Outsourcing Versus Foreign Direct Investment: A Welfare Analysis

Transcription

1 CDE ptmbr 005 Otsorcng Vrss Forgn Drct Invstmnt: Wfar nayss rt Grovr Ema: Dh choo of Economcs Unvrsty of Dh Workng Papr No. 40 Cntr for Dvopmnt Economcs Dpartmnt of Economcs, Dh choo of Economcs

2 Workng Papr No. 40 Otsorcng Vrss Forgn Drct Invstmnt: Wfar nayss RTI GROVER bstract Forgn drct nvstmnt may not ncssary b th most far nhancng form of ntrnatona nvstmnt. Th host contry may ava optons k Jont vntr, tchnoogy cnsng, franchsng, otsorcng tc. host contry s choc of organzatona form shod dpnd on ts groth and far ffcts. Ths papr compars th far ffcts of FDI th that of otsorcng n th host contry sng Grossman-Hpman qaty addrs framork. If th host absorptv capacty s abov a thrshod v, otsorcng s mor far nhancng vs-à-vs FDI; h vn th or than thrshod absorptv capacty, otsorcng bng far mprovng ovr FDI s not rd ot. Kyords: otsorcng, forgn drct nvstmnt, absorptv capacty JE Cassfcaton: F, F3 cknodgmnts Ths papr as a chaptr of my M. Ph dssrtaton ndr th sprvson of Prof. Partha n. I am dpy ndbtd to hm for motvatng nnovatv thnkng and hs nvaab sbjct mattr xprts. I am aso thankf to Dr. rghya Ghosh and Dr. Masam Das for hpng m at varos stags of ths papr.

3 cton : Th ackgrond Gobazaton, masrd by any form forgn drct nvstmnt (FDI), otsorcng, ntrnatona mrgrs and acqstons, and cross-bordr frm nkags va jont vntr or cns agrmnts has ndobtdy ncrasd n th rcnt dcads. ong th FDI, snss Procss Otsorcng (PO) has bn a grong goba bsnss. Gartnr grop stmatd that th goba markt dmand for otsorcd bsnss srvcs od b ovr $300 bon by th nd of 004. McKnsy & Co projctd that Inda od gnrat $7 bon n otsorcng rvns, mpoyng. mon by 008. Ths s ndd a phnomna contrbton not ony to Indan GDP, bt aso to goba GDP. Goba trad ths xpands th conomc p and may t both th partcpatng natons ras thr far vs. omström t a. (998), aasbramanyam t a. (996) and ornsztn t a. (998) prsnt vdnc that nard drct nvstmnt has rasd th groth rat of many dvopng contrs hch accordng to arr and Pan (997) and ornsztn t a. (998) s d to transfr of tchnoogy. Incrasd comptton, tchnoogy transfr, ncrasd accss to ord markts d to spovrs to oca frms, and orkr tranng ar som of th channs throgh hch FDI can bnft th host conomy. Th mpact of forgn nvstmnt on conomc prosprty has sgnfcant pocy mpcatons and thrfor any pocy on forgn nvstmnt shod b basd on a mor hostc v of FDI. Dspt th ncrasng mportanc of FDI n th past and rcnty of otsorcng, th mpact of ths to atrnatv forms of forgn nvstmnt on th host contrs nvovd has rcvd ratvy tt attnton n th tratr. comparson of thr affct on th far of th host contry has bcom an mportant pocy ss. Ths papr compars th affct of FDI th that of otsorcng on factor prcs and aggrgat far n th host contry. Th forgn frm s mod of ntry affcts th ratv dmand for skd and nskd abor. Th mod shos that on form of forgn nvstmnt may yd hghr far than that of th othr ndr crtan condtons. pcfcay, t s fond that thr s a strong possbty that otsorcng tn , th amont of nt FDI rcvd by dvopng contrs has ncrasd from 4.4 bon doars to 70.9 bon doars, amost a forty tms ncras. Fnstra (998) compars svra dffrnt masr of ntrnatona otsorcng and args that thy hav a ncrasd.

4 nambgosy ads to a hghr far f th host contry has hgh absorptv capacty. ch an nambgos possbty dos not xst for FDI. Wfar s dffrnt n th to atrnatv forms of forgn nvstmnt, bcas th xtnt of skd and nskd abor dmand cratd by FDI and otsorcng ar dffrnt, hch mpacts thr ag rats and hnc GDP or far. Th dstncton btn FDI and otsorcng n ths papr s motvatd ssntay by Grossman and Hpman (003) th a f mnts addd from Grossman and Hpman (005) and (00). In Grossman and Hpman s trms, FDI s sf-prodcton n a forgn and h otsorcng s prodcton throgh a contract btn th MNC and th domstc partnr. Grossman and Hpman (003) s, to th bst of my knodg, th ony papr that formay hghghts th dffrnc btn FDI and otsorcng. Thr mod stds th dtrmnants of th xtnt of otsorcng and FDI n th hom contry ndstry n hch th prodcr nds spcazd componnts. Thy xpan otsorcng n trms of prodcton sca and argd that otsorcng taks pac nstad of FDI f t s prohbtvy costy for an nd prodct prodcr to manfactr n-hos a ntrmdat npts. Thy sho ho a host of factors k - th sz of th cost dffrnta (ncdng sarch costs and cost of cstomzng npts), xtnt of contracta ncomptnss, sz of ndstry, thcknss of th host contry markt for npt spprs and th ratv ag dffrnta btn th sorc and th host contry affct th organzaton of ndstry prodcton. Grossman and Hpman (005) sggsts that otsorcng srvs as a mans to xpot comparatv advantag ndryng n cross bordr dffrncs th tt ons of prodcton procss contractd ot. Ths s nk FDI, hr xtndng spcazaton to th v of sb-procsss and componnts coms th hghr ro for th parnt company sch as montorng ts sbsdary n th host contry. nothr crca dffrnc that s not modd mathmatcay n tratr s hat ths papr sha focs on. In partcar, assm that FDI sbsdary s ss sk ntnsv ratv to otsorcng prodcton nt n th host contry. Th ratona for ths assmpton s xpand as foos. Frst, FDI nvovs gratr tchnoogy transfr ratv to otsorcng for th smp rason that FDI s a part of th parnt company, h th npt spprs ndr

