that there seems to be a productivity ordering pattern, where FI firms are the most productive ones, and DO firms are the least productive ones. The Spanish SEPI data set 2, applied in this paper, has also been investigated by others. Especially W. Kohler and M. Smolka has used the data set to investigate several 2 AdeeperpresentationoftheSEPI data set is presented in chapter 4

19 Chapter 2 Literature Review 10 implications of the AH-model. In Kohler and Smolka [2009] theproductivity-dependent sorting pattern, suggested by Antràs and Helpman [2004], is investigated. They find evidence that foreign outsourcing firms are more productive than domestic integrating firms. They note that several firms are using multiple sourcing modes. In Kohler and Smolka [2011] the existence of a sourcing productivity premium, as suggested in Antràs and Helpman [2004], is investigated. Using the Spanish SEPI data set from 2006 to 2008 they find a robustly significant productivity premium for firms using foreign integration of intermediate inputs as their choice of sourcing strategy. A lower productivity premium is found for firms using outsourcing to both foreign and domestic suppliers, while domestic outsourcing firms seem to havethelowestpremium. In order to obtain mutually exclusive sourcing strategies for the firms, Kohler and Smolka [2011] assign each firm to the category, which is the least prevalent in the data set, if the firm is active in two or more sourcing modes simultaneously. Kohler and Smolka [2011] point out, they thereby ignore the empirical fact that some firms use combined sourcing channels at a given point in time. Tomiura [2005] analyses the relationship between productivity and sourcing strategies among Japanese firms. He investigates the choice between outsourcing abroad or domestically. He finds that the firms tend to outsource more abroad, when their productivity is higher, or when their products are more labour intensive. He also highlights that firms with richer human skills or experience in FDI are more likely to perform FO Some Contradicting Evidence Eventhough the empirical literature, in general, finds evidence in favour of the AHmodel, other papers highlight facts and findings that contradict the predictions and assumptions of the AH-model. Looking at the complexity aspect, and the assumption of firms only having one supplier, the studies of this dimension have been limited by the insufficient disclosure of the external supplier relationships in the existing data sets. Regardless of that, the existing evidence suggests that firms are very diverse in terms of their complexity choices, often sourcing from more than one supplieralfaro and Charlton [2009], Altomonte and Rungi [2013].

20 Chapter 2 Literature Review 11 According to Defever and Toubal [2013] s paper, studying the French motor vehicle industry, 45 % of the firms don t choose between either outsourcing- or vertical integration, but use a combination of both. Similar conclusions have been reached in papers from Tomiura [2007] and Costinot et al. [2013]. Their data across the countries and industries showed that different sourcing patterns tent to co-exist, rather than exclude each other. Kohler and Smolka [2011] highlight some stylised facts of the Spanish data set and they find that a prevalent share of the firms in the SEPI data set use some combination of the four sourcing strategies. This empirical evidence gives space and motivation for extending the current theoretical framework in such a way that firms can have more than one supplier and choose a hybrid sourcing strategy along the location and ownership dimension. This is exactly what the model of Schwarz and Suedekum [2011] adds to the existing theoretical frameworks.

21 Chapter 3 Theoretical background In this chapter, the theoretical background for the analysis is presented and the main hypotheses are formulated. Section 3.1 provides an example of the basic mechanism, which a relationship between the headquarters and its suppliers consists of, and the environment, in which the global business operates. The purpose of this is twofold: First, the purpose is to create a deeper understanding of the factors, governing the transaction taking place, when a firm sources its inputs. Second, the purpose is to explain the environment, in which the sourcing decision takes places. Elaborating on these aspects will assist in framing the assumptions, on which the Schwarz and Suedekum [2011] model, presented in section 3.2, is built. Further more it will explain the basic mechanism, securing the optimal payoff for the firm. Section 3.2 explains the main setup of the model. Within this model, the firm has to decide on a sourcing strategy, which may differ along three dimensions: Location, Organizational structure and Complexity. Along these three dimensions each firm has to make strategic decisions. The three sourcing decisions are analyzed and explained in separate sections: Section 3.3 examines the choice of complexity, section 3.4 investigates the choice of ownership and section 3.5 elaborates on the choice of location. Finally, section 3.6 summarises the theoretical expectations and the overall expectation of the model. 12

