Lecture 5

Question 1

Global supply chain

Answer 1

Exporters are
Importers.
Importers are
Exporters.
Many
companies
invest and have
operations
across the
world.

Question 2

Supply chains and economic interests

Answer 2

Not all import-competing sectors benefit from protectionism
* Some firms and workers in import-competing sectors are part of Global
Supply Chains:
 These firms also depend on imports as inputs for production
 May receive foreign direct investment (more on that later) that depends on trade
openness

Question 3

Trump’s steel tariff

Answer 3

• In February 2018 Trump imposed a 25% Tariff on Steel Imports from EU and elsewhere
• This should have led to record profits in the US steel industry…
• They should have performed better than traditional stocks.
  Did they help the industry? They did for a bit.
  However, when Trump imposed tariffs on other
  Chinese inputs, things changed.
• Chinese imports are key intermediate goods in the
  production of many products that also use steel.
• This made other parts in goods using steel, but made
  in the US, more expensive to make and thus demand
  fell
• Less steel was demanded because the products
  making steel (like cars) became too expensive.
• The lesson:  The modern supply chain is complex. Simple tariffs can
  have complex results.
   Maybe our models are too simple for the complex global
  economy

Question 4

2 categories of FDI

Answer 4

Portfolio investment and direct investment

Question 5

Portfolio investment

Answer 5

 Investors have claim on some income, but do not manage the investment (less than a controlling percentage)
 Investors only interested in the rate of return
 Ex: Stocks, Bonds
 Highly mobile, can be sold instantaneously
 Includes sovereign lending
 Lending directly to a country’s government (We’ll explore this in greater detail in a few weeks)

Question 6

Direct investment

Answer 6

 Investment by a company that owns and controls facilities that are located in another country
 Ex. Shell Oil Refinery in Nigeria
 Ex. BMW factory in US
 Ex. Foxconn factory in Brazil
 Highly immobile, requires a fixed-investment
* When we talk about Multinational Companies, we are typically talking about direct investment

Question 7

MNC, what are they?

Answer 7

Multinational Corporation:
 A single corporate structure that controls & manages production establishments in at least 2 countries
* Emerged during the late 19th century
 Maybe before (Dutch & British East India Companies)
* Initially UK companies dominated
 1
st US MNC in 1867
 US overtook UK in 1920s as largest source of FDI
 Since 1960s US dominance has diminished
 Europe, Japan, and other countries/regions, have gathered steam
* MNCs are not new but the growth of MNCs is.

Question 8

Why invest abroad?

Answer 8

• Why not just hire a foreign company?
   Like Apple does to build its products (Foxconn)
  1. Locational Advantages
  2. Market Imperfections

Question 9

Locational advantages

Answer 9

Large reserve of natural resources
Acces a large local market
market-oriented investments
 “jump over” trade-barriers!
 E.g. car factories in Brazil
Enhance efficiency
 lower cost of the factors of production
 match the factor intensity of a production stage to the factor abundance of
particular countries:
 Go where you get the most for your money
 Design the Honda Accord in capital-abundant Japan, Assemble the car in laborabundant Mexico

Question 10

Market imperfections, horizontal integration

Answer 10

• Intangible asset:
   The value is derived from knowledge or from a set of skills/routines possessed by a firm’s
  workforce
   “know-how”
• It is difficult to sell or license intangible assets

Question 11

Market imperfections, vertical integration

Answer 11

• Specific assets – dedicated to a particular long-term economic
  relationship
• Difficult to enforce long-term contracts
• One party in the long-term relationship can take advantage of the
  specific nature of the asset to extract a larger share of the value
  from the transaction
   One party has leverage to make concessions of the other in the future and
  engage in opportunistic behavior
• Vertical integration eliminates this problem arising from specific
  assets

Question 12

Time inconsistency in long-term contracts

Answer 12

This is called a time-inconsistent preference problem
* What you want today is not what you’ll want tomorrow (and others know it!)
* You need to find a way to lock in your current preferences to solve the problem.
 Easier said than done.
* Firms face a similar problem of having different preferences across time
 They can eliminate the middle man with vertical integration
* Firms that rely heavily on specific assets are more likely to integrate vertically

Question 13

MNCs, where and when?

Answer 13

• MNCs are a “predictable” response to the economic environment in which firms
  operate
• Locational advantages tell us if MNCS are profitable
• Imperfections tell us whether a firm will internalize the production

Question 14

FDI potential economic benefits

Answer 14

1. Transfers savings (capital) between states!!!
    Aids economic growth
2. Technological and managerial experience
    Spillover effects: Advanced technology that can be learned from
3. Integration into global markets
    Opportunity to show “worth” to other firms

Question 15

FDI potential economic costs

Answer 15

1. Can potentially reduce domestic capital
    Sometimes they borrow domestic capital and “crowd out” investment to other firms
    (Over)charge affiliates with licensing fees & royalties for technology, “transfer pricing”
   SECOND. Can drive local firms out of business
    More competitive (better tech and management) than local firms.
2. Technology is often tightly controlled, limiting transfers & integration into global
   markets
3. MNC objectives might clash with domestic economic objectives
    Can undermine industrial policy or other social policy goals

Question 16

MNCs in developing world

Answer 16

After independence from colonialism, many states wanted to establish political &
economic autonomy from former powers
 Through nationalization or expropriation
* They took control of existing foreign investments and managed the terms of new
investments
* Now, many developing countries are again open to foreign direct investment and
actively try to attract it.
* Why give control back to foreign interests?
* The economic benefits are attractive

Question 17

Where does FDI go?