5 otsorcng agrmnt ar dffrnt ntts than th mtnatona. Thrfor, th hghr tchnoogy transfrrd to th sbsdary, t nd not ngag mor skd (and xpnsv) aborrs n ordr to brng abot ffcncy. Ths s on of th rason Das (00) cts for th fa n dmand for skd aborrs th FDI. cond, th basc tnt of th thory of MNC s that opratng n nfamar conomc nvronmnt and hghr tchnoogy transfr (ndr FDI) taxs a mtnatona n trms of prodcton cost and may dfat thr prpos of transtonng nto a mtnatona company. nc, th ratv ag of nskd orkrs n th soth s or than thr contrparts n th north; mor nskd orkrs ar mpoyd ndr FDI to sav on prodcton costs. Thrd, th mtnatona frm say chooss ovrsas drct nvstmnt nstad of otsorcng, d to som ntrnazaton motvaton. Th mtnatona company opratng a sbsdary n th host contry ooks at th skd orkr th sspcon as thy ar potnta carrrs of th MNC ndstra scrts (as a consqnc of orkr attrton), ths a sbsdary nvtaby hrs ss of skd orkrs. Ths aso xpans th or sk ntnsty of FDI prodcton vs-à-vs otsorcng. Forth, a rcnt srvy by Htt of otsorcng ndstrs n th dvopng contrs fnds that IT opratons and cstomr ratons tops th most frqnty gobay otsorcd fnctons (hch ar hghy sk ntnsv jobs), hras hstorcay, FDI has bn say n th manfactrng sctor. Th srvy frthr gos on to prdct that thr yars don th n, otsorcng aso ncras n fnanc and accontng and hman rsorc, makng otsorcng st mor sk ntnsv ratv to FDI. Ffth, mprca vdnc by Fnstra and Hanson (996b), achs and hatz (994), saghtr and ag (997), aghtr (000) aso ndcats that otsorcng ads to a gratr dvrgnc btn th skd and nskd orkrs ags n th sorc as as th host contry, h FDI dos not. Gratr dvrgnc n factor prcs of skd and nskd abor rfcts th dffrnta dmand for th to typs of abor ndr th atrnatv forms of forgn nvstmnt. Ths, mprca vdnc favors th assmpton that otsorcng s mor sk ntnsv than FDI for th host. xth, th abov conomc rasonng and mprca vdnc rgardng FDI and otsorcng s rfctd n th formaton of thortca conomc mods. Grossman 3

6 and Hpman (005) and (00) dscrb otsorcng as spcazd or cstomzd srvcs by th npt spprs for th mtnatona compans, mpyng gratr ntnsty of skd abor n prodcton by th otsorcng partnr. Fnstra and Hanson (996a) mod aso ndcats that otsorcng s a sk ntnsv actvty from th pont of v of th host contry (as as th sorc contry). X (000) sggsts for FDI that a ratv ncras n skd basd dmand shfts n a th sctors dos not ncssary mpy sk-basd dmand shft n th contry bcas FDI may b nskd abor-ntnsv actvty n th host contry. Morovr, Marksn and Vnabs (999a) comparson of th ra ag of skd abor btn contrs rvas that th ntry of mtnatonas throgh FDI crats a tndncy toards factor prc qazaton. Gvn that, to bgn th, th dvopng contry (oth) has hghr ratv ag for skd abor vs-à-vs th dvopd contry (North), factor prc qazaton od mpy that drct forgn nvstmnt ntry mght or th ag of skd abor n th skd-abor scarc contry (host contry). Ratv ags of skd abor may fa ndr FDI f FDI has o sk ntnsty. To nnovatons ar attmptd n ths papr. Frst formay dstngsh btn th to forms of forgn nvstmnt - FDI and otsorcng n a nfd framork and scond choos to addrss th probm from th pont of v of a host contry th non-homognos abor. Ths mod s dffrnt from Fnstra and Hanson (996b) as ntrnatona otsorcng and FDI ar togthr knt as part of a prodct cyc framork n hch mtnatonas ar trggrd by cost savng opportnts. W ao for sbstttabty btn skd and nskd abor n manfactrng, a fatr, hch s mssng n Gass and agg (00). Th mod s a varant of th standard North-oth qaty addrs groth mod of Grossman and Hpman (99) as n Gass and agg (00) bt nrchd by ntrodcng htrognty of abor. Th mod s framork shars smarty th Rs (00), hovr, th on dffrnc. In ths mod, assm that th good prodcd by th mtnatona s not compttv th th good prodcd by th domstc frms n th oth. Hnc, mtnatonas do not drv th othrn frms ot of th markt. Hovr, th mtnatonas do compt for abor th th othrn frms, hch may affct ags and otpt of th prfcty compttv othrn frms. 4