22 Chapter 3 Theoretical background The Environment of a Global Business: An Example A real life example, illustrating the reality and complexity of a transaction between the headquarters and a supplier, is found in Midler [2010] s book Poorly made in China 1. Midler worked as an agent, connecting American importers with Chinese manufactures. Among other assignments, he was to handle the relationship between a Chinese soap manufacturer named King Chemical and an American- based company, Johnson Carter. According to Midler [2010], King Chemical attracted clients by initially offering lower prices compared to their competitors. After King Chemical had secured the contract, they increased their profits through a number of manoeuvres. These often involved reductions in material costs, last-minute price increases, or even the use of the client s designs to sell the same products to alternative buyers at a higher price [Antràs, 2014]. In two specific incidents, King Chemical secretly lowered the quality of product inputs in order to save money on material costs, hence gaining a larger payoff. In one incident Midler [2010] realized that King Chemical was filling the bottles with less soap than what initially had been agreed upon. In another attempt to lower material costs, King Chemical lowered the amount of plastic used in the production of the bottles, resulting in thinner bottles, which would easier break. In both cases the value and quality of the final product had suffered. Antràs [2014] speculates that, when King Chemical and Johnson Carter originally made the deal, the contract most likely stated a given number of soap-bottles in exchange for a given amount of money (or price per bottle). While elements, such as price, quantity and delivery specifications are easy to specify, some characteristics, which clearly are relevant to the final quality, are not. It is easy to imagine how a lower quality of packaging and a thinner soap will translate into lower sales generated, when the bottles enter the market- lower quality leads to losing customers. In the King-Johnson example, the product produced is fairly simple. Issues regarding lagging compatibility between the headquarter service and the manufactured inputs could be a another problem affecting the final value of the product. Taking for instance a more complex product, such as an 1 Antràs [2014] also uses this example to show how the holdup problem might arise, and how writing an enforceable contract might be difficult, or even undesirable. The example will be used continuously throughout this paper.

23 Chapter 3 Theoretical background 14 engine. If the supplier does not calibrate the engine parts for the engine assembled by the headquarters, it will not run properly. The lesson learned from the above example is that, while some aspects of transaction, like amounts, delivery dates and etc., can easily be described in a contract, other aspects cannot. These non-contractible parts are often of great importance for the compatibility and the quality of the product, thereby affecting the final outcome, when the product goes to market[antràs, 2014]. Antràs [2014] argues, that even if the contract could be written in such a way that these non-contractible characteristics were taken into account, enforcing the contract might not be possible- even for a third party brought in to asses the agreement. Antràs [2014] points out that even if the contract between King Chemical and Johnson Carter specifically stated the quality of the bottle and stated the exact amount of soap each bottle should contain, a court of law could have difficulties judging whether the agreement had been honored or not. Especially in an international setting, where cross-border enforcement can be difficult [Antràs, 2014]. In this incomplete contract environment, where enforcement is weak and information is imperfect, the model of Schwarz and Suedekum [2011] argues that incentives become important in order to govern the transaction and the behavior of the participants. Incentives, in terms of expected payoff, become important for the suppliers in order for them to invest most optimally int the relationship. As the model will show, the incentive can be adjusted through ownership, size of the payoff and the number of parties between whom the revenue will be shared. From the perspective of the headquarters, cost differences must also be taken into account, when designing the sourcing strategy. As in the King-Johnson example, the choice of a Chinese manufacture, rather than a domestic located supplier, could very well be due to cost advantages. Summing up, in an environment, where writing complete contracts is impossible, and where enforcement is weak, the goal for any firm is to balance the incentives between the headquarters and the manufacturer, so that the firm optimizes its own share of the revenue, yet assuring that the suppliers invest enough for the final product to create the largest possible revenue. The sourcing strategy must be balanced in such a way that each party has the right (optimal) amount of incentive to invest in the relationship, while taking advantages of wage differences and any cost optimization advantages there