Answer 17

• Advanced industrial countries!
   Both the largest providers and recipients of
  FDI
• FDI to developing world is concentrated
   Largely, in most populous and wealthy
  countries (BRICS)
• FDI has increased to developing world in
  past 30 years.
   Still not as big as theory would predict.

Question 18

Bargaining for FDI

Answer 18

• The state wants the economic benefits
• The MNC wants a profit maximizing environment and limited risk
• State fears: Loss of economic policy control, other negative externalities
• MNCs fear:
   Burdensome regulation
   Expropriation of investments
   Investments are fixed and difficult to remove (i.e. immobile)
   The fixed investment can become a hostage.

Question 19

Democracy and FDI

Answer 19

Some states are better at tying their hands
* Generally, democracies attract more FDI because the costs of expropriation are
greater
* Expropriation buys them little in terms of $$ to provide to a larger group of
supporters
 Those $$ buy a lot more support where the individuals needed to remain in power is
smaller

Question 20

Other types of risk

Answer 20

• Beyond expropriation, firms fear that other policies might eat their profits.
• Policy volatility:
   Regulation changes that make conducting business difficult.
   Environment, labor laws, tax policy
• Transfer risk
   Restriction on ability to convert currency to move profits out of the country.
• Exchange rate risk
   Unstable exchange rates (led by monetary policy) can also eat into profits. We’ll look at this in a few lectures.
• Violence risk
   Civil conflict, terrorism, etc.
   Can make doing business more costly or damage fixed assets.

Question 21

Race to the bottom

Answer 21

• States want to attract FDI and thus offer incentives to firms
• Firms go wherever taxes are lowest, risk is lowest, and regulation is least
  burdensome.
   Environmental standards, labor practices, kickbacks from governments
• Developing states are at a disadvantage b/c of their need for FDI and lack of
  economic diversity
• Countries that want to attract FDI might lower regulation and taxes

Question 22

Climb to the top

Answer 22

Firms don’t only want lower taxes and regulation.
* They also want public goods!
 Infrastructure, educated workforce (human capital)
 These are usually paid for with taxes
* Democracy (remember?) and public good investment may attract FDI
* Also, multinational firms can be subject to pressure to improve “Corporate Social Responsibility”
* FDI then (maybe) pressures governments to grow and incentivizes “better” political regimes and
public good investments.

Question 23

International regulation of MNCs

Answer 23

• No Multilateral Rules or Institutions like those that govern trade.
• Some “legal” norms of behavior but no enforcement mechanism
• Attempts thus far have been unsuccessful, countries’ interests clash:
   Advanced industrialized countries want protections for investors
   Developing countries want rights for host countries

Question 24

Bilateral investment traties (BITs)

Answer 24

In the absence of global rules, states have turned to bilateral treaties to govern int’l
investment
* BITS govern:
 Treatment of foreign investors under the law
 Protection of assets and flow of assets
 Basically, they make sure foreign firms aren’t exploited by host governments
* BITS tend to be highly skewed towards the rights of foreign investors (as opposed to host
countries)

Question 25

Investor-State Dispute Settlement (ISDS)

Answer 25

• Provision included in many trade agreements (such as TPP) and BITS –
  should sound familiar from previous trade lectures
• Allows investors to sue countries for “expropriation” and rulings may
  take precedence over country’s laws
   Traditionally expropriation meant the literal seizing of assets
   Both now often much broader, e.g. expropriation of expected profits through new
  regulations

Question 26

Example global supply chains

Answer 26

• E.g. Milner and Jamal’s 2019 survey in Tunisia finds that workers in
  import-competing sectors that are embedded in Global Supply Chains
  are more supportive of free trade than those not embedded in Global
  Supply Chains

Question 27

Investor state dispute settlement court stuff

Answer 27

• Suit is heard in private court adjudicated by a panel of arbitrators
• Cost of lawsuits might be crippling for poor countries.
• Many suggest the system is being abused and infringes on norms of
  sovereignty, countries have started pulling out/not renewing BITs over it
  (e.g. India, Indonesia, Ecuador, South Africa…)

Question 28

Widespread benefits FDI

Answer 28

• Plus, FDI has widespread benefits
   Leaders will be punished (with poor economic growth) if they deter investment with
  expropriation.
• Democracies have more “veto players” that can constraint policy choices

Question 29

Obsolescing bargain FDI

Answer 29

• Obsolescing bargain:
   Over time, bargaining power shifts towards the governments (b/c fixed investments grow)
• These fears (the time inconsistency problem) make attracting FDI difficult for states
• How can governments tie their hands?

Question 30

States managing FDI and MNC

Answer 30

• States try to manage FDI and MNCs to their advantage
   Prohibited ownership of: utilities, extractive industries and other
  important industries.
   Required some local ownership
   Imposed performance requirements
• Countries varied in how they regulated FDI
   Thus, competition to attract FDI was born

Question 31

Paradox of info, horizontal integration

Answer 31

• Paradox of information:
   The value of the information for the purchaser is not known until she has the
  information… but then she has acquired it without cost
• The owner of the information is unwilling to share info, the purchaser unwilling to buy
• Rather than sell the information, the firm can simply set up shop in a new location