7 Kpng th basc prms of or mod n mnd, that s, otsorcng partnrs s mor sk ntnsv tchnq of prodcton than thr contrparts n a sbsdary, mov on to otn th organzaton of ths papr. cton bds p th mod; scton 3 charactrzs qbrm n th host contry and th condtons ndr hch on form of forgn nvstmnt scors ovr th othr n trms of far. cton 4 dmonstrats a comparatv statc xrcs of th mpact of nvstmnt n hman capta n th oth on far n th host contry. cton 5 concds th papr. cton : Th Mod Ths scton bds a North-oth framork that spcfcay rvovs arond th vnts happnng n th host contry. Each contry s ndod th to typs of nastcay sppd abor, th skd and th nskd abor, ho ar consmrs of fna goods. Consmrs n th ord conomy drv tty from consmpton of to knds of goods. On of th consmpton goods s th homognos agrctra good, hch s prodcd ony n th oth ndr prfct comptton. Th othr good, hch ntrs th tty fncton of th consmrs, s th vrtcay dffrntatd manfactrng good. y dfnton, thn th manfactrng prodcts, consmrs drv mor tty from hghr qaty manfactrng prodcts and ar ng to pay a prmm for hghr qaty. Ths gvs manfactrng frms an ncntv to do xpnsv R&D and nnovat to cmb p th qaty addr. Th tchnoogca capabty of th frms n th oth s assmd to b o and thrfor, ony th northrn frms carry ot nnovaton. Imtaton s rd ot n th mod. prodct cyc s gnratd n hch shfts n prodcton to th oth may occr thr throgh FDI or otsorcng. FDI and otsorcng ar modd as mtay xcsv forms of forgn nvstmnt. Ths s nk Grossman and Hpman (003) hr FDI and otsorcng co-xst n th ndstry. Evn thogh th assmpton s ss rastc, ts ssnta to vaat th ndpndnt mpact of ach of ths forms of forgn nvstmnt on host contry far and factor prcs. Or approach s smar to Ottavano and Trrn (003), hr thy mod xports, FDI and otsorcng as 5

8 mtay xcsv ays of captrng th othrn markt. Gass and agg (00) aso ao thr forms of forgn nvstmnt, FDI and cnsng to co-xst bt ths can b attrbtd to th smpcty of thr mod. Th startng pont of th mod by Gass and agg s th optma mod choc by th mtnatona frm and groth ffcts atomatcay foo. Thy assm aay any changs n ags n thr symmtrc tocontry mod d to changs n mod shfts. Morovr, a chang n nnovaton ntnsty manatng from th ratv masr of FDI or cnsng s th ony drvng forc for groth n thr mod. In th mod prsntd bo, gnor th probm of mod choc btn FDI and otsorcng from th prspctv of th mtnatona frm, and focs on th prfrrd mod of forgn nvstmnt by th host contry govrnmnt. Ths knd of approach coms from th bf that proft maxmzaton s th ony motv that drvs a frm to choos a partcar form of forgn nvstmnt. Thrfor, a host contry govrnmnt can aays fram ncntv schms to attract that vry mod of forgn nvstmnt that brngs hghr far for ts conomy. To mak mattrs smp, assm that th host contry s a ratvy sma opn conomy to b ab to affct any of th varabs n th North or th sorc contry. Thrfor, varabs k northrn ags, masr of Northrn frms ar xognosy gvn for othrn stady stat qbrm. On th othr hand, th mtnatonas n th host contry ar arg nogh to mpng on th abor markts n th host contry and hnc affct ags and far. cton.: Hoshod havor cton..: Consmpton Consmrs probm s modd n th sprt of Grossman and Hpman (99) qaty addrs mod. Consmrs v n on of th to contrs, North or oth, h {N, }, bong to on of th abor typs, {, }, for nskd abor and for skd abor. Consmrs tak markt varabs as gvn and maxmz a Cobb Dogas Utty fncton ncrasng n consmpton of homognos good y and an aggrgat X of th vrtcay dffrntatd manfactrng good hos prc vars accordng to th stag of th prodct cyc. For consmpton of X, consmrs choos from a contnm of manfactrng prodcts ndxd by j [0, ] avaab n dscrt qaty vs ndxd 6