24 Chapter 3 Theoretical background 15 may be, into account. As the following model will show, a firm s level of productivity determines the optimal strategy related to cost savings effects, while the relative importance of inputs (headquarter and supplier input) determines the optimal allocation of incentives. 3.2 Schwarz & Suedekum s Model of Hybrid Sourcing Schwarz and Suedekum [2011] s model of global sourcing of complex production processes, examines the optimal sourcing decisions, made along three dimensions, given the firm s level of productivity and its headquarter intensity. Instead of repeating the rather complex exercise of providing the theoretical and mathematical logic of the model, provided by Schwarz and Suedekum [2011], the focus in this paper will be on discussing the economical logic behind it, while keeping the mathematical evidence and expressions to a minimum. Nevertheless, the assumptions of the model will first be presented together with the basic structure of the model and steps of events. The model, presented in Schwarz and Suedekum [2011] and Schwarz and Suedekum [2014], differs in several ways. For instance, 62 use market size, rather than productivity to explain firm heterogeneity. In this paper, the focus will be on their earlier work inschwarz and Suedekum [2011], since productivity is used here Firm Structure The model is centered around a firm that produces a final good y and is facing the following iso-elastic demand function: y = Y p 1/(α 1) (3.1) Where Y is a demand shifter, and p is the price of the good sold. 1/(α 1) represents the demand elasticity. Producing this good requires two types of inputs: A headquarter service -input, denoted h, and a manufacturing components-input denoted M (equation 3.2). h is provided by the headquarters (from now on, referred to as the firm ), while M is produced by a supplier. These inputs are combined, according to the following Cobb-Douglas production function, in order to produce the final output y :

25 Chapter 3 Theoretical background 16 ( ) h η H ( ) M 1 η H y = θ η H 1 η H (3.2) Where θ is a productivity shifter, and the parameter η H i {0, 1} is the headquarter intensity. The headquarter service thus accounts for a fixed share η of the total value added and must be produced by the firm itself, e.i. it cannot be unbundled, offshored or outsourced [Schwarz and Suedekum, 2014]. Accordingly, 1 η H = η M is the overall component intensity of production. The manufacturing component M, is assumed to be represented on a continuum of components consisting of N units. Each component is provided by an individual supplier. The supplier i {0,N} contribute with m i units of the particular component. The aggregated component input M is given by the following constant elasticity of substitution function: [ N M = 0 ( ) ϵ ] 1/ϵ mi η i di (3.3) η i ϵ {0, 1} denotes the degree of substitutability for each individual component. The parameter η i reflects the intensity of component i within the aggregated M, with N 0 η jdj = 1. It is assumed that all components are symmetric in terms of importance, meaning that η i =1/N. Each component has an individual input intensity equal to η M η i =(1 η H )/N. Combining the three equations above, the total firm revenue is given by: R = θ α Y 1 α [ ( ) h η H ( ) ] M η M α η H 1 η M (3.4) Structure of the Game The model evolves around a game that consists of five stages. The five stages span from the initial sourcing decisions made by the firm, through investment in the relationship by all parties, until production and negotiations are complete. The sequence of events is as follows: 1. The firm has to simultaneously make three decisions: a) the level of complexity of the supply structure (how many suppliers/components shall the firm cooperate with?), b) the boundaries of the firm (shall these components be

26 Chapter 3 Theoretical background 17 supplied by an integrated or external producer?), and c) the global scale of the production (is the supplier going to be located domestically or in a foreign location?). The outcome of these three decisions is what this paper investigates. 2. Given the firms decision on choice a), b) and c), the producer offers a contract to potential suppliers for every component needed i [0,N]. It is assumed that a large pool of potential suppliers for each component exists in both countries. This contract includes an upfront payment τ i (positive or negative) to be paid or received depending on the sign. 3. The suppliers have an outside opportunity equal to wr M in country r = {Domestic, Foreign}. In order for the suppliers to accept the contract, the potential payoff has to be equal to or larger than wr M. The payoff for the supplier depends on three elements: 1) An upfront payment, T i, 2) the revenue share, β i,whichthesupplierexpectsto receive after the bargaining stage (stage 5) and 3) the investment costs which the supplier has to pay in order to provide the needed input. Potential suppliers apply for the contract, and the firm chooses one supplier for each component i {0,N}. 4. The firm and the suppliers then independently decide on their non-contractible investment levels. The issue of incentives is important at this stage since the incentives affect the non-contractible investments, which affect the quality of the parties inputs. The quality of the inputs directly affects the performance of the final product. 5. The final output is produced and sold, thereby realizing the revenue, according to the decisions made in step (2), (3), and (4). The surplus is divided between the firm and the suppliers. Any potential renegotiation will take place right in this step and the bargaining power of the participants becomes of great importance. Compared to the paper of Schwarz and Suedekum [2014], where different scenarios with different assumptions are analysed, this paper will focus on a scenario, where the companies are assumed to; 1) operate in an open economy with incomplete contracts, and where 2) the suppliers have a positive outside opportunity. Further, it is assumed that 3) the unit cost of foreign suppliers are lower than for the domestic suppliers. The fixed cost of doing business in the two countries is also assumed to differ. Specifically, it is assumed that 4) the fixed cost is higher in a foreign country than if business is performed