9 by m. Qaty v m of prodct j provds qaty q j) ξ m m (. consmrs va hghr qaty of manfactrng goods, that s, ξ >. ξ dnots th nnovaton sz or magntd of th qaty jmp. Th tty fncton of a rprsntatv consmr n contry h and of abor typ s gvn by: γ γ [ Χ ] [ y ] U = {(nskd), (skd)} () y, hch s th homognos prfcty compttv agrctra good s chosn to b th nmrar h X, th aggrgat vrtcay dffrntatd manfactrng good s rprsntd as: Χ h = 0 m h ξ x, m ( j) dj () m Whr m ξ s th assssmnt of qaty v m and ( ) s th consmpton of qaty v m of prodct j by abor typ n contry h. x h, m j Th consmrs maxmz th tty as gvn by th tty fncton n () sbjct to th bdgt constrant: h h h y P X = E (3) Whr h E s th ncom of a rprsntatv abor typ rsdng n contry h and P s th compost prc of th manfactrng good. Maxmzng () sbjct to (3), and aggrgatng ovr both contrs and both typs of abor gt th aggrgat dmands of th homognos agrctra good and th vrtcay dffrntatd manfactrng goods as: y = ( γ )E (4) P X = γ E (5) Whr N N E E E = E = (6) ( dnots mpoymnt of typ abor n oth and th corrspondng ag). nc ths s a statc mod ook at on dscrt v jmp n qaty that gnrats a prodct cyc. 7

10 pcfcay, E ncds th ag ncom of th othrn aborrs, ag ncom of th northrn aborrs and profts of th frms n th to contrs. s mntond bfor, N oth bng sma contry cannot nfnc E. consmr tty maxmzaton probm s brokn n thr stags. In stag on, thy dcd on th proporton of xpndtr to b spnt on manfactrng and agrctra goods. In stag to, thy aocat th avaab xpndtr for ach prodct. In th fna stag, th consmr aocats spndng for ach prodct to th qaty v m ~ ( j ) offrng th ost qaty adjstd prc. Ths, n qbrm, th consmrs choos ony on qaty of a prodct that has ost qaty adjstd prc. am qaty v s chosn rrspctv of th contry of rsdnc or th typ of abor bcas thr s a nq qaty of a prodct that has ost adjstd prc. In th scond stag, th consmr vny sprads spndng across th nt masr of a prodcts, γ E ( j) = γ E as th astcty of sbsttton btn varos h h prodcts of th manfactrng sctor s assmd to b nty. ggrgat Consmrs dmand x ~ ( j) = γ E p ~ ( j) nts of qaty v m ~ ( j ) of prodct j and no othr nts of m othr qaty v of that prodct. m cton.: Prodcrs cton..: Prodcton trctr Th consmrs ar ng to pay a prmm of ξ for a sng jmp n th qaty of th prodct, hch motvats th frm to ndg n costy R&D of nnovatng hghr qaty vs. ssmng that th potnta for qaty mprovmnt s nbondd, ony th northrn frms has th abty to drv forard th ord qaty frontr for th xstng prodcts throgh nnovaton. Wh R&D racs n th North occr smtanosy for a prodcts thn th X sctor, ntrprnrs n th oth ar nffcnt at nnovaton or mtaton. Onc a hghr qaty prodct s dvopd, northrn frms ndrtak ts prodcton and rap profts. s n Vrnon (966), aso assm that a prodct dvopd n th north s prodcd by th northrn frms t ts prodcton gts standardzd. Onc ts prodcton s standardzd, as n Gass and agg (00), Marksn and Vnabs (998), th northrn frm has th opportnty to 8

11 bcom a MNC by shftng ts basc stag of prodcton to a o cost naton thr throgh FDI or otsorcng. Otsorcng s a mor transacton ntnsv procss vs-à-vs sbsdary formaton. Grossman and Hpman (003) dscrb th formaton of otsorcng ratonshp as a to-stag procss frst, th nvstmnt contract and thn th ordr contract. Evn thogh th procss of fndng an otsorcng partnr n oth s mch mor compcatd 3 than sttng p a sbsdary nt, abstract from sch dffrncs to focs on th far comparson ss. Ths smpfyng assmpton mps that th rgm shft n th host contry from FDI qbrm to otsorcng qbrm (or vcvrsa) ntas ony on xognos chang, that s, th chang n th tchnoogy of prodcton (va th xognos chang n sk ntnsty). t ths stag, prhaps t s orth mntonng that otsorcng may sm to shar smarts th cnsng. Hovr, n ssnc t s a vry dffrnt procss than cnsng. cnsng mps sa of tchnoogy to a host contry ntrprnr h otsorcng s a contract to prodc a part/stag of tota otpt, that s, otsorcng say nvovs fragmntaton of th prodcton procss h cnsng dos not. Otsorcng partnrs n th host contry provd on of th npts for th fna good prodcd by th mtnatona company hras, th cns prodcs th ntr prodct hrsf and drcty ss t to th markt. cond, vn thogh cnsng aso nvovs fndng a match btn th cnsor and th cns bt th natr of ths sarch or matchng procss s vry dffrnt ndr otsorcng. In tratr, cns sarch has bn modd mor k an acton (Casson and cky, 98 and Casson, 979) h sarchng for otsorcng partnrs hav bn modd n a mannr smar to R&D (Grossman and Hpman, 00a). Thrd, onc th cns s sod to th cns h s say fr from any knd of nspcton of prodcton procss, pr contra, otsorcng partnr contrbts to an npt n th fna good prodcd by th MNC. Thrfor, apprasa and qaty chck of th partnr s prodct s a mst. Ths, otsorcng s a mch ongr trm and ntractv ratonshp than smpy cnsng. 3 Fndng an approprat partnr n th oth, Grossman and Hpman (005), ntas sarch R&D on th part of th prospctv MNC. Th probabty of fndng th partnr as n Grossman and Hpman (005) dpnds on markt thcknss, ga nvronmnt n th oth and aso by th sk ntnsty of prodcton bng transfrrd. 9