27 Chapter 3 Theoretical background 18 domestically. Finally it is assumed that 5) the components are complementary rather than substitutes The Make-or-Buy Decision The decision, which most directly relates to the question of incentive, is the choice of ownership. As illustrated in section 3.1, contracting the important aspects of investing in the inputs, is impossible. The implication is that the parties have to renegotiate, how the revenue should be distributed among the parties (stage 5) after the investment has been made (stage 4). Since the parties anticipate this renegotiation, the parties choose to invest accordingly. Said differently, the final division of revenue among the participants is not dependent on the size of the investment. For each component the firm has to decide, whether the respective component should be produced by an integrated subsidiary, or outsourced to an external contractor. The main difference between an outsourced and an integrated supplier is that, if the integrated supplier renege on the contracts and drops out of the coalition, he cannot threaten to take away the full input [Schwarz and Suedekum, 2011]. The reason for this is that he is merely hired as a manager by the firm. If the manager reneges, he will be fired 3. On the contrary, the external supplier can threaten to withdraw completely from the relationship, taking his full input with him. Thus, the integrated supplier s bargaining power, is smaller than an outsourced contractor s. The increased bargaining power assures that the external supplier will receive a larger share of the revenue, when the negotiation takes place, compared to the integrated supplier. The expected larger revenue-share increases the incentive to invest. In order to obtain the largest possible joint revenue, both parties have to invest according to the importance of their respective inputs. Unfortunately, since investments are non-contractible, and because all participants want to optimize their own payoff, both parties will always tend to underinvest in comparison to the optimal case. This is similar to the model of Grossman and Hart [1986]. As explained above, the external supplier will tend to invest more than an integrated supplier, because the increased 2 If the opposite was the case (substitutes rather than complement), the bargaining power in stage 5 would be smaller, since the relative importance of each input would be smaller. 3 The manager will receive a compensation, if fired, which leaves the manager with some bargaining power. However, it is still small compared to an external supplier, who can threaten to take away the full input.

28 Chapter 3 Theoretical background 19 bargaining power ensures him a larger revenue-share. If the supplier is integrated, the payoff is no longer the manager s to keep. Summing up, an outsourced (integrated) supplier, has more (less) bargaining power, and will therefore obtain a larger (smaller) revenue share, when renegotiation takes place. Because the supplier anticipates this in the investment phase, the resulting effect is a higher (lower) incentive to invest which leads to a larger (smaller) value of the final output in the end. The same mechanism works for the firm. A larger (smaller) anticipated revenue share will make the firm invest more (less). In other words, the outsourcing/integrations decision is a trade-off between producing the largest joint revenue possible, here called size effect, or obtaining the largest revenue-share, when negotiating, here called share effect. Who should integrate and who should outsource? It depends on the intensity of inputs. A product with high headquarter intensity should integrate, since this will make sure that the firm obtains the largest revenue share possible. Sincethesupplierinput is less important in this case, the supplier s incentive to invest, is low. Conversely, if the value of the final product is most sensitive to investments made by the suppliers (component intensive), the firm should outsource in order to increase the incentive of the suppliers, hence increase the investments in components. The logic behind the argument here is similar to the one used by Antràs and Helpman [2004]. Now, why would some firms choose a hybrid mode? Compared to Antràs and Helpman [2004] s model, the difference is that the firm can gradually change the composition of the size effect and the share effect, when the firm does not belong to any of the two extremes. For instance, if the product is equally headquarter- and component intensive, the firm can gradually affect the share of the surplus that is left for the suppliers, by adjusting the share of integrated/ outsourced suppliers. In this way, the firm can adjust the supplier s and its own incentive, to a more optimal level, where the share effect and size effect, in total, yield the largest payoff for the firm. The testable implication can be formulated as follows: Testable Implication 1. Firms from more headquarter intensive industries have a lower outsourcing share.

29 Chapter 3 Theoretical background Choice of Complexity When deciding on the level of complexity N, the firm has three effects it needs to balance in order to obtain the optimal amount of suppliers: A positive cost saving effect, and two negative effects called the dilution effect and the complexity penalty effect 4. The cost saving effect can also be referred to as a specialization effect. The model assumes that, as the level of complexity N, increases, each supplier has to perform a more narrowly defined task, thus potentially becoming more efficient at what they do. The increase in efficiency translates into a lower variable cost. The higher level of specialization leads, therefore, to an increase in the firms payoff. This effect was also the main driver behind the model of Acemoglu et al. [2007]. As mentioned, increasing complexity has downsides. First, increased complexity makes each supplier s input less important compared to the value of the final output, i.e. as the individual input intensity η i decreases, the overall revenue has to be split among more parties. In an incomplete contract environment, the resulting effect is that the supplier s incentive to invest becomes diluted, hence dilution effect. As in the King-Johnson example, the lower incentive to invest will affect the quality of the inputs and eventually affect the size of the revenue generated. Besides the dilution effect, adding additional suppliers to the supply chain also means more relationships to manage. Adding an additional supplier therefore increases the fixed cost of the firm. The complexity penalty can therefore be seen as a cost that increases, as more suppliers enter the supply structure. Summing up, the optimal complexity decision is therefore a trade-off between specialization and the incentive to invest; higher complexity leads to higher specialization, meaning a lower unit cost which will increase the firm s profitability. On the other hand, a complex structure with many suppliers decreases the investment incentive for each supplier, since their input becomes relatively less important. This resolves in a lower quality of components, leading to a smaller overall revenue. Further, an increase in complexity implies an increase in fixed costs, arising from maintaining relationships with a greater number of suppliers. 4 The terms used here are analogous to the ones used in [Schwarz and Suedekum, 2011]

30 Chapter 3 Theoretical background 21 Since the cost saving effect affects the variable cost, productive firms will have the largest gain from having many suppliers. The larger gain will make it easier to cope with the fixed cost, arising from the complexity penalty. The level of complexity is therefore expected to increase with productivity. As the example of King & Johnson illustrated, the allocation of incentives to invest is one of the main questions in an incomplete contract environment. Similarly, the expected revenue share should follow the importance of the input. For instance, in a case, where the headquarter intensity is increasing, so will the firm s optimal expected share of the final revenue. Since the remaining revenue share becomes smaller, but has to be split among the same number of suppliers, their incentive decreases. In order to countervail this effect, the headquarters can rely on fewer suppliers, meaning each supplier s component becomes relatively more important, and each supplier will therefore anticipate a larger share of the revenue generated. The downside is that less suppliers leads to a loss of specialisation, hence the cost saving effect becomes smaller. Still, the effect of an increase in the revenue share and the increase in importance of the component to the final output is here assumed to outweigh the reduction in the cost saving effect. These implications can be summarized in the following testable implications: Testable Implication 2. Within an industry more productive firms have a larger mass of suppliers, henceamorecomplexorganization. Testable Implication 3. Firms from more headquarter intensive industries have a lower mass of suppliers, hencealesscomplexorganization Choice of Global Scale When deciding on the global scale of operations, the firm can choose between sourcing from a domestic supplier or a foreign supplier. The trade-off in the model of Schwarz and Suedekum [2011] is that the fixed cost of setting up business abroad is higher than domestically. On the contrary, due to an assumed lower wage level in the foreign country, a firm would incur a relatively lower variable cost. This mechanism is similar to Antràs and Helpman [2004]. They were the first to introduce the dimension of global scale in an incomplete contract setting with the firm in center.

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