12 Forth, f a cnsor maks ffort to ntrnaz and assmat and frthr mprov th tchnoogy, t s pry hs gan, h f th otsorcng partnr bds on th tchnoogy gvn by th mtnatona, both agnts gan. Ffth, say th cnsng contract spcfs x-ant ho mch a cnsor arns n th proft and aso th royaty f h ndr an otsorcng contract ths dcson s mad x-post prodcton. Gttng back to th mod, shftng a part of a mtnatona frm prodcton to th oth hthr throgh cratng a sbsdary or throgh contractng ot to otsorcng partnr frm, ors ts cost of prodcton and drvs th northrn frms ot of th markt. On th othr hand, th MNC may aso b drvn ot of th markt by frthr nnovaton by th northrn frms, ( fgr ). cton..: Manfactrng Tchnoogy ssm that th prodcton ndr th mtnatona frm s sparatd nto to stags th basc stag of prodcton and th advancd stag. s n Gass and agg (00), assm that to prodc on nt of fna good, a mtnatona frm mst combn α nts of otpt from basc stag of prodcton th ( α ) nts of otpt from advancd stag of prodcton prodcd n th North. Ths can b nvsond as a fragmntd prodcton strctr hrby advancd prodcton 4 nvovs th manfactrng of sophstcatd ntrmdat npts and basc prodcton nvovs th bndng of fna goods by sng ths ntrmdat npts. Pr contra, Gass and agg (00) assm that on nt of abor s rqrd for prodcng on nt of otpt, hch maks thr prodcton stratgy vry rgd as abor rqrmnts do not rspond to factor prcs. Morovr, thy do not dstngsh btn skd and nskd abor, and as a rst thr mod dos not ao for any sbstttabty across factors of prodcton. W do aay th ths assmptons n or mod. W s a standard nocassca prodcton fncton. Th prodcton tchnoogy of MNC s rprsntd as: 4 Gass (004b) xpans th fndamnta assmpton bhnd th rason for not transtonng th ntr prodcton procss to th oth. Ths foos as a drct mpcaton of th assmpton of nffcncy of oth n handng th advancd stag of prodcton. 0

13 X M N N N = ( α ) f (, ) α f (, ) Ot of th tota manfactrng otpt prodcd by th mtnatona frm ( α) s prodcd sng mtnatona tchnoogy n North and α sng th sbsdary or th ( otsorcng partnr tchnoogy, f, ) n oth. It shod b notd that th tchnoogy of prodcton s dffrnt for FDI sbsdary and otsorcng partnr and ths th sbscrpt ε {q(fdi), o(otsorcng)}. Th margna cost (MC) of prodcton of th Mtnatona frm s a ghtd sm of basc stag MC ncrrd by th MNC prodcton nt n th oth, MC (by sbsdary or otsorcng partnr) and advancd stag MC ncrrd by th MNC prodcton nt n th North, N MC MNC MC Or MC M M N ( α ) MC α MC = MNC N ( ) MC [ a ( ) a ( ] α (7) = α MNC,,, ), k h a ( ) s th nt/margna rqrmnt 5 of typ othrn abor, ndr MNC ntry, mod, by th frm typ k ε {(othrn domstc frms), (sbsdary or otsorcng partnr n oth)} 6. othrn domstc frms prodc th homognos good y ndr prfct comptton th a CR prodcton fncton, f, ). Th margna cost of prodcton ( n a othrn frm prodcng agrctra good y s gvn by: 5 It s knon that for a no-cassca, constant rtrns to sca prodcton fncton, th nt abor rqrmnts s qa to th margna abor rqrmnt and that ths coffcnts of abor rqrmnts h h = h can b xprssd as a fncton of th ratv ag. t rprsnt th ratv ag of skd abor for contry h = N,. To obtan th nt/margna abor rqrmnts, consdr th mpd cost fncton and s hphard s mma aong th homognos of dgr on proprty of th prodcton fncton. 6, q( ) For xamp, a s th nskd abor rqrmnt by th othrn frms ndr FDI and smary, a, o( ) s th skd abor rqrmnt by Mtnatona prodcton nt n th oth ndr otsorcng.

14 MC = a (, (8), ), a, ( ) nc northrn ags ar assmd to b gvn xognosy, margna cost of th northrn natona frms s jst qa to a constant, say, χ. cton..3: Prcng Dcsons of th frms mtnatona frm, hch spts prodcton btn North and oth, compt th a northrn frm. Th qaty v of th prodct of a mtnatona frm s no bttr than that of th northrn qaty adr. Thrfor, mtnatona frms ngag n mt prcng and charg a prc qa to th margna cost of prodcton of northrn frms, χ. On th othr hand, prc comptton among othrn frms drvs don good y prcs to margna cost qa to on. P = MC = C = cton..4: Indstry Fos t N n and n M rprsnt th masr of northrn frms and mtnatona frms rspctvy. In qbrm, ths masrs ar constant and dtrmnd by Northrn frms nnovaton ntnsty, th probabty of standardzaton and th probabty of formaton of sbsdary or otsorcng partnr. In ths mod assm ths factors to b xognos. cton..5: Rsorc Constrants Th ast bdng bock of th mod s th rsorc constrant of th oth. othrn skd abor rqrd by othrn frms for good y prodcton ndr mod of forgn nvstmnt s a ( ) [( γ ) E ], and by mtnatona frms for good X s M γ E α n a, ( ) χ For skd abor markt qbrm n oth, γ E = M a ) [( γ ) E ] α n a (, (, ) χ ()

15 mary, n qbrm, nskd abor dmand n oth s qa to th gvn nskd abor sppy: γ E = M a ( [( γ ) E ] α n a ) ( ) (),, χ Ths compts th formaton of th mod. W can no trn to th nxt scton that compars far ndr th to atrnatv forms of ntrnatona nvstmnt n oth. cton 3: Eqbrm n oth and Wfar Comparson In ths scton, compar th far mpact of a rgm shft of forgn nvstmnt from say, FDI qbrm to otsorcng qbrm (or vc-vrsa) n th host contry. W can mod th far ffct of a chang n th mod of forgn nvstmnt n th host contry as a comparatv statc xrcs. To carry ot ths xrcs, nd to spcfy on of th to mods of forgn nvstmnt as th nta qbrm. Wthot oss of gnraty, may assm that FDI consttts th nta qbrm 7 n th host contry. Ths mps that, to bgn th, th ord conomy bng anayzd has a ts ntrnatona nvstmnt or fragmntd prodcton throgh forgn sbsdars. Thn may ask hthr a rgm shft from FDI to otsorcng can ncras th ra GDP of th oth and f t s possb, qafy ths condtons. W can aso rvrs or qston and qafy condtons ndr hch aggrgat ra ag arnngs fa rprsntng a far oss aftr rgm shft from FDI to otsorcng. Thr ar to dffrnt componnts of chang n th sk rqrmnts ndr otsorcng. Th frst of ths chang s ndognos, hch coms abot d to changs n ags as mov from nta FDI qbrm to th otsorcng stady stat. sds ths ndognos chang, thr aso xsts an xognos chang n th ratv dmand for th to typs of abor manatng from th chang n tchnoogy of 7 Thr s nothng sacrosanct abot choosng FDI as th nta qbrm and cod aso choos otsorcng to consttt th nta qbrm. Ths not chang th natr of or rsts and condtons obtand. 3

16 prodcton sd ndr otsorcng vs-à-vs FDI. s notd n th ntrodcton s or assmpton that otsorcng prodcton by partnrs of MNC n th oth ss a hghr sk ntnsv tchnq of prodcton vs-à-vs FDI prodcton n forgn sbsdars. W spt th changs n margna abor rqrmnts that rst from th rgm shft of forgn nvstmnt nto th xognos and ndognos componnts. t th xognos rat of chang (that corrsponds to th chang n tchnoogy of prodcton) n margna abor rqrmnts th rgm stch by th mtnatona prodcton nt n th oth for typ of abor b rprsntd by da ( xognos) = =, a mary, th ndognos contrpart chang s rprsntd by k k k da ( ) a = =, and k =, a oth xognos and ndognos changs n margna abor rqrmnt ntas a chang n margna cost of prodcton th a shft from FDI qbrm to otsorcng qbrm. Totay dffrntatng MC to gt th chang n margna cost of prodcton of th othrn nt of th mtnatona frm (as mov from FDI qbrm to otsorcng stady stat): MC = (4) nd totay dffrntatng qaton (8), gt: MC = 0 (nc y s th nmrar good) (5) = = In qaton (4) and (5) a. MC k k k = rprsnts th cost shar of typ abor n k prodcton by k typ frm n th host contry. Usng th abov xprsson gt that, k k k = σ ( ) and a = σ ( ) k =, (6) k a k k 4

17 5 Whr k σ s th astcty of sbsttton btn th to factors of prodcton. Totay dffrntatng th othrn rsorc constrants, and sbstttng for k â from (6) and sng E = Whr ψ E E E E = = and ψ s th shar of th host contry GDP n goba GDP, gt th foong to qatons n and 8 ( ) [ ] ( ) [ ] = (7) [ ] [ ] = (8) Whr σ σ = σ σ = Th abov systm of qatons may b rprsntd n th foong matrx form: [ ] [ ] [ ] [ ] [ ] 0 0 ) ( ) ( = Th st of to qatons and th sbsqnt matrx can b sovd to gt th chang n ags d to xognos ncras n sk ntnsty that happns as a rst of rgm shft of forgn nvstmnt from FDI to otsorcng, that s, can drv d d = for =,. 8 s ar th proportona abor shars. For xamp, = χ γ α E a n M ) ( s th proporton of typ abor of oth mpoyd by MNC manfactrng prodcton nt n th oth.

18 6 [ ][ ] [ ] ) ( ) ) ( ( ) ( = Inttvy, hn th sk ntnsty of prodcton ncrass 9, od xpct th sk prmm to ncras and by qaton (5), ths mps that an ncras n ags of skd abor shod ncssary b matchd by a fa n ags of nskd abor. To mak far comparsons across th to atrnatv rgms of forgn nvstmnt, nd to ook at ra ag ffct. In th crrnt stp, th othrn domstc good s chosn as th nmrar h th prc of th mtnatona good dpnds on th xognosy gvn margna cost of northrn frms, χ. Th ony dffrnc that arss n prc ndx ndr th atrnatv rgms of ntrnatona nvstmnt s d to prc of th northrn frms goods 0. Th prc of northrn frm s good s a qaty mark p ovr th margna cost of th mtnatona s prodcton nt n th oth. Ths, a comparson of ra ags n th to mtay xcsv forms of ntrnatona nvstmnt mst dpnd on th MC of prodcton of th sbsdary and th otsorcng partnr. MC p = FDI ads to a hghr far vs-à-vs otsorcng f th ra GDP aftr th rgm shft to otsorcng s or, that s: 0 < p p or, ( ) 0 < K ζ 9 ppndx for condtons ndr hch 0 > 0 nc th host s sma by assmpton a chang n margna cost of MNC prodcton nt n oth hch changs th prcs of northrn goods s a vry sma componnt of prc ndx of th North. trcty spakng th prc ndx shod chang by a proporton of chang n margna cost of mtnatona prodcton, hovr, to smpfy th agbra assm an q-proportona chang.

19 Whr, ζ = and K = > 0 s xognos. If, rstrct > 0, gvn by th condtons n th appndx, thn a ncssary condton for FDI to gnrat hghr far vs-à-vs otsorcng s ζ < (9.) Ths, FDI may ad to a hghr far ratv to otsorcng f th host contry has a or absorptv capacty ratv to forgn sctor absorpton of skd abor. On th othr hand, th abov rst aso ndcats that a sffcnt condton for otsorcng to gnrat hghr far s: ζ > (9.) Ths mps that f th absorptv capacty of th host contry s abov th forgn sctor absorpton gvn by ratv cost shar of skd abor to nskd abor n th forgn sctor, thn otsorcng dfnty ads to hghr far. Ths rst s nttv bcas of th fact that otsorcng vas skd abor mor than FDI. Ths, otsorcng crtany ads to hghr far provdd th host contry has th rqrd absorptv capacty. Ths rst ndcats som sson for th dvopng contrs that compt bndy for FDI offrng sbsds and attractv packag ncntvs to th mtnatonas. It maks sns for th host contry to attract FDI ony f thy hav o v of sks ratv to forgn sctor absorpton n th host contry. Hovr, th rsts aso ndcat that vn f th domstc absorptv capacty,ζ, s o, FDI may st not ad to hghr far. On th othr hand, f th domstc absorptv capacty s abov th thrshod dfnd, thn, th host contry crtany gans from otsorcng contracts rathr than FDI. 7

20 cton 4: Comparatv tatc: Th Effct of Invstmnt n Hman Capta ppos ao for nvstmnt n hman capta formaton n oth. Wth an nvstmnt n dcaton that ads to hghr ratv sppy of skd abor ovr th ong rn prod, th far of th conomy s mpactd d to changs n ags n stady stat. Dos ths ncssary mpy a hghr v of far for th host contry and hthr ths mpact s hghr ndr FDI or otsorcng? W carry ot a comparatv statc xrcs thn ach rgm of forgn nvstmnt FDI and otsorcng and ask th qston that ndr hat condton dos th ra GDP ncras th nvstmnt n hman capta. In th crrnt st p of th mod, cannot drcty compar th dffrnta ffcts of ncras n th ratv sppy of skd abor on FDI th that of otsorcng. Hovr, may do so ndrcty by comparng condtons ndr hch thy gnrat smar rst. cton 4.: Effct of Hman Capta Formaton ndr FDI and otsorcng Invstmnt n hman capta formaton s sch that nskd orkrs pgrad thr sks and mov to th skd abor catgory of orkrs, kpng th tota abor forc constant. Thrfor, d = d d d = = ζ (0) Totay dffrntatng th rsorc constrants, that s, qatons () and () and sbstttng qatons (4), (5) and (0), gt th foong to tota dffrnta qatons: [ ] [ ] = (),,,, [ ] [ ] ζ () =,,,, Pttng th abov systm of qatons n matrx form, gt th foong matrx. 8

21 9 [ ],,,,,,,, = ζ [ ] [ ] Ω =,,,, ζ, ( ) ( ) [ ] Ω =,,,, ζ nc th ags of th to typs of abor mov n oppost drcton by vrt of qaton (5), t s thrfor ky that th nvstmnt n hman capta, hch ncrass th ratv sppy of skd abor, th sk prmm gos don. cton 4.: FDI Vs Otsorcng: Th Effct of Hman Capta Invstmnt Wfar rss ndr FDI or otsorcng aftr nvstmnt n sk f th foong condton hods: ( ) ( ) 0 > p p sf sf Usng qaton (7) gt, MC p M sf = =. bstttng qaton (5), gt = p sf bstttng qaton (5), and th prc chang aftr sk formaton, sf p nto th abov xprsson, gt: 0 > ζ ζ (3) Ths, condton (3), nds to b satsfd n any rgm of forgn nvstmnt for nvstmnt n sk formaton to b far nhancng. Ths, a ncssary condton for ffcnt condton for 0 < s: < ζ,,, h th sffcnt condton for 0 > s:,, < ζ. Combnng th to condtons, gt:,,,, < < ζ

22 ra GDP to rs th nvstmnt n sk formaton, gvn that sk prmm fas th ncras n skd abor s: ζ <. No, to compar th mpact of sk nvstmnt ndr FDI th that of otsorcng, not that, at gvn ratv ags n th oth, hghr sk ntnsty of otsorcng partnr vs-à-vs forgn sbsdary mps that < and >. q o q o Ths mps that o > Ths, thr s a gratr chanc that th domstc q absorptv capacty,ζ, s or (than acta absorpton by th MNC prodcton nt) for otsorcng rathr than FDI. In othr ords, f ζ < s satsfd by FDI rgm, thn t ncssary s satsfd ndr otsorcng bt not vc-vrsa. Hnc, t may pay mor to hav nvstmnt n hman capta ndr otsorcng rathr than FDI bcas otsorcng vas skd abor mor than FDI. Thrfor, t s mor probab for nvstmnt n sks ndr otsorcng to b far mprovng vs-à-vs FDI. cton 5: Concsons In ths papr forgn nvstmnt n th form of thr FDI or otsorcng s takn as an xognos vnt and th focs of ntrst s on thr affct on far n th host contry. Th approach that choos rns as foos. W dvopd a prodct f-cyc mod n ths papr that focss spcfcay on th vnts n th host contry. Th dstncton btn FDI and otsorcng n th mod prsntd s motvatd ssntay by Grossman and Hpman (003) th a f mnts addd from Grossman and Hpman (005) and (00). Th mprca and thortca dffrncs btn FDI and otsorcng ads to th concson that FDI s ratvy ss sk ntnsv vs-à-vs otsorcng. Ths concson drvs a nmbr of rsts 3 n ths 3 It s aso possb accommodat th dffrnta mpact of FDI and otsorcng on sk formaton n th host contry by ndognzng th sk acqston dcson of orkrs as n ayk and nr (00) and a t a. (003). In sch a sttng, FDI ndcs sk formaton by gttng th nskd abor n cos contact th th n tchnoogy of th North, h ndr otsorcng, ndvdas rspond to ncrasd sk prmm by ndrtakng tranng and bcomng skd. 0

23 papr. It s fond that ndr crtan condtons, dpndng on th absorptv capacty of th host contry, astcty of sbsttton n prodcton and th ratv dmands gnratd by FDI and otsorcng for th to factors of prodcton, otsorcng or FDI may ad to a hghr v of ra GDP. pcfcay, a vry ntrstng rst coms abot throgh or forma tratmnt of th mod. It s fond that, f th absorptv capacty of th host s hghr than th forgn absorpton (gvn by th rato of costs shars of th skd and nskd abor n th forgn sctor), thn, otsorcng crtany ads to hghr far. Hovr, f th absorptv capacty of th host contry s bo ths drvd thrshod, thn, FDI may ad to hghr far. Evn n ths cas, otsorcng bng far nhancng s not rd ot. Ths rst shod ras aarm for contrs bndy tryng to attract FDI by gvng ncntvs spcay n th form of sbsds and tax raxaton. Th scond crca rst of ths papr concrns th ratv mportanc of nvstmnt n sk formaton n th to atrnatv mods of forgn nvstmnt. It s fond that fforts to ncras sks n th host contry s mor ky to payoff ndr otsorcng ratv to FDI, snc otsorcng vas skd abor mor than FDI.

24 tandardzaton Northrn Natona Frms Mtnatona Frms Innovaton Innovaton X Prodcton Cyc bsdary formaton Or Otsorcng partnr arch othrn Natona Frms: y Prodcton MNC nt n oth (sbsdary or otsorcng partnr) Fgr : Prodcton trctr of th Word Economy

25 ppndx Th to atrnatv condtons ndr hch sk prmm to ncrass th otsorcng ar: Cas a.: If <, thn a sffcnt condton for sk prmm to ncras th otsorcng s: < <. Ths, f a ghtd masr of astcty of sbsttton btn th to typs of abor s or (than th xpndtr shar of th nskd abor), thn, a sffcnt condton for sk prmm to rs th otsorcng s that th cost shar of nskd abor mst b gratr than th shar of skd abor n th forgn sctor. Th ntton for ths rst s smp. Wth hgh nskd abor shar n th forgn sctor, a shft to otsorcng (from FDI) dramatcay ncrass th dmand for skd abor that tnds to ras sk prmm. On th othr hand, a o dgr of sbstttabty btn th factors dos not ao asy sbsttton of nskd th skd abor. Thrfor th ags of skd abor dfnty rs. Cas a.: If >, thn a ncssary condton for sk prmm to ncras th otsorcng s: > >. That s, f a ghtd masr of astcty of sbsttton s hghr (than th xpndtr shar of th nskd abor), thn, a ncssary condton for sk prmm to rs th otsorcng s that th cost shar of skd abor n th forgn sctor of mst b gratr than that of th nskd abor. 3

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28 aghtr, M. and ag, P., Th ffcts of gobazaton on ags n th advancd conoms, IMF Workng Papr WP/97/43 (997). Vrnon, R., Intrnatona nvstmnt and ntrnatona trad n th prodct cyc, Qartry Jorna of Economcs 80 (966): X, n, Th Ratonshp btn Otsorcng and Wag Inqaty Undr ctor- pcfc FDI arrrs, Unvrsty of Forda, Workng Papr (5//00) (000). * Compt st of orkng paprs s avaab at th CDE bst: 6